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~~FORM 10-Q MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES INDEX~~

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

~~(Mark One)~~
ý	~~QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934~~
~~For the Quarterly Period Ended September 30, 2004~~
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended March 31, 2005 Or ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Or
o	~~TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934~~
~~For the transition period from to~~

Commission File No. 1-6639

MAGELLAN HEALTH SERVICES, INC.

(Exact name of registrant as specified in its charter)

Delaware		~~Delaware~~58-1076937
(State of other jurisdiction of incorporation or organization)		~~58-1076937~~ (IRS Employer Identification No.)
16 Munson Road Farmington, Connecticut		06032
(Address of principal executive offices)		~~06032~~ (Zip code)

(860) 507-1900

(~~Registrant's~~Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ýx No o¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ox No ýo

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes ýx No o

The number of shares of the ~~registrant's~~registrant’s Ordinary Common Stock and Multi-Vote Common Stock outstanding as of ~~September 30, 2004~~March 31, 2005 was ~~26,883,016~~27,006,056 and ~~8,487,750~~8,505,600 respectively.

MAGELLAN HEALTH SERVICES, INC. ~~AND SUBSIDIARIES~~

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

~~September 30, 2004~~
March 31, 2005
(Unaudited)

NOTE A—General

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of Magellan Health Services, Inc., a Delaware corporation ~~("Magellan"~~(“Magellan”), include the accounts of Magellan, its majority owned subsidiaries, and all variable interest entities ~~("VIEs"~~(“VIEs”) for which Magellan is the primary beneficiary (together with Magellan, the ~~"Company"~~“Company”). The financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the Securities and Exchange ~~Commission's~~Commission’s (the ~~"SEC"~~“SEC”) instructions to Form 10-Q. Accordingly, ~~they~~the financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments considered necessary for a fair presentation, have been included. The results of operations for the three-month period ~~and nine-month period~~ ended ~~September 30, 2004~~March 31, 2005 are not necessarily indicative of the results to be expected for the full year. All intercompany accounts and transactions have been eliminated in consolidation.

These unaudited condensed consolidated financial statements should be read in conjunction with the ~~Company's~~Company’s audited consolidated financial statements for the year ended December 31, ~~2003~~2004 and the notes thereto, which are included in the ~~Company's~~Company’s Annual Report on Form 10-K filed with the SEC on March ~~30, 2004.~~3, 2005.

~~Recent Events~~

On January 5, 2004 (the "Effective Date"), the Company's plan of reorganization (the "Plan") became effective and the Company emerged from bankruptcy. The principal terms of the Plan, including the treatment afforded under the Plan to the holders of the Company's pre-existing indebtedness and other liabilities and equity interests, are summarized in Item 1 of the Company's Annual Report on Form 10-K for the year ended December 31, 2003, previously filed with the SEC. In the discussion herein of periods prior to the Effective Date, references to such pre-existing indebtedness and other securities shall have the meaning set forth therein. The Company, as of December 31, 2003 and subsequently, is referred to herein as the "Reorganized Company" and, in connection with prior periods, is referred to herein as the "Predecessor Company".

Giving effect to the Plan, the Company continued, in its previous organizational form, to conduct its business as previously conducted, with the same assets in all material respects (except for cash to be distributed under the Plan to former creditors of the Company), but the Company was recapitalized. Specifically, Onex Corporation, a Canadian corporation, through an affiliate (together, "Onex"), invested approximately $102.1 million in the equity of Magellan in the form of Multi-Vote Common Stock (the "Onex Investment"), which entitles it to a fifty percent voting interest in all matters that come before Magellan's stockholders, with certain exceptions. Pursuant to the Plan, the Company received additional equity infusions totaling $63.3 million from holders of the Company's Old Subordinated Notes (the "Holders") and other general unsecured creditors (the "Other GUCs"), which elected to purchase common stock in the form of Ordinary Common Stock of the Company in an equity offering. Onex's equity investment included initial capital contributions to the Company pursuant to the Plan of $86.7 million and additional capital contributions of $15.4 million under its commitment to fund the election by creditors to receive cash in lieu of common stock distributions in satisfaction of

their claims (the "Cash-Out Election") by purchasing that amount of shares of Multi-Vote Common Stock equal to the amount of shares of Ordinary Common Stock cashed out by the Holders and the Other GUCs pursuant to the Cash-Out Election. Capital contributions of $146.9 million, net of approximately $3.1 million of issuance costs and excluding funds received from the Cash-Out Election, are reflected as "Stock subscriptions receivable" in the accompanying condensed consolidated balance sheet as of December 31, 2003. Of the funds received by the Company pursuant to the Cash-Out Election, $15.2 million are included in "Other current assets" in the accompanying condensed consolidated balance sheet as of December 31, 2003, with the remaining amount of $0.2 million being recorded by the Company and paid by Onex subsequent to March 31, 2004. All previously existing equity interests in Magellan were cancelled as of the Effective Date.
        Also pursuant to the Plan, the Company entered into a new credit agreement with Deutsche Bank AG (the "Credit Agreement"), issued $233.5 million of Series A Senior Notes and $7.1 million of Series B Senior Notes (together, the "Senior Notes"), renewed its agreement with Aetna, Inc. ("Aetna") to manage the behavioral healthcare of members of Aetna's healthcare programs and issued to Aetna an interest bearing note in the amount of $48.9 million (the "Aetna Note"). The Company's secured bank loans under its old credit agreement, as existing before the Effective Date (the "Old Credit Agreement"), were paid in full, and other then existing indebtedness (i.e., two classes of notes and general unsecured creditor claims) was cancelled as of the Effective Date.
        The discussion above represents a summary of certain transactions which occurred as of and subsequent to the Effective Date pursuant to the Plan. Please refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2003 for a more detailed description of the recapitalization of the Company and other transactions pursuant to the Plan.
~~Accounting Impact of Chapter 11 Filing~~
        In connection with the consummation of the Plan, the Company adopted the fresh start reporting provisions of American Institute of Certified Public Accountants ("AICPA") Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7") with respect to its financial reports, which required the Company to restate its assets and liabilities to their fair values based upon the provisions of the Plan and certain valuations which the Company made in connection with the implementation of the Plan. The Company applied the fresh start reporting provisions as of December 31, 2003. Upon adoption of fresh start reporting, the Company created, in substance, per SOP 90-7, a new reporting entity, which is referred to herein as the "Reorganized Company". Accordingly, the unaudited condensed consolidated statements of operations for the three months and nine months ended September 30, 2004 and statement of cash flows for the nine months ended September 30, 2004 are not comparable with the unaudited condensed consolidated statements of operations for the three months and nine months ended September 30, 2003 and statement of cash flows for the nine months ended September 30, 2003. Therefore, all statements of operations data for the three months and nine months ended September 30, 2004 and statement of cash flows data for the nine months ended September 30, 2004 have been disclosed herein as results of operations and cash flows of the Reorganized Company, and all statements of operations data for the three months and nine months ended September 30, 2003 and statement of cash flows data for the nine months ended September 30, 2003 have been disclosed herein as results of operations and cash flows of the Predecessor Company. Balance sheet data as of December 31, 2003 and September 30, 2004 presented herein represents balances of the Reorganized Company. All references to the Company with respect to disclosures of amounts recorded for the three months and nine months ended September 30, 2003 in relation to income statement items and recorded for the nine months ended September 30, 2003 in relation to cash flow items pertain to the Predecessor Company. All references to the Company with respect to disclosures of amounts recorded for the three months and nine months ended September 30, 2004 or to be recorded subsequent to September 30, 2004 in relation to income statement items and

~~recorded for the nine months ended September 30, 2004 or recorded subsequent to September 30, 2004 in relation to cash flow items pertain to the Reorganized Company.~~
        The unaudited condensed consolidated statements of operations for the three months and nine months ended September 30, 2003 and statement of cash flows for the nine months ended September 30, 2003 in this Form 10-Q were prepared in accordance with SOP 90-7, as the Predecessor Company was under bankruptcy protection during those periods. As such, the Predecessor Company's unaudited condensed consolidated statements of operations for the three months and nine months ended September 30, 2003 and statement of cash flows for the nine months ended September 30, 2003 distinguished transactions and events that were directly associated with the reorganization from the Predecessor Company's ongoing operations. In accordance with SOP 90-7, the write-off of deferred financing fees associated with the Old Senior Notes and the Old Subordinated Notes, as well as certain professional fees and expenses and other amounts directly associated with the bankruptcy process, were recorded as reorganization expenses, and are included in the unaudited condensed consolidated statement of operations caption "Reorganization expense, net" for the three months and nine months ended September 30, 2003.
        ~~The following table summarizes reorganization expense (benefit) for the three months and nine months ended September 30, 2003 (in thousands):~~

Predecessor Company

Three Months Ended
September 30, 2003
Nine Months Ended
September 30, 2003

Continuing operations:
Deferred financing costs $ — $ 18,459
Professional fees and expenses 7,112 17,019
Net benefit from lease rejections (331 ) (599 )
Net benefit from resolution of claims through Bankruptcy Court proceedings (1,920 ) (1,920 )
Interest income (321 ) (714 )

$ 4,540 $ 32,245

Discontinued operations, before taxes:
Net benefit from lease rejections (259 ) (3,426 )
Net benefit from resolution of claims through Bankruptcy Court proceeding (29 ) (29 )

$ (288 ) $ (3,455 )

        In accordance with SOP 90-7, the Predecessor Company's redeemable preferred stock was recorded at the amount expected to be allowed as a claim by the Bankruptcy Court. Accordingly, during the three months ended March 31, 2003, the Predecessor Company recorded a net $2.7 million adjustment, which was mainly composed of the write-off of unamortized issuance costs related to the redeemable preferred stock. Such amount is reflected in "Preferred stock reorganization items, net" in the accompanying unaudited condensed consolidated statements of operations for the nine months ended September 30, 2003.

~~NOTE B—~~Summary of Significant Accounting Policies
~~Review of Significant Accounting Policies~~
        The Reorganized Company has adopted the same accounting policies as the Predecessor Company with the exception of the date on which the Reorganized Company intends to perform its annual goodwill impairment test (see "Goodwill" below).
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Significant estimates of the Company include, among other things, accounts receivable realization, valuation allowances for deferred tax assets, valuation of goodwill and ~~other~~ intangible assets, medical claims payable and legal liabilities. Actual results could differ from those estimates.
Managed Care Revenue
Managed care revenue is recognized over the applicable coverage period on a per member basis for covered members. Managed care risk revenue earned by the ~~Predecessor~~ Company for the three months ended March 31, 2004 and ~~nine months ended September 30, 2003~~2005 approximated ~~$325.3~~$386.3 million and ~~$1,008.4 million, respectively. Managed care risk revenue earned by the Reorganized Company for the three months and nine months ended September 30, 2004 approximated $402.8 million and $1,185.8~~$402.3 million, respectively.
Performance-based Revenue
The Company has the ability to earn performance-based revenue ~~primarily~~ under certain risk and non-risk contracts. Performance-based revenue generally is based on either the ability of the Company to manage care for its ~~administrative services only ("ASO")~~ clients below specified ~~cost targets.~~targets, or on other operating metrics. For each such contract, the Company estimates and records performance-based revenue after considering the relevant contractual

terms and the data available for the performance-based revenue calculation. Pro-rata performance-based revenue is recognized on an interim basis pursuant to the rights and obligations of each party upon termination of the contracts. The ~~Predecessor~~ Company recognized performance-based revenue of approximately ~~$1.3~~$0.9 million and ~~$5.6~~$2.7 million for the three months ended March 31, 2004 and nine months ended September 30, 2003, respectively. The Reorganized Company recognized performance-based revenue of approximately $1.9 million and $5.6 million for the three months and nine months ended September 30, 2004,2005, respectively.
Significant Customers
        ~~Net~~The Company’s contracts with Aetna, Inc. (“Aetna”) and the State of Tennessee’s TennCare program (“TennCare”) each generated revenues ~~from two customers each~~that exceeded ten percent of consolidated net revenues in ~~each of~~ the three-month ~~and nine-month~~ periods ended ~~September 30, 2003~~March 31, 2004 and ~~2004.~~2005. The Company is party to several contracts with entities that are now controlled by WellPoint, Inc. (“WellPoint”), that represent a significant concentration of business for the Company. In addition, the Company has a significant concentration of business from individual customers which are part of the Pennsylvania Medicaid program.
        ~~Net revenue~~Revenue from the Aetna ~~earned by the Predecessor Company approximated $48.1~~contract was $55.8 million and ~~$144.8~~$62.0 million for the ~~three months~~three-month periods ended March 31, 2004 and ~~nine months ended September 30, 2003,~~2005, respectively. ~~Net revenue from~~On December 8, 2004, the Company was informed that Aetna ~~earned by the Reorganized Company approximated $58.4 and $170.4 million for the three months and nine months ended September 30, 2004, respectively. The current Aetna~~would not renew such contract ~~extends through~~as of December 31, 2005, and ~~includes an~~that Aetna planned to exercise its option ~~for Aetna at that time to either extend the agreement or~~ to purchase, on December 31, 2005, certain assets of the Company used ~~solely~~ in the management of ~~the~~ behavioral ~~healthcare of Aetna~~health care services for Aetna’s members (the ~~"Aetna-Dedicated Assets"~~“Aetna Assets”). On February 23, 2005, the Company and Aetna executed an asset purchase agreement related to Aetna’s purchase of the Aetna Assets. The purchase price for the Aetna Assets is based on certain variable factors and the Company estimates that the price will be $50 million to $55 million.
The Company provides managed behavioral healthcare services ~~to the State of Tennessee's~~for TennCare, ~~program,~~ both through ~~direct~~ contracts held by the ~~Company's~~Company’s wholly owned subsidiary

Tennessee Behavioral Health, Inc. ~~("TBH"~~(“TBH”) and through a contract held by Premier Behavioral Systems of Tennessee, LLC ~~("Premier"~~(“Premier”), a joint venture in which the Company owns a fifty percent interest. ~~The direct TennCare~~In addition, the Company contracts ~~(exclusive of Premier's contract~~ with ~~TennCare) accounted for approximately $35.9 million and $121.0 million of~~Premier to provide certain services to the Predecessor Company's net revenues in the three months and nine months ended September 30, 2003, respectively. Such revenue included approximately $5.4 million and $34.4 million for the three and nine months ended September 30, 2003, respectively, associated with services performed by the Predecessor Company on behalf of Premier. The direct TennCare contracts accounted for approximately $55.4 million and $120.1 million of the Reorganized Company's net revenues in the three months and nine months ended September 30, 2004, respectively.joint venture. The Company no longer performs certain services on behalf of Premier due to a program change. In the three months and nine months ended September 30, 2004, the Reorganized Company recorded approximately $52.0 million and $200.0 million, respectively, in net revenues related to Premier's contract with TennCare, which represents 100 percent of Premier's net revenue derived from such contract, due to the adoption of FIN 46 (see "Recent Accounting Pronouncements" below) pursuant to whichconsolidates the results of operations of Premier, ~~were~~including revenue and cost of care, in the Company’s consolidated ~~with~~statement of income. The Company recorded $103.7 million and $113.2 million of revenue from its TennCare contracts during the ~~Reorganized Company's results of operations. In the three months~~three-month periods ended March 31, 2004 and ~~nine months ended September 30, 2003, the results of operations of Premier were accounted for by the Predecessor Company under the equity method of accounting.~~2005, respectively.
In September 2003, the State of Tennessee ~~issued a request for proposal ("RFP") relating to~~divided the TennCare program ~~under which the program would be divided~~ into three regions. The ~~Company, through TBH, submitted a proposal~~Company’s contract for the East region ~~only and was awarded the contract, which~~ has a term ~~from July 1, 2004~~ through December 31, 2005, with extensions at the ~~State's~~State’s option through December 31, 2008. ~~When contract negotiations between the State and the vendor that had been awarded the~~The Company’s contracts for the Middle and West regions ~~were discontinued, the State asked TBH and Premier to continue with their current contracts for those regions~~have terms through December 31, ~~2004. Effective~~2005.
The Governor of Tennessee has stated that, because of the increased costs of the TennCare program, the State will cease providing coverage for up to approximately 323,000 adults (which represents approximately one-fourth of total TennCare membership) who do not qualify for Medicaid, and may limit benefits to be delivered under the TennCare program. Certain advocacy groups had filed suits in attempts to prevent the Governor from implementing any reductions in membership and benefits; however, such suits have since been dismissed. Representatives of the State of Tennessee have publicly indicated that they intend to phase-in the membership reductions as early as July 1, 2005. A reduction in membership would, and benefit changes could, adversely affect the Company’s revenues and profitability. The Company does not yet know which members would be eliminated from the program, and because capitation rates for TennCare members vary depending upon the level of benefits received by such members, the Company cannot estimate the impact of the proposed membership reductions. Further, the Company does not yet know the actual timing of the phased-in membership reductions, the benefit changes being proposed or the timing of those changes, and as such, the Company cannot estimate the impact of these potential developments at this time.

Total revenue from the various contracts with entities that are now controlled by WellPoint totaled $31.4 million and $33.9 million during the three-month periods ended March 31, 2004 ~~agreements with~~and 2005, respectively. One such contract, which generated revenue of $24.4 million during the ~~State were reached, under which TBH and Premier will continue serving the Middle and West regions of TennCare~~three-month period ended March 31, 2005, extends through December 31, 2005. ~~As a result~~A second contract with an entity controlled by WellPoint, which generated revenue of ~~these agreements,~~$6.7 million for the three-month period ended March 31, 2005, extends through September 30, 2005, and the Company ~~will continue~~has recently been notified by the customer that it does not intend to ~~manage behavioral health care for the entire TennCare program.~~renew this contract beyond such date. The other WellPoint-related contracts have terms ranging from June 30, 2006 through December 31, 2007.
        AThe Company derives a significant portion of its revenue ~~is derived~~ from contracts with various counties in the ~~State~~state of Pennsylvania (the ~~"Pennsylvania Counties"~~“Pennsylvania Counties”). Although these are separate contracts with individual counties, they all pertain to the Pennsylvania Medicaid program. Revenues ~~earned by the Predecessor Company~~ from the Pennsylvania Counties in the aggregate totaled ~~approximately $60.0~~$43.9 million and ~~$175.7~~$51.5 million in the ~~three months~~three-month periods ended March 31, 2004 and ~~nine months ended September 30, 2003,~~2005, respectively. ~~Revenues earned by~~
Restricted Assets
The Company has certain assets which are considered restricted for: (i) the ~~Reorganized Company from~~payment of claims under the ~~Pennsylvania Counties~~terms of certain managed behavioral care contracts; (ii) regulatory purposes related to the payment of claims in certain jurisdictions; and (iii) the ~~aggregate totaled approximately $48.1 million and $139.3 million in the three months and nine months ended September 30, 2004, respectively. The contract with one~~maintenance of minimum required tangible net equity levels for certain of the ~~counties was terminated~~Company’s subsidiaries. Significant restricted assets of the Company as of December 31, ~~2003. Revenue~~2004 and March 31, 2005 were as follows (in thousands):

December 31,
2004

March 31,
2005

Restricted cash

$
104,414

$
116,328

Restricted short-term investments

35,600

31,554

Restricted deposits (included in other current assets)

17,098

18,231

Restricted long-term investments

592

3,255

Total

$
157,704

$
169,368

Investments
Investments consist primarily of U.S. Government and agency securities, corporate debt securities, and certificates of deposit. The Company accounts for its investments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”). Prior to fiscal 2004, the Company classified its investments as “held to maturity,” and reclassified its investments as “available-for-sale” during fiscal 2004. Investments classified as available-for-sale are carried at fair value, based on quoted market prices. The Company’s policy is to classify all investments with contractual maturities within one year as current. Investment income is recognized when earned and reported net of investment expenses. Unrealized holding gains and losses are excluded from earnings and are reported, net of tax, as “accumulated other comprehensive loss” in the accompanying condensed consolidated balance sheets until realized, unless the losses are deemed to be other-than-temporary. Realized gains or losses, including any provision for other-than-temporary declines in value, are included in the accompanying condensed consolidated statements of income.
The Company periodically evaluates whether any declines in the fair value of investments are other-than-temporary. This evaluation consists of a review of several factors, including but not limited to: the length of time and extent that a security has been in an unrealized loss position; the existence of an event that would impair the issuer’s future earnings potential; the near-term prospects for recovery of the market value of a security; and the intent and ability of the Company to hold the security until the market value recovers. Declines in value below cost for investments are not assumed to be other-than-temporary

where it is considered probable that: (i) all contractual terms of the investment will be satisfied, (ii) the decline is due primarily to changes in interest rates (and not because of increased credit risk), and (iii) where the Company intends and has the ability to hold the investment for a period of time sufficient to allow a market recovery. In accordance with Emerging Issues Task Force (“EITF”) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” (“EITF 03-1”), the Company periodically reviews those investment securities for which unrealized losses have remained unrealized for more than six months to determine if such unrealized losses are other-than-temporary. Unrealized losses related to ~~this particular county earned by~~investments greater and less than one year are not material.
As of March 31, 2005, there were no unrealized losses that the ~~Predecessor~~ Company ~~totaled approximately $7.1 million and $20.7 million in~~believed to be other-than-temporary. No realized gains or losses were recorded for the three months ended March 31, 2004 and ~~nine months ended September 30, 2003, respectively. Changes in fiscal 2003 in several~~2005. The following is a summary of short-term and long-term investments at December 31, 2004 (in thousands):

Amortized
Cost

Gross
Unrealized
Gains

Gross
Unrealized
Losses

Estimated
Fair Value

U.S. Government and agency securities

$
220,091

$
—

$
(474
)

$
219,617

Corporate debt securities

126,376

—

(370
)

126,006

Certificates of deposit

467

—

—

467

Total investments at December 31, 2004

$
346,934

$
—

$
(844
)

$
346,090

The following is a summary of short-term and long-term investments at March 31, 2005 (in thousands):

Amortized
Cost

Gross
Unrealized
Gains

Gross
Unrealized
Losses

Estimated
Fair Value

U.S. Government and agency securities

$
198,067

$
—

$
(600
)

$
197,467

Corporate debt securities

189,462

—

(836
)

188,626

Certificates of deposit

432

—

—

432

Total investments at March 31, 2005

$
387,961

$
—

$
(1,436
)

$
386,525

The maturity dates of the ~~individual contracts for certain~~Company’s investments as of ~~the Pennsylvania Counties have resulted in lower revenue, cost of care and direct service costs, with no impact to the net profitability of the contracts.~~March 31, 2005 are summarized below (in thousands):

Amortized
Cost

Estimated
Fair Value

Due in 2005

$
312,322

$
311,621

Due in 2006

75,639

74,904

Total investments at March 31, 2005

$
387,961

$
386,525

Property and Equipment
Property and equipment ~~acquired subsequent to December 31, 2003~~ is stated at ~~cost. Property and equipment owned at December 31, 2003 was adjusted~~cost, except for assets that have been impaired, for which the carrying amount has been reduced to ~~its then~~estimated fair ~~value as part of the Company's application of fresh start reporting.~~value. Expenditures for renewals and improvements are capitalized to the property accounts. Replacements and maintenance and repairs that do not improve or extend the life of the respective assets are expensed as incurred. Internal-use software is capitalized in accordance with

~~AICPA~~ American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 98-1, ~~"Accounting~~“Accounting for Cost of Computer Software Developed or Obtained for Internal ~~Use".~~Use.” Amortization of capital lease assets is included in depreciation ~~expense.~~expense and is included in accumulated depreciation. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets, which is generally two to ten years for buildings and improvements, three to ten years for equipment and

three to five years for capitalized internal-use software. Depreciation expense ~~recorded by the Predecessor Company~~for continuing operations was $6.8 million and $7.7 million for the ~~three months~~three-month periods ended March 31, 2004 and nine months ended September 30, 2003 was $7.1 million and $23.1 million, respectively. Depreciation expense recorded by the Reorganized Company for the three months and nine months ended September 30, 2004 was $7.3 million and $21.1 million,2005, respectively.
Goodwill
Goodwill was recorded ~~by the Reorganized Company~~ at December 31, 2003 for the amount of reorganization value in excess of amounts allocated to tangible and identified intangible assets resulting from the application of the fresh start reporting provisions of AICPA Statement of Position 90-7, “Financial Reporting by Entities in Reorganization under the Bankruptcy Code” (“SOP ~~90-7.~~90-7”) (See Note B—“Emergence from Chapter 11” for a discussion of the Company’s bankruptcy proceedings). Goodwill is accounted for in accordance with ~~Statement of Financial Accounting Standards ("SFAS")~~SFAS No. 142, ~~"Goodwill~~“Goodwill and Other Intangible ~~Assets" ("~~Assets” (“SFAS ~~142"~~142”). ~~Under~~Pursuant to SFAS 142, ~~the Company no longer amortizes goodwill; instead,~~ the Company is required to test ~~the~~its goodwill for impairment ~~based upon fair values~~on at least on an annual ~~basis, or more frequently should there be indicators that~~basis.
The changes in the carrying amount of goodwill ~~may be impaired. The Reorganized~~for the three months ended March 31, 2005 are reflected in the table below (in thousands):
Balance as of December 31, 2004

$
392,267

Adjustment to goodwill as a result of the projected realization of net operating loss carryforwards subsequent to fresh-start reporting(1)

(15,104
)
Balance as of March 31, 2005

$
377,163

(1)          During fiscal 2005, the Company utilized a tax benefit from the utilization of pre-bankruptcy net operating loss carryforwards (“NOLs”). This tax benefit has ~~selected October 1~~been reflected as a reduction of goodwill rather than as a reduction to the ~~date~~provision for income taxes in the consolidated statements of ~~its annual impairment test, as opposed to September 1, which was the date used by the Predecessor Company.~~income, in accordance with SOP 90-7.
Intangible Assets
        ~~Intangible assets were valued, and related estimated useful lives were determined, based upon independent appraisals at~~At December 31, ~~2003 as a result of the application of fresh start reporting. At September 30,~~ 2004 and March 31, 2005, the Company had identifiable intangible assets (primarily customer agreements and lists and provider networks) of approximately ~~$47.7~~$44.3 million and $40.8 million, respectively, net of accumulated amortization of approximately ~~$10.4 million. The remaining~~$13.8 million and $17.3 million, respectively. Intangible assets are amortized over their estimated useful lives, ~~of the customer agreements and lists and provider networks~~which range from approximately two to eighteen years. Amortization expense recorded by the ~~Predecessor~~ Company for ~~the intangible assets~~each of ~~the Predecessor Company for~~ the three months ended March 31, 2004 and ~~nine months ended September 30, 2003~~2005 was $4.5 million and $13.2 million, respectively. Amortization expense recorded by the Reorganized Company for the three months and nine months ended September 30, 2004 was $3.4 million and $10.4 million, respectively.$3.5 million.
Long-lived Assets
Long-lived assets, including property and equipment and intangible assets to be held and used, are currently reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount should be addressed pursuant to SFAS No. 144, ~~"Accounting~~“Accounting for the Impairment or Disposal of Long-Lived ~~Assets"~~Assets” (“SFAS 144”). Pursuant to this guidance, impairment is determined by comparing the carrying value of these long-lived assets to ~~management's~~management’s best estimate of the future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. The cash flow projections used to make this assessment are consistent with the cash flow projections that management uses internally ~~to assist~~ in making key decisions. In the event an impairment exists, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the asset, which is generally determined by using quoted market prices or the discounted present value of expected future cash flows.

Cost of Care and Medical Claims Payable
Cost of care ~~recorded as a component of operating expenses,~~ is recognized in the period in which members received behavioral health services. In addition to actual benefits paid, cost of care includes the impact of accruals for estimates of medical claims payable.

Medical claims payable represents the liability for healthcare claims reported but not yet paid and claims incurred but not yet reported ~~("IBNR"~~(“IBNR”). related to the Company’s managed healthcare businesses. The IBNR portion of medical claims payable is estimated based on past claims payment experience for member groups, enrollment data, utilization statistics, authorized healthcare services and other factors. This data is incorporated into contract-specific actuarial reserve models. ~~The~~Although considerable variability is inherent in such estimates, for submitted claims and IBNR claims are made on an accrual basis and adjusted in future periods as required. However, changes in assumptions for medical costs caused by changes in actual experience (such as changes inmanagement believes the delivery system, changes in utilization patterns, unforeseen fluctuations in claims backlogs, etc.) may ultimately prove these estimates inaccurate. As of September 30, 2004, the Reorganized Company believes that itsliability for medical claims payable ~~balance of $200.9 million~~ is ~~adequate in order to satisfy ultimate claim liabilities incurred through September 30, 2004.~~adequate. Medical claims payable balances are continually monitored and reviewed. Changes in assumptions for cost of care caused by changes in actual experience could cause these estimates to change in the near term. The Company believes that the amount of medical claims payable is adequate to cover its ultimate liability for unpaid claims as of March 31, 2005; however, actual claims payments and other items may differ from established estimates.
Income Taxes
The Company files a consolidated federal income tax return for the Company and its ~~eighty percent~~eighty-percent or more owned consolidated subsidiaries. The Company accounts for income taxes in accordance with SFAS No. 109, ~~"Accounting~~“Accounting for Income Taxes". Deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled.Taxes.” The ~~effect of a change in tax rates on deferred~~Company records taxes ~~is recognized in income in the period that includes the enactment date. Valuation allowances on deferred tax assets are estimated~~ based on ~~the Company's assessment of the realizability of such amounts. Deferred tax assets were fully reserved at December 31, 2003 and September 30, 2004, accordingly the Company's~~its estimated current taxable income ~~tax provision for fiscal 2004 does not include a deferred tax component.~~
        The Predecessor Company's effective income tax rate was (310.9) percent for the nine months ended September 30, 2003 and was 29.6 percent for the Reorganized Company for the nine months ended September 30, 2004. The Reorganized Company's effective income tax rate for the nine months ended September 30, 2004 varies from federal statutory rates primarily due to certain transactions which occurred pursuant to the Plan, as consummated on the Effective Date, which reduced taxable income. The Predecessor Company's effective income tax rate for the nine months ended September 30, 2003 varies substantially from federal statutory rates primarily due to the ~~impact of non-deductible goodwill included in the goodwill impairment charge and the estimated utilization of net operating loss carryforwards ("NOLs") that existed prior~~uncertainty as to the ~~Company's emergence from bankruptcy in 1992. Under SOP 90-7, the~~Company’s ability to realize deferred tax benefit related to the realization of these pre-bankruptcy NOLs is not reflected in the consolidated statements of operations. The income tax provision for the nine months ended September 30, 2003 also reflects certain changes in estimates regarding the Company's anticipated utilization of pre-bankruptcy NOLs due to amendments of prior year tax returns. Because the utilization of such pre-bankruptcy NOLs is subject to continued review and adjustment by the Internal Revenue Service, utilization of these NOLs is fully reserved.assets. In accordance with SOP 90-7, subsequent (post-bankruptcy) utilization by the ~~Reorganized~~ Company of NOLs which existed at January 5, 2004 will be accounted for as reductions to goodwill ~~or additional paid-in capital~~ and therefore, will only benefit cash flows due to reduced tax payments and will not benefit the ~~Company's~~Company’s tax provision for income ~~taxes in the statements of operations.~~taxes.
The Company’s effective income tax rate was 21.5 percent for the three months ended March 31, 2004, and was 41.9 percent for the three months ended March 31, 2005. The current year effective rate varies from federal statutory rates primarily due to the inclusion of state taxes on current year income. The prior year effective rate varies substantially from federal statutory rates primarily due to certain transactions which occurred pursuant to the Plan (as defined below), as consummated on the Effective Date (as defined below), which reduced taxable income for 2004 but reduced book income in 2003 under SOP 90-7.
Stock-Based Compensation
Under SFAS No. 123, ~~"Accounting~~“Accounting for Stock-Based ~~Compensation" ("~~Compensation” (“SFAS ~~123"~~123”), which established financial accounting and reporting standards for stock-based compensation plans, entities are allowed to measure compensation cost for stock-based compensation under SFAS 123 or

Accounting Principles Board ~~("APB"~~(“APB”) Opinion No. 25, ~~"Accounting~~“Accounting for Stock Issued to ~~Employees"~~Employees” (“APB 25”). Entities electing to continue accounting for stock-based compensation under the provisions of APB 25 are required to make pro forma disclosures of net income and income per share as if the provisions of SFAS 123 had been applied. ~~The Company has adopted SFAS 123 on a pro forma disclosure basis.~~
The Company measures compensation cost for stock-based compensation under APB 25, and discloses stock-based compensation under the requirements of SFAS 123 and SFAS No. 148, ~~"Accounting~~“Accounting for Stock-Based Compensation, Transition and ~~Disclosure"~~Disclosure”(“SFAS 148”). At ~~September 30,~~December 31, 2004 and March 31, 2005, the Company had stock-based employee incentive plans, which are described more fully in Note 8 in the ~~Company's~~Company’s Annual Report on Form 10-K for the year ended December 31, ~~2003.~~2004. Under APB 25, the ~~Reorganized~~ Company recorded stock compensation expense of ~~$2.6~~$10.8 million and ~~$15.9~~$3.8 million, before taxes, in the three months ended March 31, 2004 and ~~nine months ended September 30, 2004,~~2005, respectively. ~~These charges represent compensation expense related to the following:~~
•
approximately 4.2 million stock options (net of forfeitures) granted during the nine months ended September 30, 2004 to the Company's Chief Executive Officer, Chief Operating Officer and Chief Financial Officer (the "Senior Executives") and other management pursuant to the Company's Management Incentive Plan (the "MIP");
11

The following table illustrates pro forma net income and pro forma net income per share as if the fair value-based method of accounting for stock options had been applied in measuring compensation cost for stock-based awards (in thousands, except per share data):

	Predecessor Company			Reorganized Company			Predecessor Company			Reorganized Company			Three Months Ended March 31,
	Three Months Ended September 30, 2003			Three Months Ended September 30, 2004			Nine Months Ended September 30, 2003			Nine Months Ended September 30, 2004			2004			2005
Net income (loss), as reported	$	(50,215	)	$	26,556		$	(48,178	)	$	67,918
Net income, as reported													$	12,938		$	23,616
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		—			1,547			—			4,641	(1)	1,569		(1)	2,145		(1)
Deduct: Total stock-based employee compensation expense determined under fair value method, net of related tax effects		(265	)		(1,926	)		(794	)		(5,891	)	(2,020		)	(2,881		)

Pro forma net income (loss)	$	(50,480	)	$	26,177		$	(48,972	)	$	66,668

Income (loss) per common share:
Pro forma net income													$	12,487		$	22,880
Income per common share:
Basic—as reported	$	(1.42	)	$	0.75		$	(1.47	)	$	1.92		$	0.37		$	0.67

Basic—pro forma	$	(1.43	)	$	0.74		$	(1.49	)	$	1.89		$	0.35		$	0.65

Diluted—as reported	$	(1.42	)	$	0.73		$	(1.47	)	$	1.87		$	0.35		$	0.64

Diluted—pro forma	$	(1.43	)	$	0.72		$	(1.49	)	$	1.84		$	0.34		$	0.62

(1)

Represents stock-based compensation expense related to ~~approximately 4.2 million~~ stock options granted to ~~the Senior Executives and other~~ management pursuant to the ~~MIP,~~2003 Management Incentive Plan (“MIP”), net of related income taxes.

Recent Accounting Pronouncements

InThe Company currently measures compensation cost for stock-based compensation under APB 25, and discloses pro forma stock-based compensation under the requirements of SFAS 123 and SFAS 148. Currently, the Company uses the Black-Scholes-Merton formula to estimate the value of stock options granted to employees and expects to continue to use this acceptable option valuation model upon the required January ~~2003, the FASB issued Interpretation No. 46, "Consolidation~~1, 2006 adoption of ~~Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51" ("FIN 46"~~Statement 123 (revised 2004) “Share-Based Payment” (“SFAS 123R”). ~~FIN 46~~Since SFAS 123R must be applied not only to new awards but also to previously granted awards that are not fully vested on the effective date, compensation cost for some previously granted awards that were not recognized under SFAS 123 will be recognized under SFAS 123R. However, had SFAS 123R been adopted in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per share above entitled “Stock-Based Compensation.” SFAS 123R also requires ~~consolidation~~the benefits of ~~entities~~tax credits in ~~which an enterprise absorbs a majority~~excess of ~~the entity's expected losses, receives a majority of the entity's expected residual returns, or both,~~recognized compensation cost to be reported as a ~~result of ownership, contractual or other financial interests~~financing cash flow, rather than as an operating cash flow as permitted under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the ~~entity. The Reorganized Company adopted~~future (because they depend on, among other things, when employees exercise stock options), the ~~provisions~~amount of FIN 46 effective December 31, 2003. Adoption of new accounting pronouncements is required by companies implementing the fresh start reporting provisions of SOP 90-7. Based on the guidance of FIN 46, the Reorganized Company has determined that it is the primary beneficiary of Premier, a variable interest entityoperating cash flows recognized in prior periods for which the Reorganized Company maintains a fifty percent voting interest. Consistent with the provisions of FIN 46, the Reorganized Company has consolidated the balance sheets of Premier into the Reorganized Company's balance sheets as of December 31, 2003 and September 30, 2004. Through December 31, 2003, the Predecessor Company accounted for Premier under the equity method, whereby the Predecessor Company included its portion of Premier's earnings or loss in its consolidated statement of operations under the caption "Equity in (earnings) loss of unconsolidated subsidiaries". The consolidation of Premier at December 31, 2003 increased total assets and total liabilities each by $43.2 million. The fair value of the accounts consolidated was equivalent to their book value at December 31, 2003. In the three months and nine months ended September 30, 2004, the Reorganized Company consolidated the results of operations of Premier in its consolidated statements of operations. The effect of this consolidation was to increase net revenue by approximately $52.0 million and $200.0 million in the three months and nine months ended September 30, 2004, respectively. The consolidation of Premier did not affect the Company's profitability.

~~Reclassifications~~such excess tax deductions were immaterial.

Reclassifications

Certain amounts previously reported for the three months ~~and nine months~~ ended ~~September 30, 2003~~March 31, 2004 have been reclassified to conform to the presentation of amounts reported for the three months ended March 31, 2005.

NOTE B—Emergence From Chapter 11

On January 5, 2004 (the “Effective Date”), Magellan and ~~nine months ended September 30, 2004.~~88 of its subsidiaries consummated their Third Joint Amended Plan of Reorganization, as modified and confirmed (the “Plan”), under chapter 11 of title 11 of the United States Bankruptcy Code (the “Bankruptcy Code”), which was confirmed by order of the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”) on October 8, 2003, and accordingly the Plan became fully effective and the companies emerged from the protection of their chapter 11 proceedings. A final decree closing their chapter 11 cases was entered by the Bankruptcy Court on January 19, 2005.

All distributions required by the Plan were made as of the Effective Date except for distributions related to disputed claims for certain general unsecured creditor claims (“Other GUCs”), for which distributions were made subsequent to the Effective Date periodically as such disputed claims were settled. As of April 22, 2005, the total amount of outstanding, disputed claims for Other GUCs is $4.0 million (“Disputed Claims”). The Company does not believe that it is probable that any liability for the Disputed Claims will be incurred, and thus no liability has been recorded for the Disputed Claims as of March 31, 2005. Nonetheless, the Company has withheld from distribution 93,128 shares of Ordinary Common Stock which will be distributed in accordance with the terms of the Plan upon the final resolution of the Disputed Claims. If the Disputed Claims were to be settled for the full amount of $4.0 million, then the amount of additional consideration that the Company would be required to issue to the individual claimants that filed the Disputed Claims is cash of $0.2 million and 9.375% Series B Notes due 2008 (“Series B Notes”) of $1.0 million.

NOTE C—Supplemental Cash Flow Information

Below is supplemental cash flow information related to the ~~nine~~three months ended ~~September 30, 2003~~March 31, 2004 and ~~2004~~2005 (in thousands):

	Predecessor Company			Reorganized Company		Three Months Ended March 31,
	Nine Months Ended September 30, 2003			Nine Months Ended September 30, 2004		2004			2005
Income taxes paid (refunds received)	$	(737	)	$	4,463

Income taxes paid							$	1,997		$	691
Interest paid	$	12,033		$	17,361		$	2,181		$	2,749

Assets acquired through capital leases	$	—		$	1,858		$	590		$	—

NOTE D—Long-Term Debt and Capital Lease Obligations

Information with regard to the ~~Company's~~Company’s long-term debt and capital lease obligations at December 31, ~~2003~~2004 and ~~September 30, 2004~~March 31, 2005 is as follows (in thousands):

		December 31, 2003			September 30, 2004
Old Credit Agreement:
	Old Revolving Facility (6.50% at December 31, 2003)	$	45,076		$	—
	Old Term Loan Facility (7.25% to 7.50% at December 31, 2003)		115,762			—		December 31, 2004				March 31, 2005
Credit Agreement:	Credit Agreement:
	Revolving Facility (5.38% at September 30, 2004) due through 2008		—			—
	Term Loan Facility (5.38% at September 30, 2004) due through 2008		—			88,750
Revolving Facility due through 2008									$	—		$	—
Term Loan Facility (5.26% at March 31, 2005) due through 2008									85,000			79,375
9.375% Series A Senior Notes due 2008	9.375% Series A Senior Notes due 2008		250,000			233,456			233,456			233,456
9.375% Series B Senior Notes due 2008	9.375% Series B Senior Notes due 2008		6,890			7,116			7,116			7,181
Note payable to Aetna (8.00% at September 30, 2004)			63,915			48,915
4.5625% to 4.875% capital lease obligations due through 2008			12,056			5,614
Note payable to Aetna (9.00% at March 31, 2005) due through 2005									48,915			48,915
4.562% to 4.875% capital lease obligations due through 2009									4,991			3,203
									379,478			372,130
			493,699			383,851
Less debt paid upon consummation of the Plan			(92,382	)		—
Less current maturities of long-term debt and capital lease obligations	Less current maturities of long-term debt and capital lease obligations		(24,785	)		(23,543	)		(75,158		)	(74,170		)
									$	304,320		$	297,960
		$	376,532		$	360,308

~~Credit Agreement~~

On the Effective Date, the Company repaid amounts outstanding under the Old Credit Agreement totaling $160.8 million utilizing proceeds from the Credit Agreement and the additional capital provided by the Onex Investment, as contemplated by the Plan. Amounts repaid on the Effective Date under the Old Credit Agreement in excess of amounts advanced under the Credit Agreement were classified as "Debt paid upon consummation of the Plan" in the accompanying condensed consolidated balance sheet as of December 31, 2003.

The Credit Agreement provides for a Term Loan Facility in an original aggregate principal amount of $100.0 million, a Revolving Loan Facility providing for loans of up to $50.0 million and a Credit-Linked Facility for the issuance of letters of credit for the account of the Company in an original aggregate principal amount of $80.0 million. As of September 30, 2004, the Credit-Linked Facility was reduced to $50.0 million. Borrowings under the Credit Agreement will mature on August 15, 2008 and certain quarterly principal payments on the Term Loan Facility are also required. As of September 30, 2004, the Company had outstanding approximately $88.8 million under the Term Loan Facility. On the Effective Date, the Company incurred deferred financing fees of approximately $7.4 million related to the Credit Agreement. The Company has not drawn on the Revolving Loan Facility, resulting in unutilized commitments of $50.0 million. As of September 30, 2004, the Company had issued letters of credit in the amount of $45.1 million, resulting in unutilized commitments under the Credit-Linked Facility of $4.9 million. The Credit Agreement is guaranteed by substantially all of the subsidiaries of the Company and is secured by substantially all of the assets of the Company and the subsidiary guarantors.

On October 25, 2004 ("the First Amendment Effective Date"), the Credit Agreement was amended (the "Amendment") to reduce the annual interest rate on borrowings under the Term Loan Facility and to reduce the commitment fee on the Credit-Linked Facility, each by 1.25 percent. As a result of the Amendment, the annual interest rate on borrowings under the Term Loan Facility fluctuates at a rate equal to the sum of (i) a borrowing margin of 2.25 percent (subject to reduction of up to 0.50 percent based on the Company's debt ratings) plus (ii) (A) in the case of U.S. denominated

loans, the higher of the prime rate or one-half of one percent in excess of the overnight "federal funds" rate, or (B) in the case of Eurodollar loans, an interest rate which is a function of the Eurodollar rate for the selected interest period. The Company has the option to borrow in U.S. denominated loans or Eurodollar loans at its discretion. As of September 30, 2004 and the First Amendment Effective Date, all loans under the Term Loan Facility were Eurodollar loans at the borrowing rate of 5.38 percent and 4.13 percent, respectively. As a result of the Amendment, the commitment fee on the Credit-Linked Facility is equal to the sum of 2.25 percent (subject to reduction of up to 0.50 percent based on the Company's debt ratings), plus an additional amount that is based on the administrative costs and term of the Credit-Linked Facility. As of September 30, 2004 and the First Amendment Effective Date, the commitment fee on the Credit-Linked Facility was 3.62 percent and 2.37 percent, respectively. In addition, under the Amendment, certain mandatory prepayment requirements were eliminated, and several covenants that restricted or limited the Company's ability to repurchase or refinance Senior Notes, make investments, and incur debt pertaining to letters of credit were amended.
~~Capital Leases~~
        On April 2, 2004, the Company repaid a $6.4 million obligation, plus accrued interest, to the City of Albuquerque, New Mexico with cash on hand. The $6.4 million of principal represented an obligation of the Company's discontinued segments, and the amount is included in current maturities of long-term debt and capital lease obligations in the table above as of December 31, 2003.

NOTE E—Income ~~(Loss)~~ per Common Share
The following tables reconcile income ~~(loss)~~ (numerator) and shares (denominator) used in the computations of income ~~(loss)~~ from continuing operations per common share (in thousands, except per share data):

Predecessor
Company
Reorganized
Company
Predecessor
Company
Reorganized
Company

Three Months Ended
September 30, 2003
Three Months Ended
September 30, 2004
Nine Months Ended
September 30, 2003
Nine Months Ended
September 30, 2004
Numerator:
Income (loss) from continuing operations $ (29,567 ) $ 27,163 $ (32,231 ) $ 68,526
Less preferred dividends — — 884 —
Less amortization of redeemable preferred stock issuance costs and other — — 171 —
Less preferred stock reorganization items, net — — 2,668 —

Income (loss) from continuing operations available to common stockholders—basic $ (29,567 ) $ 27,163 $ (35,954 ) $ 68,526
Add: presumed conversion of redeemable preferred stock — — — —

Income (loss) from continuing operations available to common stockholders—diluted $ (29,567 ) $ 27,163 $ (35,954 ) $ 68,526

Denominator:
Weighted average number of common shares outstanding—basic 35,319 35,371 35,300 35,365
Common stock equivalents—stock options — 996 — 688
Common stock equivalents—warrants — 227 — 182
Common stock equivalents—redeemable preferred stock — — — —

Weighted average number of common shares outstanding—diluted 35,319 36,594 35,300 36,235

Income (loss) from continuing operations available to common stockholders per common share—basic $ (0.84 ) $ 0.77 $ (1.02 ) $ 1.94

Income (loss) from continuing operations available to common stockholders per common share—diluted $ (0.84 ) $ 0.74 $ (1.02 ) $ 1.89

Three Months Ended
March 31,

2004

2005

Numerator:

Income from continuing operations available to common stockholders—basic and diluted

$
12,908

$
23,568

Denominator:

Weighted average number of common shares outstanding—basic

35,355

35,403

Common stock equivalents—stock options

308

1,211

Common stock equivalents—warrants

142

233

Weighted average number of common shares outstanding—diluted

35,805

36,847

Income from continuing operations available to common stockholders per common share—basic

$
0.37

$
0.67

Income from continuing operations available to common stockholders per common share—diluted

$
0.35

$
0.64

Weighted average number of common shares outstanding for the three months ended March 31, 2004 and nine months ended September 30, 2003 was calculated using the then outstanding shares of the Predecessor Company's pre-petition common stock. Weighted average number of common shares for the three months and nine months ended September 30, 20042005 was calculated using outstanding shares of the ~~Reorganized Company's~~Company’s Ordinary Common ~~stock~~Stock and Multi-Vote Common stock. Conversion of the Predecessor Company's redeemable preferred stock was not presumed for the three months and nine months ended September 30, 2003 due to its anti-dilutive effect. Because the Predecessor Company reported a loss from continuing operations during the three months and nine months ended September 30, 2003, no common stock equivalents were included in the computation of weighted average common shares outstanding.Stock. Common stock equivalents included in the calculation of diluted weighted average common shares outstanding for the three months ended March 31, 2004 and ~~nine months ended~~

~~September 30, 2004~~2005 represent stock options to purchase shares of the ~~Reorganized Company's~~Company’s Ordinary Common Stock, which were granted ~~during the nine months ended September 30, 2004~~ pursuant to the MIP, and shares of Ordinary Common Stock related to certain warrants issued on the Effective Date.

On January 24, 2005 and January 31, 2005, the Company granted 50,000 and 7,200 options, respectively, pursuant to employment agreements executed with two members of management, at exercise prices of $36.16 per share and $37.14 per share, which equaled the fair market value of the Company’s Ordinary Common Stock on the respective grant dates. These options vest ratably over four years.
On March 10, 2005, the Company granted 872,298 options and 107,584 shares of restricted stock pursuant to the MIP. The options have an exercise price of $34.57 per share which equaled the fair market value of the Company’s Ordinary Common Stock on the grant date. These options and restricted stock awards vest ratably over four years. The compensation charge of $3.7 million from the grant of restricted stock will be recognized ratably over the vesting period.
NOTE F—Discontinued Operations
Accounting for Discontinued Operations
The Company has accounted for the disposal of its discontinued segments under APB Opinion No. 30, ~~"Reporting~~“Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and ~~Transactions" ("~~Transactions” (“APB ~~30"~~30”). APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. All activities related to the healthcare provider and franchising segments, the specialty managed healthcare segment and the human services segment are reflected as discontinued operations for the three-month ~~and nine-month~~ periods ended ~~September 30, 2003~~March 31, 2004 and ~~2004.~~2005. As permitted, the assets, liabilities and cash flows related to discontinued operations have not been segregated from those related to continuing operations.
The summarized results of the discontinued operations segments, net of taxes, are as follows (in thousands):

Predecessor
Company
Reorganized
Company
Predecessor
Company
Reorganized
Company

Three Months Ended
September 30, 2003
Three Months Ended
September 30, 2004
Nine Months Ended
September 30, 2003
Nine Months Ended
September 30, 2004

Discontinued Operations
Net revenue(1) $ 316 $ — $ 389 $ 118

Salaries, cost of care and other operating expenses(2) 25,264 814 26,386 840
Other expenses (income)(3)(4) (4,012 ) (207 ) (6,595 ) (114 )
Reorganization benefit, net(5) (288 ) — (3,455 ) —

Net income (loss) $ (20,648 ) $ (607 ) $ (15,947 ) $ (608 )

Three Months Ended
March 31,

    2004

    2005

Discontinued Operations

Net revenue(1)

$
138

$
—

Direct service costs and other operating expenses(2)

100

(119
)

Income tax provision

8

71

Income from discontinued operations

$
30

$
48

(1)
Amounts represent settlements of certain outstanding Medicare and Medicaid cost reports.

(2)
In September 2003, the Predecessor Company entered into an agreement to settle certain claims related to the healthcare provider and franchising segment. As a result of the settlement, the Predecessor Company recorded an adjustment to other operating expenses of $24.0 million, for which there was no tax effect.

~~(3)~~
Interest expense has not been allocated to discontinued operations.

~~(4)~~
~~Includes (income) loss from disposal of discontinued operations and/or provision (benefit) for income taxes.~~

~~(5)~~
As part of its financial restructuring plan and chapter 11 proceedings, the Predecessor Company rejected certain leases for closed offices. The estimated cost to the Predecessor Company as a result of rejecting such leases was less than the liability recorded. In accordance with SOP 90-7, such difference was recorded as reorganization benefit, net.

The remaining assets and liabilities of the discontinued segments at ~~September 30, 2004~~March 31, 2005 include, among other things, (i) cash and cash equivalents of ~~$0.8~~$1.0 million; (ii) restricted cash of ~~$0.8~~$0.5 million; (iii) investment in provider joint ventures of $1.9 million; and (iv) accounts payable and accrued liabilities of ~~$1.6~~$3.3 million. In July 2004, the Reorganized Company sold hospital-based real estate that resulted in a pre-tax loss of $0.1 million that is reflected as loss on disposal of discontinued operations, net of tax, in the accompanying unaudited condensed consolidated financial statements included elsewhere herein for the nine months ended September 30, 2004.
15

NOTE G—Commitments and Contingencies

Insurance

The Company maintains a program of insurance coverage for a broad range of risks in its business. As part of this program of insurance, the Company is self-insured for a portion of its general and current professional liability risks. Prior to July 1999, the Company maintained certain reserves related primarily to the professional liability risks of the ~~Company's~~Company’s healthcare provider segment arising prior to the sale of its domestic acute-care psychiatric hospitals and residential treatment facilities to Crescent Real Estate Equities in fiscal 1997. On July 2, 1999, the Company transferred its remaining medical malpractice claims portfolio (the ~~"Loss~~“Loss Portfolio ~~Transfer"~~Transfer”) to a third-party ~~insurer for approximately $22.3 million.~~insurer. The ~~Loss Portfolio Transfer was funded from assets restricted for settlement of unpaid claims. The~~Company believes that the insurance limit obtained through the Loss Portfolio Transfer for ~~future~~ medical malpractice claims with respect to such business is ~~$26.3 million. The Company continually evaluates the adequacy of these insured limits and management believes these amounts are~~ sufficient; however, there can be no assurance in that regard.

The Company ~~recently~~has renewed its general, professional and managed care liability insurance policies with unaffiliated insurers for a one-year period from June 17, 2004 to June 17, 2005. The general liability policies are written on an ~~"occurrence"~~“occurrence” basis, subject to a $0.1 million per claim un-aggregated self-insured retention. The professional liability and managed care errors and omissions liability policies are written on a ~~"claims-made"~~“claims-made” basis, subject to a $1.25 million per claim ($10.0 million per class action claim) un-aggregated self-insured retention for managed care liability, and a $0.1 million per claim un-aggregated self-insured retention for professional liability. The Company also purchases excess liability coverage in an amount ~~deemed~~that management believes to be reasonable ~~by management~~ for the size and profile of the organization. The Company is responsible for claims within its self-insured retentions, including portions of claims reported after the expiration date of the policies if they are not renewed, or if policy limits are exceeded.

Regulatory Issues

The healthcare industry is subject to numerous laws and regulations. The subjects of such laws and regulations cover, but are not limited to, matters such as licensure, accreditation, government healthcare program participation requirements, information privacy and security, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Over the past several years, government activity has increased with respect to investigations and/or allegations concerning possible violations of fraud and abuse and false claims statutes and/or regulations by healthcare organizations and insurers. Entities that are found to have violated these laws and regulations may be excluded from participating in government healthcare programs, subjected to fines or penalties or required to repay amounts received from the government for previously billed patient services. Compliance with such laws and regulations can be subject to future government review and interpretation, as well as regulatory actions unknown or unasserted at this time.

In addition, regulators of certain of the ~~Company's~~Company’s subsidiaries may exercise certain discretionary rights under regulations including increasing ~~their~~its supervision of such entities, requiring additional

restricted cash or other security or seizing or otherwise taking control of the assets and operations of such subsidiaries.
Legal
The Company is subject to or party to certain class action suits, litigation and claims relating to its operations and business practices. ~~Litigation~~Except as otherwise provided under the Plan, litigation asserting claims against the ~~Predecessor~~ Company and its subsidiaries that were parties to the chapter 11 proceedings for pre-petition obligations (the ~~"Pre-petition Litigation"~~“Pre-petition Litigation”), was enjoined as of the Effective Date as a consequence of the confirmation of the Plan inby the ~~Predecessor Company's chapter 11 proceedings.~~Bankruptcy Court. The Company believes that ~~except as otherwise provided by the Plan,~~ the Pre-petition Litigation claims constitute pre-petition general unsecured claims and, to the extent allowed by the ~~bankruptcy court,~~Bankruptcy Court, would be resolved as ~~other general unsecured claims under~~Other General Unsecured Claims as defined by the Plan. See Note B—“Emergence from Chapter 11.”

In the opinion of management, the Company has recorded reserves that are adequate to cover litigation, claims or assessments that have been or may be asserted against the Company, and for which the outcome is probable and reasonably estimable. Management believes that the resolution of such litigation and claims will not have a material adverse effect on the ~~Company's~~Company’s financial position or results of operations; however, there can be no assurance in ~~this~~that regard.
Operating Leases
The Company leases certain of its operating facilities. The leases, which expire at various dates through January 2013, generally require the Company to pay all maintenance, property tax and insurance costs.
NOTE H—Special Charges
Performance Improvement Plan
In April 2003, the Company implemented a ~~new~~ business and performance initiative, named Performance Improvement Plan ~~("PIP"~~(“PIP”). PIP iswas focused on consolidating service centers, creating more efficiencies in corporate overhead, consolidating systems, improving call center technology and instituting other operational and business efficiencies while maintaining or improving service to customers. During the fiscal year ended December 31, 2003, PIP resulted in the recognition of special charges of (a) $7.5 million to terminate employees that represented both operational and corporate personnel, and (b) $2.4 million to downsize and close excess facilities, and other associated activities.
In the ~~nine~~three months ended ~~September 30,~~March 31, 2004, PIP resulted in the recognition of special charges of (a) $2.6 million to terminate employees that represented both operational and corporate personnel, and (b) $1.8 million to terminate leases and provide for other exit costs. The employee termination costs of $2.6 million, which are provided under an ongoing benefit arrangement, include severance and related termination benefits, including payroll taxes. All terminations communicated to employees by September 30, 2004 are expected to be completed by December 2004 and termination costs associated with such employees are expected to be paid in full by August 2005. Termination liabilities attributable to ongoing benefit arrangements have been accrued when probable in accordance with SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Lease termination costs are accounted for under SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS 146"). In accordance with SFAS 146, the liability for lease termination costs is accrued at the time that all employees have vacated the leased property. These closure and exit costs include payments required under lease contracts (less any applicable existing and/or estimated sublease income) after the properties were abandoned, write-offs of leasehold improvements related to the facilities and other related expenses.$1.9 million. Outstanding liabilities of approximately ~~$3.8~~$1.5 million related to PIP are included in the accompanying ~~September 30, 2004~~March 31, 2005 condensed consolidated balance sheet in ~~"Accrued liabilities".~~

        Implementation of PIP resulted in additional incremental costs that were expensed as incurred. Special charges for the nine months ended September 30, 2004 includes a credit of $0.1 million which represents a reduction of previously expensed consulting costs.
“Accrued liabilities.” The following table provides a roll-forward of liabilities resulting from the special charges incurred in the implementation of this plan (in thousands):
Type of Cost
Balance
December 31,
2003
Additions
Payments
Adjustments(1)
Balance
September 30,
2004
Employee severance and termination benefits $ 4,702 $ 2,613 $ (5,183 ) $ 48 $ 2,180
Lease termination and other costs 146 1,802 (353 ) — 1,595

$ 4,848 $ 4,415 $ (5,536 ) $ 48 $ 3,775

~~(1)~~
~~Represents the reclassification of liabilities from accrued leave for certain terminated employees.~~
Type of Cost

Balance
December 31,
2004

Additions

Payments

Balance
March 31,
2005

Employee severance and termination benefits

$
866

$
—

$
(661
)

$
205

Lease termination and other costs

1,448

—

(143
)

1,305

$
2,314

$
—

$
(804
)

$
1,510

NOTE I—Business Segment Information
The Company is engaged in the managed behavioral healthcare business. The Company provides managed behavioral healthcare services to health plans, insurance companies, corporations, labor unions and various governmental agencies. Within the managed behavioral healthcare business, the Company is further divided into the following four segments, based on the services it provides and/or the customers that it serves, as described below.
Health Plan Solutions.The ~~Company's~~Company’s Health Plan Solutions segment generally reflects managed behavioral healthcare services provided under contracts with Blue Cross Blue Shield health plans and other managed care companies, health insurers and ~~other~~ health plans. This ~~segment's~~segment’s contracts encompass both risk-based and ~~ASO~~administrative services only (“ASO”) contracts. Although certain health plans provide their own managed behavioral healthcare services, many health plans ~~"carve out"~~“carve out” behavioral healthcare from their general healthcare services and subcontract such services to managed behavioral healthcare companies such as the Company. In the Health Plan Solutions segment, the ~~Company's~~Company’s members are the beneficiaries of the health plan (the employees and dependents of the customer of the health ~~plan and their dependents)~~plan), for which the behavioral healthcare services have been carved out to the Company.

Employer Solutions.The ~~Company's~~Company’s Employer Solutions ~~(formerly "Workplace")~~ segment generally reflects the provision of employee assistance program ~~("EAP"~~(“EAP”) services, managed behavioral healthcare services and integrated products under contracts with employers, including corporations and governmental agencies, and labor unions. This ~~segment's~~segment’s managed behavioral healthcare services are primarily ASO products.
Public Sector Solutions.The ~~Company's~~Company’s Public Sector Solutions segment generally reflects managed behavioral healthcare services provided to Medicaid recipients under contracts with state and local governmental agencies. This ~~segment's~~segment’s contracts encompass both risk-based and ASO contracts. The Company provides managed behavioral healthcare services to the State of Tennessee's TennCare program, both through direct contracts with TBH and a contract held by Premier, a joint venture in which the Company owns a fifty percent interest.
Corporate and Other.This segment of the Company is composed primarily of operational support functions such as ~~information technology and~~ sales and marketing and information technology as well as corporate support functions such as executive, finance, human resources and legal. Discontinued operations activity is not included in the Corporate and Other segment operating results.

The accounting policies of these segments are the same as those described in Note A—“General—Summary of Significant Accounting Policies.” The Company evaluates performance of its segments based on profit or loss from continuing operations before depreciation and amortization, interest expense, interest income, stock compensation expense, special charges, income taxes and minority interest (“Segment Profit”). Management uses Segment Profit information for internal reporting and control purposes and considers it important in making decisions regarding the allocation of capital and other resources, risk assessment and employee compensation, among other matters. Intersegment sales and transfers are not significant.
The Company’s customer segments are defined above. In certain limited cases, customer contracts that would otherwise meet the definition of one segment are managed and reported internally in another segment, in which cases the membership and financial results of such contracts are reflected in the segment in which it is managed and reported internally. During the quarter ended September 30, 2004, the ~~Company's~~Company’s internal reporting of certain operational and corporate support costs, such as claims administration and network services, changed to allocate such costs from the Corporate and Other segment to the Health Plan Solutions, Employer Solutions and Public Sector Solutions ~~segments.~~segments, based upon each such segment’s respective use of such services. Accordingly, the Company has ~~restated~~reclassified the financial results for all prior periods to allocate such costs into the corresponding segments consistent with its internal reporting. This ~~restatement~~reclassification does not affect consolidated financial results for any periods presented. ~~Additionally, in fiscal 2003 the Company transferred the reporting of certain contracts between segments. Refer~~All periods presented were adjusted to ~~the Company's Current Report on Form 8-K dated April 9, 2004 for further discussion related to~~conform with the fiscal ~~2003 segment modification.~~
        The accounting policies of these segments are the same as those described in Note B—"Summary of Significant Accounting Policies". The Company evaluates performance of its segments based on profit or loss from continuing operations before depreciation, amortization, interest expense, interest income, reorganization expense, stock compensation expense, special charges, goodwill impairment charges, income taxes and minority interest ("Segment Profit"). Management uses segment profit information for internal reporting and control purposes and considers it important in making decisions regarding the allocation of capital and other resources, risk assessment and employee compensation, among other matters. Intersegment sales and transfers are not significant.
2004 reclassification. The following tables summarize, for the periods indicated, operating results by business segment (in thousands):

Predecessor Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Three Months Ended September 30, 2003
Net revenue $ 205,740 $ 38,837 $ 129,130 $ — $ 373,707
Cost of care 107,626 9,792 105,406 — 222,824
Direct service costs 44,766 19,085 13,236 — 77,087
Other operating expenses — — — 31,676 31,676
Equity in (earnings) loss of unconsolidated subsidiaries (1,797 ) — 435 — (1,362 )

Segment profit (loss) $ 55,145 $ 9,960 $ 10,053 $ (31,676 ) $ 43,482

Reorganized Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Three Months Ended September 30, 2004
Net revenue $ 233,769 $ 32,991 $ 191,194 $ — $ 457,954
Cost of care 126,681 8,981 167,706 — 303,368
Direct service costs 41,483 15,785 10,746 — 68,014
Other operating expenses — — — 22,992 22,992
Equity in earnings of unconsolidated subsidiaries (1,863 ) — — — (1,863 )

Segment profit (loss) $ 67,468 $ 8,225 $ 12,742 $ (22,992 ) $ 65,443

Health
Plan
Solutions

Employer
Solutions

Public
Sector
Solutions

Corporate
and
Other

Consolidated

Three Months Ended March 31, 2004

Net revenue

$
223,139

$
35,269

$
181,768

$
—

$
440,176

Cost of care

123,010

10,227

160,967

—

294,204

Direct service costs

44,372

18,192

10,273

—

72,837

Other operating expenses

—

—

—

26,887

26,887

Equity in earnings of unconsolidated subsidiaries

(1,844
)
—

—

—

(1,844
)

Segment profit (loss)

$
57,601

$
6,850

$
10,528

$
(26,887
)

$
48,092

Predecessor Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Nine Months Ended September 30, 2003
Net revenue $ 654,787 $ 121,329 $ 396,835 $ — $ 1,172,951
Cost of care 372,936 34,496 326,049 — 733,481
Direct service costs 135,810 60,213 39,064 — 235,087
Other operating expenses — — — 83,434 83,434
Equity in (earnings) loss of unconsolidated subsidiaries (4,751 ) — 1,590 — (3,161 )

Segment profit (loss) $ 150,792 $ 26,620 $ 30,132 $ (83,434 ) $ 124,110

Reorganized Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Nine Months Ended September 30, 2004
Net revenue $ 684,094 $ 102,254 $ 563,886 $ — $ 1,350,234
Cost of care 370,254 29,028 499,513 — 898,795
Direct service costs 128,981 49,981 31,190 — 210,152
Other operating expenses — — — 73,234 73,234
Equity in earnings of unconsolidated subsidiaries (5,561 ) — — — (5,561 )

Segment profit (loss) $ 190,420 $ 23,245 $ 33,183 $ (73,234 ) $ 173,614

The segment financial information disclosed for the three and nine months ended September 30, 2003 in the tables above is different than that which was previously reported in the Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, due to certain reclassifications between segments as discussed above.

Health
Plan
Solutions

Employer
Solutions

Public
Sector
Solutions

Corporate
and
Other

Consolidated

Three Months Ended March 31, 2005

Net revenue

$
224,902

$
31,660

$
196,192

$
—

$
452,754

Cost of care

121,728

7,860

174,620

—

304,208

Direct service costs

39,582

15,705

7,587

—

62,874

Other operating expenses

—

—

—

25,847

25,847

Equity in earnings of unconsolidated subsidiaries

(1,449
)
—

—

—

(1,449
)

Segment profit (loss)

$
65,041

$
8,095

$
13,985

$
(25,847
)

$
61,274

        ~~The following table reconciles Segment Profit to consolidated income (loss) from continuing operations before income taxes and minority interest (in thousands):~~

Predecessor Company
Reorganized Company
Predecessor Company
Reorganized Company

Three Months Ended
September 30, 2003
Three Months Ended
September 30, 2004
Nine Months Ended
September 30, 2003
Nine Months Ended
September 30, 2004

Segment profit $ 43,482 $ 65,443 $ 124,110 $ 173,614
Depreciation and amortization (11,593 ) (10,712 ) (36,265 ) (31,478 )
Interest expense (4,748 ) (9,109 ) (31,474 ) (27,499 )
Interest income 670 1,760 2,173 3,593
Reorganization expense, net (4,540 ) — (32,245 ) —
Stock compensation expense — (2,580 ) — (15,898 )
Special charges (3,230 ) (1,770 ) (5,322 ) (4,304 )
Goodwill impairment charges (28,780 ) — (28,780 ) —

Income (loss) from continuing operations before income taxes and minority interest $ (8,739 ) $ 43,032 $ (7,803 ) $ 98,028

        The following tables include the restatement of previously reported quarterly results by business segment to reflect the Company's allocation of certain operational and corporate support costs from the Corporate and Other segment to the other segments as discussed above (in thousands):

Predecessor Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Three Months Ended March 31, 2003
Net revenue $ 226,632 $ 42,579 $ 139,763 $ — $ 408,974
Cost of care 130,260 13,212 116,576 — 260,048
Direct service costs 46,938 21,126 13,387 — 81,451
Other operating expenses — — — 27,340 27,340
Equity in (earnings) loss of unconsolidated subsidiaries (1,351 ) — 736 — (615 )

Segment profit (loss) $ 50,785 $ 8,241 $ 9,064 $ (27,340 ) $ 40,750

Predecessor Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Three Months Ended June 30, 2003
Net revenue $ 222,415 $ 39,913 $ 127,942 $ — $ 390,270
Cost of care 135,050 11,492 104,067 — 250,609
Direct service costs 44,106 20,002 12,441 — 76,549
Other operating expenses — — — 24,418 24,418
Equity in (earnings) loss of unconsolidated subsidiaries (1,603 ) — 419 — (1,184 )

Segment profit (loss) $ 44,862 $ 8,419 $ 11,015 $ (24,418 ) $ 39,878

Predecessor Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Three Months Ended December 31, 2003
Net revenue $ 215,753 $ 37,705 $ 84,337 $ — $ 337,795
Cost of care 91,192 10,362 71,449 — 173,003
Direct service costs 44,526 18,858 1,402 — 64,786
Other operating expenses — — — 35,095 35,095
Equity in earnings of unconsolidated subsidiaries (1,809 ) — (1,232 ) — (3,041 )

Segment profit (loss) $ 81,844 $ 8,485 $ 12,718 $ (35,095 ) $ 67,952

Reorganized Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Three Months Ended March 31, 2004
Net revenue $ 223,139 $ 35,269 $ 181,768 $ — $ 440,176
Cost of care 123,010 10,227 160,967 — 294,204
Direct service costs 44,372 18,192 10,273 — 72,837
Other operating expenses — — — 26,887 26,887
Equity in earnings of unconsolidated subsidiaries (1,844 ) — — — (1,844 )

Segment profit (loss) $ 57,601 $ 6,850 $ 10,528 $ (26,887 ) $ 48,092

Reorganized Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Three Months Ended June 30, 2004
Net revenue $ 227,186 $ 33,994 $ 190,924 $ — $ 452,104
Cost of care 120,563 9,820 170,840 — 301,223
Direct service costs 43,126 16,004 10,171 — 69,301
Other operating expenses — — — 23,355 23,355
Equity in earnings of unconsolidated subsidiaries (1,854 ) — — — (1,854 )

Segment profit (loss) $ 65,351 $ 8,170 $ 9,913 $ (23,355 ) $ 60,079

The following table reconciles Segment Profit to consolidated income from continuing operations before income taxes and minority interest (in thousands):

Predecessor
Company
Predecessor
Company
Predecessor
Company
Reorganized
Company
Reorganized
Company

Three Months Ended
March 31,

Three Months
Ended
March 31, 2003
Three Months
Ended
June 30, 2003
Three Months
Ended
December 31, 2003
Three Months
Ended
March 31, 2004
Three Months
Ended
June 30, 2004

2004

2005

Segment profit $ 40,750 $ 39,878 $ 67,952 $ 48,092 $ 60,079

$
48,092

$
61,274

Depreciation and amortization (13,652 ) (11,020 ) (11,782 ) (10,249 ) (10,517 )

(10,249
)
(11,218
)
Interest expense (21,788 ) (4,938 ) (29,542 ) (9,334 ) (9,056 )

(9,334
)
(8,639
)
Interest income 827 676 700 781 1,052

781

3,033

Reorganization expense, net (23,154 ) (4,551 ) 470,462 — —
Stock compensation expense — — — (10,777 ) (2,541 )

(10,777
)
(3,750
)
Special charges (1,705 ) (387 ) (4,206 ) (1,908 ) (626 )

(1,908
)
—

Income (loss) from continuing operations before income taxes and minority interest $ (18,722 ) $ 19,658 $ 493,584 $ 16,605 $ 38,391

Income from continuing operations before income taxes and minority interest

$
16,605

$
40,700

NOTE J—Shelf Registration Statement
Magellan filed a registration statement on Form S-3 with the U.S. Securities and Exchange Commission on November 15, 2004, and subsequently filed Amendment No. 1 to the Form S-3 on April 18, 2005, with respect to the possible public offering from time to time of a total of 8,588,454 shares of Ordinary Common Stock that either would be issued upon the automatic conversion of shares of Multi-Vote Common Stock purchased in a private transaction under the Plan and owned by Magellan Holdings, L.P., an affiliate of Onex Corporation, a Canadian corporation (together with its affiliates, collectively, “Onex”), as a result of a sale pursuant to such offering or that have already been issued upon conversion upon a private sale by Onex of shares of Multi-Vote Common Stock to a party not affiliated with Onex. The registration statement was filed pursuant to a Registration Rights Agreement dated as of January 3, 2004 between the Company and Onex that was entered into in connection with the issuance of the Multi-Vote Common Stock under the Plan to Onex. The registration statement has not yet been declared effective by the Securities and Exchange Commission.
19

	Predecessor Company		Predecessor Company		Predecessor Company		Reorganized Company		Reorganized Company			Three Months Ended March 31,
	Three Months Ended March 31, 2003		Three Months Ended June 30, 2003		Three Months Ended December 31, 2003		Three Months Ended March 31, 2004		Three Months Ended June 30, 2004			2004		2005
Segment profit	$	40,750		$	39,878		$	67,952		$	48,092		$	60,079			$	48,092		$	61,274
Depreciation and amortization	(13,652	)		(11,020	)		(11,782	)		(10,249	)		(10,517	)		(10,249	)	(11,218	)
Interest expense	(21,788	)		(4,938	)		(29,542	)		(9,334	)		(9,056	)		(9,334	)	(8,639	)
Interest income	827		676		700		781		1,052			781		3,033
Reorganization expense, net	(23,154	)		(4,551	)		470,462		—		—
Stock compensation expense	—		—		—		(10,777	)		(2,541	)		(10,777	)	(3,750	)
Special charges	(1,705	)		(387	)		(4,206	)		(1,908	)		(626	)		(1,908	)	—

Income (loss) from continuing operations before income taxes and minority interest	$	(18,722	)	$	19,658		$	493,584		$	16,605		$	38,391

Income from continuing operations before income taxes and minority interest		$	16,605		$	40,700

Item 2. ~~Management's~~Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis of the financial condition and results of operations of Magellan Health Services, Inc. ~~("Magellan"~~(“Magellan”), and its majority owned subsidiaries and all variable interest entities ~~("VIEs"~~(“VIEs”) for which Magellan is the primary beneficiary (together with Magellan, the ~~"Company"~~“Company”) should be read together with the Condensed Consolidated Financial Statements and the notes to the Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q and the ~~Company's~~Company’s Annual Report on Form 10-K for the year ended December 31, ~~2003,~~2004, which was filed with the Securities and Exchange Commission ~~("SEC"~~(“SEC”) on March ~~30, 2004.~~3, 2005.

Forward-Looking Statements

This Form 10-Q includes ~~"forward-looking statements"~~“forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the ~~"Securities Act"~~“Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the ~~"Exchange Act"~~“Exchange Act”). Although the Company believes that its plans, intentions and expectations as reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those contemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements include:

•

· restricted covenants in the Company’s debt instruments;

· the impact of behavioral healthcare costs on fixed fee contracts;

· the impact of present or future state regulations and contractual requirements;

· the Company’s inability to renegotiate or extend expiring customer contracts, or the termination ~~or non-renewal~~ of ~~contracts by customers;~~

•

~~election~~customer contracts;
· changes in business practices of the industry, including the possibility that certain of the ~~Company's health plan~~Company’s managed care customers could seek to ~~manage the~~provide managed behavioral healthcare services directly to their subscribers, instead of ~~their members directly;~~

•

~~renegotiation of rates paid to and/or by~~contracting with the Company ~~by customers and/or to providers;~~

•

~~higher utilization of behavioral health treatment services by members;~~

•

~~delays, higher costs or inability to implement the Company's initiatives;~~

•

~~the impact of new or amended laws or regulations;~~

•

for such services;
·the impact of increased competition on ability to maintain or obtain contracts;

•

· the Company’s dependence on government spending for managed healthcare, including changes in federal, state and local healthcare policies;

· the possible impact of healthcare reform;

· government regulation;

· the inability to realize the value of goodwill and intangible assets;

· pending or future actions or claims for professional liability;

· claims brought against the Company that exceed the scope of the Company’s liability coverage or denial of coverage;

· class action suits and other legal proceedings; and

·the impact of ~~increased competition on rates paid to or by the Company; and~~

•

governmental ~~inquiries and/or litigation.~~

investigations.
Further discussion of factors currently known to management that could cause actual results to differ materially from those in forward-looking statements is set forth under the heading ~~"Cautionary Statements"~~“Cautionary Statements” in Item 1 of ~~Magellan's~~Magellan’s Annual Report on Form 10-K for the year ended December 31, ~~2003.~~ 2004.

When used in this Quarterly Report on Form 10-Q, the words ~~"estimate," "anticipate," "expect," "believe," "should,"~~“estimate,” “anticipate,” “expect,” “believe,” “should,” and similar expressions are intended to be forward-looking statements. Magellan undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time.
Overview
The Company coordinates and manages the delivery of behavioral healthcare treatment services that are provided through its contracted network of third-party treatment providers, which includes psychiatrists, psychologists, other behavioral health professionals, psychiatric hospitals, residential treatment centers and other treatment facilities. The treatment services provided through the ~~Company's~~Company’s provider network include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services), inpatient

treatment and crisis intervention services. The Company, however, generally does not directly provide, or own any provider of, treatment services. The Company provides its management services primarily through: (i) risk-based products, where the Company assumes all or a portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) administrative services only ~~("ASO"~~(“ASO”) products, where the Company provides services such as utilization review, claims administration and/or provider network management but does not assume responsibility for the cost of the treatment services, (iii) employee assistance programs ~~("EAPs"~~(“EAPs”) and (iv) products which combine features of some or all of the ~~Company's~~Company’s risk-based, ASO or EAP products. At ~~September 30, 2004,~~March 31, 2005, the Company managed the behavioral healthcare benefits of approximately ~~58.4~~57.7 million individuals.
        On January 5, 2004 (the "Effective Date"), the Company's plan of reorganization (the "Plan") became effective and the Company emerged from bankruptcy. The principal terms of the Plan, including the treatment afforded under the Plan to the holders of the Company's pre-existing indebtedness and other liabilities and equity interests, are summarized in Item 1 of the Company's Annual Report on Form 10-K for the year ended December 31, 2003, previously filed with the SEC. In the discussion herein of periods prior to the Effective Date, references to such pre-existing indebtedness and other securities shall have the meaning set forth therein. The Company, as of December 31, 2003 and subsequently, is referred to herein as the "Reorganized Company" and, in connection with prior periods, is referred to herein as the "Predecessor Company." See "New Capitalization" below for a discussion of post-emergence external funding received by the Company.
        As further discussed in "Accounting Impact of Chapter 11 Filing," below, the results of operations for the three months and nine months ended September 30, 2004 and the cash flows for the nine months ended September 30, 2004 are not comparable with the results of operations and cash flows for the similar prior year periods.
        The Company operates in four reportable business segments, based on the services it provides and/or the customers that it serves: (i) Magellan Health Plan Solutions ("Health Plan Solutions"); (ii) Magellan Employer Solutions ("Employer Solutions"); (iii) Magellan Public Sector Solutions ("Public Sector Solutions") and (iv) Corporate and Other. See "Business Segments" below for a discussion of each segment. Health Plan Solutions, Employer Solutions and Public Sector Solutions contributed 51.0 percent, 7.2 percent and 41.8 percent, respectively, of the Reorganized Company's net revenue for the quarter ended September 30, 2004, and 50.7 percent, 7.6 percent and 41.7 percent of the Company's net revenue for the nine months ended September 30, 2004. Health Plan Solutions, Employer Solutions and Public Sector Solutions contributed 76.3 percent, 9.3 percent and 14.4 percent, respectively, of the Reorganized Company's segment profit (as defined below), excluding the Corporate and Other segment, for the quarter ended September 30, 2004, and 77.1 percent, 9.4 percent and 13.5 percent of the Company's segment profit, excluding the Corporate and Other segment, for the nine months ended September 30, 2004.
        The Reorganized Company reported income from continuing operations of $27.2 million and $68.5 million, or $0.74 per share and $1.89 per share on a diluted basis, respectively, for the three months and nine months ended September 30, 2004. The Predecessor Company reported losses from continuing operations of $(29.6) million and $(32.2) million, or $(0.84) per share and $(1.02) per share on a diluted basis, respectively, for the three months and nine months ended September 30, 2003. The Reorganized Company reported net income of $26.6 million and $67.9 million, or $0.73 per share and $1.87 per share on a diluted basis, respectively, for the three months and nine months ended September 30, 2004. The Predecessor Company reported net losses of $(50.2) million and $(48.2) million, or $(1.42) per share and $(1.47) per share on a diluted basis, respectively, for the three months and nine months ended September 30, 2003. See "Results of Operations" below for discussion of the components of income (loss) from continuing operations and net income (loss) and explanations for significant variances in amounts reported for the periods presented.

        The Reorganized Company reported cash flow from operating, investing and financing activities of $88.3 million, $(10.1) million and $28.8 million, respectively, for the nine months ended September 30, 2004. The Predecessor Company reported cash flow from operating, investing and financing activities of $140.5 million, $(16.4) million and $(2.5) million for the nine months ended September 30, 2003. Cash flows for the current year and prior year periods were significantly affected by activities related to the bankruptcy filing in March 2003 and the subsequent emergence from bankruptcy in January 2004 with equity financing secured by the Company in the form of an investment by Onex Corporation, a Canadian company, through an affiliate (together, "Onex"). See "Historical—Liquidity and Capital Resources" below for further discussion of cash flows.
        The securing of external capital and restructuring of long-term debt enabled the Company to emerge from bankruptcy, and this new capital along with profitable operations has enabled the Company to focus on executing its strategic plan, which includes improving operating efficiencies and margins and leveraging the Company's market position to grow revenue and increase earnings of its managed behavioral healthcare business, as well as designing new products to facilitate growth of the Company. The Company believes that it has the management expertise and operating and systems infrastructure in place to achieve these objectives; however, no assurance can be given in that regard.
~~New Capitalization~~
        Giving effect to the Plan, the Company continued, in its previous organizational form, to conduct its business as previously conducted, with the same assets in all material respects (except for cash to be distributed under the Plan to former creditors of the Company), but the Company was recapitalized. Specifically, Onex invested approximately $102.1 million in the equity of Magellan in the form of Multi-Vote Common Stock (the "Onex Investment"), which entitles it to a fifty percent voting interest in all matters that come before Magellan's stockholders, with certain exceptions. Pursuant to the Plan, the Company received additional equity infusions totaling $63.3 million from holders of the Company's Old Subordinated Notes (the "Holders") and other general unsecured creditors (the "Other GUCs"), which elected to purchase common stock in the form of Ordinary Common Stock of the Company in an equity offering. Onex's equity investment included initial capital contributions to the Company pursuant to the Plan of $86.7 million and additional capital contributions of $15.4 million under its commitment to fund the election by creditors to receive cash in lieu of common stock distributions in satisfaction of their claims (the "Cash-Out Election") by purchasing that amount of shares of Multi-Vote Common Stock equal to the amount of shares of Ordinary Common Stock cashed out by the Holders and the Other GUCs pursuant to the Cash-Out Election. Capital contributions of $146.9 million, net of approximately $3.1 million of issuance costs and excluding funds received from the Cash-Out Election, are reflected as "Stock subscriptions receivable" in the accompanying condensed consolidated balance sheet as of December 31, 2003. Of the funds received by the Company pursuant to the Cash-Out Election, $15.2 million are included in "Other current assets" in the accompanying condensed consolidated balance sheet as of December 31, 2003, with the remaining amount of $0.2 million being recorded by the Company and paid by Onex subsequent to March 31, 2004. All previously existing equity interests in Magellan were cancelled as of the Effective Date.
        Also pursuant to the Plan, the Company entered into a new credit agreement with Deutsche Bank AG (the "Credit Agreement"), issued $233.5 million of Series A Senior Notes and $7.1 million of Series B Senior Notes (together, the "Senior Notes"), renewed its agreement with Aetna, Inc. ("Aetna") to manage the behavioral healthcare of members of Aetna's healthcare programs and issued to Aetna an interest bearing note in the amount of $48.9 million (the "Aetna Note"). The Company's secured bank loans under its old credit agreement, as existing before the Effective Date (the "Old Credit Agreement"), were paid in full, and other then existing indebtedness (i.e., two classes of notes and general unsecured creditor claims) was cancelled as of the Effective Date.

        The discussion in this section represents a summary of certain transactions which occurred as of and subsequent to the Effective Date pursuant to the Plan. Please refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2003 for a more detailed description of the recapitalization of the Company and other transactions pursuant to the Plan.
Business Segments
Health Plan Solutions.The ~~Company's~~Company’s Health Plan Solutions segment generally reflects managed behavioral healthcare services provided under contracts with Blue Cross Blue Shield health plans and other managed care companies, health insurers and ~~other~~ health plans. This ~~segment's~~segment’s contracts encompass both risk-based and ASO contracts. Although certain health plans provide their own managed behavioral healthcare services, many health plans ~~"carve out"~~“carve out” behavioral healthcare from their general healthcare services and subcontract such services to managed behavioral healthcare companies such as the Company. In the Health Plan Solutions segment, the ~~Company's~~Company’s members are the beneficiaries of the health plan (the employees and dependents of the customer of the health ~~plan and their dependents)~~plan), for which the behavioral healthcare services have been carved out to the Company. The ~~Company's~~Company’s Health Plan Solutions segment managed the behavioral health benefits of approximately ~~42.4~~42.3 million covered lives as of ~~September 30, 2004.~~March 31, 2005.
Employer Solutions.The ~~Company's~~Company’s Employer Solutions segment ~~(formerly "Workplace")~~ generally reflects the provision of EAP services, managed behavioral healthcare services and integrated products under contracts with employers, including corporations and governmental agencies, and labor unions. This ~~segment's~~segment’s managed behavioral healthcare services are primarily ASO products. The ~~Company's~~Company’s Employer Solutions segment provided these services for approximately ~~13.3~~13.4 million covered lives as of ~~September 30, 2004.~~March 31, 2005.
Public Sector Solutions.The ~~Company's~~Company’s Public Sector Solutions segment generally reflects managed behavioral healthcare services provided to Medicaid recipients under contracts with state and local governmental agencies. This ~~segment's~~segment’s contracts encompass both risk-based and ASO contracts. Risk contracts in the Public Sector Solutions segment generally have higher per member premiums, cost and (to some degree) more volatility than risk contracts in either the Health Plan Solutions or Employer Solutions segments due to the nature of populations, benefits provided and other matters. The ~~Company's~~Company’s Public Sector Solutions segment managed the behavioral health benefits of approximately ~~2.7~~2.0 million covered lives as of ~~September 30, 2004.~~March 31, 2005.
Corporate and Other.This segment of the Company is composed primarily of operational support functions such as ~~information technology and~~ sales and marketing and information technology as well as corporate support functions

such as executive, finance, human resources and legal. Discontinued operations activity is not included in the Corporate and Other segment operating results. In the quarter ended September 30, 2004, the Company reclassified certain expenses from its Corporate and Other segment to its other business segments, as discussed in Note I—"“Business Segment ~~Information"~~Information” to the ~~Company's~~Company’s unaudited condensed consolidated financial statements set forth elsewhere herein.
Significant Customers
The ~~Company's~~Health Plan Solutions segments includes revenue derived from the Company’s contract with Aetna, Inc. (“Aetna”) of $55.8 million and $62.0 million, respectively, during the three-month periods ended March 31, 2004 and 2005. As described in Note A—“General—Summary of Significant Accounting Policies” the Aetna contract will terminate on December 31, 2005.
The Company is party to several contracts with entities that are now controlled by WellPoint, Inc. (“WellPoint”), that represent a significant concentration of business for the Company. Total revenue from such contracts totaled $31.4 million and $33.9 million during the three-month periods ended March 31, 2004 and 2005, respectively. One such contract, which generated revenue of $24.4 million during the three-month period ended March 31, 2005, extends through December 31, 2005. A second contract with an entity controlled by WellPoint, which generated revenue of $6.7 million for the three-month period ended March 31, 2005, extends through September 30, 2005, and the Company has recently been notified by the customer that it does not intend to renew this contract beyond such date. The other WellPoint-related contracts have terms ranging from June 30, 2006 through December 31, 2007.
As noted above, substantially all of the Company’s Health Plan Solutions segment ~~provides~~revenues are derived from Blue Cross and Blue Shield health plans, and other managed care companies, health insurers and health plans. As described in the section entitled “Cautionary Statements—Changes in the Managed Care Industry” in the Company’s Form 10-K for the year ended December 31, 2004, some of the Company’s customers have decided to provide managed behavioral healthcare services directly to ~~certain of~~their subscribers. In addition to Aetna and the membership of Aetna. During the three months and nine months ended September 30, 2003, the Predecessor Company derived approximately $48.1 million and $144.8 million, respectively, of consolidated net revenue from itsWellPoint-related contract with Aetna. During the three months and nine months ended September 30, 2004, the Reorganized Company derived approximately $58.4 and $170.4 million, respectively, of consolidated net revenue from its contract with Aetna. The current Aetna contract extends through December 31, 2005, and includes an option for Aetna at that time to either extend the agreement or to purchase certain assetsnoted above, other managed care customers of the Company ~~used solely in~~have decided not to renew all or part of their contracts with the ~~management of the~~Company, and will instead manage behavioral healthcare services for their subscribers. The Company believes that the total impact of ~~Aetna members (the "Aetna-Dedicated Assets"). If the behavioral health~~

~~services contract is extended by Aetna at its option through at least December 31,~~such non-renewals will be a reduction to revenue of approximately $330 million during fiscal 2006, ~~one-half~~$250 million of ~~the Aetna Note of $48.9 million would be payable on December 31, 2005, and the remainder would be payable on December 31, 2006. If Aetna opts~~which relates to ~~purchase the Aetna-Dedicated Assets, the purchase price could be offset against any amounts owing under the Aetna Note.~~Aetna.
The ~~Company's~~Company’s Public Sector Solutions segment provides managed behavioral healthcare services to the State of ~~Tennessee's~~Tennessee’s TennCare program (“TennCare”), both through ~~direct~~ contracts held by the ~~Company's~~Company’s wholly owned subsidiary Tennessee Behavioral Health, Inc. ~~("TBH"~~(“TBH”), and through a contract held by Premier Behavioral Systems of Tennessee, LLC ~~("Premier"~~(“Premier”), a joint venture in which the Company owns a fifty percent interest. ~~The direct TennCare~~In addition, the Company contracts ~~(exclusive of Premier's contract~~ with TennCare) accounted for approximately $35.9 million and $121.0 million of the Predecessor Company's net revenues in the three and nine months ended September 30, 2003, respectively. Such revenue included approximately $5.4 million and $34.4 million for the three and nine months ended September 30, 2003, respectively, associated withPremier to provide certain services performed by the Predecessor Company on behalf of Premier. The direct TennCare contracts accounted for approximately $55.4 million and $120.1 million of the Reorganized Company's net revenues in the three months and nine months ended September 30, 2004, respectively.
        In the three months and nine months ended September 30, 2004, the Reorganized Company recorded approximately $52.0 million and $200.0 million, respectively, in net revenues related to Premier's contract with TennCare, which represents 100 percent of Premier's net revenue derived from such contract, due to the ~~adoption of FIN 46 (see "Management's Discussion and Analysis of Financial Condition and Results of Operations—Recent Accounting Pronouncements" below for a discussion of FIN 46) pursuant to which~~joint venture. The Company consolidates the results of operations of Premier, ~~were~~including revenue and cost of care, in the Company’s consolidated ~~with~~statement of income. The Company recorded $103.7 million and $113.2 million of revenue from its TennCare contracts during the ~~Reorganized Company's results of operations. In the three months~~three-month periods ended March 31, 2004 and nine months ended September 30, 2003, the results of operations of Premier were accounted for by the Predecessor Company under the equity method of accounting. The consolidation of Premier did not affect the Company's profitability.2005, respectively.
In September 2003, the State of Tennessee ~~issued a request for proposal ("RFP") relating to~~divided the TennCare program ~~under which the program would be divided~~ into three regions. The ~~Company, through TBH, submitted a proposal~~Company’s contract for the East region ~~only and was awarded the contract, which~~ has a term ~~from July 1, 2004~~ through December 31, 2005, with extensions at the ~~State's~~State’s option through December 31, 2008. ~~When contract negotiations between the State and the vendor that had been awarded the~~The Company’s contracts for the Middle and West regions ~~were discontinued, the State asked TBH and Premier to continue with their current contracts for those regions~~have terms through December 31, ~~2004. Effective~~2005.
The Governor of Tennessee has stated that, because of the increased costs of the TennCare program, the State will cease providing coverage for up to approximately 323,000 adults (which represents approximately one-fourth of total TennCare membership) who do not qualify for Medicaid, and may limit benefits to be delivered under the TennCare program. Certain advocacy groups had filed suits in attempts

to prevent the Governor from implementing any reductions in membership and benefits; however, such suits have since been dismissed. Representatives of the State of Tennessee have publicly indicated that they intend to phase-in the membership reductions as early as July 1, ~~2004 agreements with~~2005. A reduction in membership would, and benefit changes could, adversely affect the ~~State were reached, under~~Company’s revenues and profitability. The Company does not yet know which ~~TBH~~members would be eliminated from the program, and ~~Premier will continue serving~~because capitation rates for TennCare members vary depending upon the ~~Middle~~level of benefits received by such members, the Company cannot estimate the impact of the proposed membership reductions. Further, the Company does not yet know the actual timing of the phased-in membership reductions, the benefit changes being proposed or the timing of those changes, and ~~West regions of TennCare through December 31, 2005. As a result~~as such, the Company cannot estimate the impact of these ~~agreements, the Company will continue to manage behavioral health care for the entire TennCare program.~~potential developments at this time.
The ~~Company's~~Company’s Public Sector Solutions segment derives a significant portion of its revenue from contracts with various counties in the ~~State~~state of Pennsylvania (the ~~"Pennsylvania Counties"~~“Pennsylvania Counties”). Although these are separate contracts with individual counties, they all pertain to the Pennsylvania Medicaid program. Revenues ~~earned by the Predecessor Company~~ from the Pennsylvania Counties in the aggregate totaled approximately ~~$60.0~~$43.9 million and ~~$175.7~~$51.5 million in the ~~three months~~three-month periods ended March 31, 2004 and ~~nine months ended September 30, 2003,~~2005, respectively. Revenues earned by the Reorganized Company from the Pennsylvania Counties in the aggregate totaled approximately $48.1 million and $139.3 million in the three months and nine months ended September 30, 2004, respectively. The contract with one of the counties was terminated as of December 31, 2003. Revenue related to this particular county earned by the Predecessor Company totaled approximately $7.1 million and $20.7 million in the three months and nine months ended September 30, 2003, respectively. Changes in fiscal 2003 in several of the individual contracts for certain of the Pennsylvania Counties have resulted in lower revenue, cost of care and direct service costs, with no impact to the net profitability of the contracts.

Off-Balance Sheet Arrangements
The Company does not currently maintain any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on the ~~Company's~~Company’s finances that is material to investors.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The Company considers the following to be its critical accounting policies and estimates:
        ~~Fresh Start Reporting.~~    In connection with the consummation of the Plan, the Company adopted the fresh start reporting provisions of American Institute of Certified Public Accountants ("AICPA") Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"), with respect to its financial reports, which required the Company to restate its assets and liabilities to their fair values based upon the provisions of the Plan and certain valuations which the Company made in connection with the implementation of the Plan. Upon adoption of fresh start reporting as of December 31, 2003, the Company created, in substance, per SOP 90-7, a new reporting entity, which is referred to herein as the "Reorganized Company." The Reorganized Company has adopted the same accounting policies as the Predecessor Company with the exception of the date on which the Reorganized Company intends to perform its annual goodwill impairment test (see "Goodwill" below).
Managed Care Revenue.Managed care revenue is recognized over the applicable coverage period on a per member basis for covered members. Managed care risk revenue earned by the ~~Predecessor~~ Company for the three months ended March 31, 2004 and ~~nine months ended September 30, 2003~~2005 approximated ~~$325.3~~$386.3 million and ~~$1,008.4~~$402.3 million, respectively. ~~Managed care risk revenue earned by the Reorganized Company for the three months and nine months ended September 30, 2004 approximated $402.8 million and $1,185.8 million, respectively.~~
Performance-based Revenue.   The Company has the ability to earn performance-based revenue ~~primarily~~ under certain risk and non-risk contracts. Performance-based revenue generally is based on either the ability of the Company to manage care for its ~~ASO~~ clients below specified ~~cost targets.~~targets, or on other operating metrics. For each such contract, the Company estimates and records performance-based revenue after considering the relevant contractual terms and the data available for the performance-based revenue calculation. Pro-rata performance-based revenue is recognized on an interim basis pursuant to the rights and obligations of each party upon termination of the contracts. The ~~Predecessor~~ Company recognized performance-based revenue of approximately ~~$1.3~~$0.9 million and ~~$5.6~~$2.7 million for the three months ended March 31, 2004 and nine months ended September 30, 2003, respectively. The Reorganized Company recognized performance-based revenue of approximately $1.9 million and $5.6 million for the three months and nine months ended September 30, 2004,2005, respectively.
Goodwill.    Goodwill was recorded by the Reorganized Company at December 31, 2003 for the amount of reorganization value in excess of amounts allocated to tangible and identified intangible assets resulting from the application of the fresh start reporting provisions of SOP 90-7. Goodwill is accounted for in accordance with ~~SFAS~~Statement of Financial Accounting Standards (“SFAS”) No. 142, ~~"Goodwill~~“Goodwill and Other Intangible ~~Assets" ("~~Assets” (“SFAS ~~142"~~142”). Under SFAS 142, ~~the Company~~goodwill is no longer ~~amortizes goodwill; instead, the Company~~amortized over its estimated useful life, but rather is ~~required to test the goodwill~~tested for impairment based upon fair values at least on an annual ~~basis, or more frequently should there be indicators that~~basis. In accordance with SFAS 142, the book value of goodwill ~~may be impaired. The Reorganized~~is assigned to the Company’s reporting units. See Note A—“General—Summary of Significant Accounting Policies” to the condensed consolidated financial statements set forth elsewhere herein.

~~Company has selected October 1 as the date of its annual impairment test, as opposed to September 1, which was the date used by the Predecessor Company.~~
Long-lived Assets.Long-lived assets, including property and equipment and intangible assets to be held and used, are currently reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount should be addressed pursuant to SFAS No. 144, ~~"Accounting~~“Accounting for the Impairment or Disposal of Long-Lived ~~Assets."~~Assets” (“SFAS 144”). Pursuant to this guidance, impairment is determined by comparing the carrying value of these long-lived assets to ~~management's~~management’s best estimate of the future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. The cash flow projections used to make this assessment are consistent with the cash flow projections that management uses internally ~~to assist~~ in making key decisions. In the event an impairment exists, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the asset, which is generally determined by using quoted market prices or the discounted present value of expected future cash flows.
Cost of Care and Medical Claims ~~Payable.~~Payable.   Cost of care ~~recorded as a component of operating expenses,~~ is recognized in the period in which members ~~receive~~received behavioral health services. In addition to actual benefits paid, cost of care includes the impact of accruals for estimates of medical claims payable.
Medical claims payable ~~in the Company's condensed consolidated balance sheets as of December 31, 2003 and September 30, 2004~~ represents the liability for healthcare claims reported but not yet paid and claims incurred but not yet reported ~~("IBNR"~~(“IBNR”). related to the Company’s managed healthcare businesses. The IBNR portion of medical claims payable is estimated based on past claims payment experience for member groups, enrollment data, utilization statistics, authorized healthcare services and other factors. This data is incorporated into contract-specific actuarial reserve models. ~~The~~Although considerable variability is inherent in such estimates, for submitted claims and IBNR claims are made on an accrual basis and adjusted in future periods as required. However, changes in assumptions for medical costs caused by changes in actual experience (such as changes inmanagement believes the delivery system, changes in utilization patterns, unforeseen fluctuations in claims backlogs, etc.) may ultimately prove these estimates inaccurate. As of September 30, 2004, the Reorganized Company believes that itsliability for medical claims payable ~~balance of $200.9 million~~ is ~~adequate in order to satisfy ultimate claim liabilities incurred through September 30, 2004.~~adequate. Medical claims payable balances are continually monitored and reviewed. Changes in assumptions for cost of care caused by changes in actual experience could cause ~~the~~these estimates to change in the near term. The Company believes that the amount of medical claims payable is adequate to cover its ultimate liability for unpaid claims as of March 31, 2005; however, actual claims payments and other items may differ from established estimates.
Deferred Taxes.The Company files a consolidated federal income tax return for the Company and its ~~eighty percent~~eighty-percent or more owned consolidated subsidiaries. The Company accounts for income taxes in accordance with SFAS No. 109, ~~"Accounting~~“Accounting for Income ~~Taxes".~~Taxes.” The Company estimates income taxes for each of the jurisdictions in which it operates. This process involves estimating current tax exposures together with assessing temporary differences resulting from differing treatment of items for tax and book purposes. Deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The Company then assesses the likelihood that the deferred tax assets will be recovered from the reversal of temporary timing differences and future taxable income, and to the extent the Company cannot conclude that recovery is more likely than not, it establishes a valuation allowance. The effect of a change in tax rates on deferred taxes is recognized in income in the period that includes the enactment date. ~~Valuation allowances on deferred tax assets are estimated based on the Company's assessment of the realizability of such amounts.~~
        ~~The Company notes that for~~For federal income tax purposes, the emergence from bankruptcy, including the cancellation of indebtedness event, ~~takes place~~occurred on ~~the date of the Company's emergence from bankruptcy (January~~January 5, ~~2004)~~2004, and the ~~actual~~ attribute reduction calculation as set forth under Internal Revenue Code Section 108 ~~occurs~~occurred at or immediately after December 31, 2004 (the taxable year of discharge), and generally after determining the income tax liability for 2004. The Company changed its income tax reporting year to a calendar year basis in conformity with its financial reporting year effective December 31, 2003. For financial reporting purposes, the emergence from bankruptcy is deemed to occur in 2003; however, since the Company did not emerge from bankruptcy until January 5, 2004, for federal income tax purposes, the emergence from bankruptcy is a 2004 event.

After consideration of the effect of bankruptcy emergence, including the effect of cancellation of indebtedness income and the related attribute reduction effects as provided under Internal Revenue Code Section 108, ~~and after consideration of changes in estimates identified upon completion of the December 31, 2003 federal income tax return,~~ the Company ~~had estimated tax~~estimates that it has reportable net operating loss carryforwards ~~("NOLs"~~(“NOLs”) as of December 31, ~~2003~~2004 of approximately ~~$492.2~~$525 million available to reduce future federal taxable income. ~~The future utilization of these NOLs could be limited under certain circumstances.~~ These estimated NOLs expire in ~~2008~~2009 through ~~2019.~~
        ~~Valuation allowances on deferred tax assets~~2020 and are estimated based on the Company's assessment of the realizability of such amounts. The Company's emergence from bankruptcy and financial restructuring activities created uncertainty as to the Company's ability to realize its NOLs and other deferred tax assets. In addition, the Company's utilization of NOLs became subject to ~~limitation under~~ examination and adjustment by the

Internal Revenue Code Section 382 upon emergence from bankruptcy, which affects the timing of the use of, or ultimate realization of, NOLs. Accordingly, as of December 31, 2003 and September 30, 2004, the Company has a total valuation allowance covering all of the Company's net deferred tax assets; therefore, the Company's income tax provision for fiscal 2004 does not include a deferred tax component.Service. In accordance with American Institute of Certified Public Accountants (“AICPA”) Statement of Position 90-7, “Financial Reporting by Entities in Reorganization under the Bankruptcy Code” (“SOP ~~90-7,~~90-7”), subsequent (post-bankruptcy) utilization by the ~~Reorganized~~ Company of NOLs which existed at January 5, 2004 will be accounted for as reductions to goodwill ~~or additional paid-in capital~~ and therefore, will only benefit cash flows due to reduced tax payments and will not benefit the ~~Company's~~Company’s tax provision for income ~~taxes in~~taxes.
Valuation allowances on deferred tax assets (including NOLs) are estimated based on the ~~statements~~Company’s assessment of ~~operations.~~the realizability of such amounts. The Company’s history of recent operating losses (prior to reorganization benefits) and financial restructuring activities and the lack of a sufficient history of profitable operations subsequent to its emergence from bankruptcy have created uncertainty as to the Company’s ability to realize its NOLs and other deferred tax assets. Accordingly, the Company had a valuation allowance covering substantially all of its net deferred tax assets at December 31, 2004 and March 31, 2005. As of December 31, 2004 and March 31, 2005, net deferred tax assets, after reduction for valuation allowance, represent the Company’s estimate of those net deferred tax assets which are more likely than not to be realizable.
The ~~Predecessor~~ Company recognized ~~current~~ tax expense attributable to estimated, current taxable income for the nine months ended September 30, 2003. This expense was recorded due to the anticipated utilization of previously recognized NOLs that were generated prior to a previous bankruptcy filing in 1992 and were generated prior to the occurrence of certain other events that may cause limitation on its NOLs. This expense also includes changes in estimates regarding the Company's utilization of the above-referenced NOLs due to amendments of prior year tax returns. The Reorganized Company recognized current tax expense attributable to estimated, current taxable income for the nine months ended September 30, 2004. This expense was recorded due to the estimated utilization of NOLs that were generated by the Predecessor Company and were generated prior to the occurrence of certain events that may cause limitation on its NOLs.
        ~~Stock-Based Compensation.~~    The Company accounts for stock-based compensation in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and has adopted the disclosure provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). Under APB 25, stock compensation expense is recognized to the extent that the fair market value of the common stock on the date of the grant of shares and/or options exceeds the exercise price of the shares and/or options. The expense is recognized on the date of the grant of shares or evenly over the vesting period of the underlying options in the case of stock options. In accordance with SFAS 123, the Company discloses the pro forma effect on net income (loss) and income (loss) per common share in the notes to the consolidated financial statements assuming the shares and/or options were valued at fair value.
~~Accounting Impact of Chapter 11 Filing~~
        In connection with the consummation of the Plan, the Company adopted the fresh start reporting provisions of SOP 90-7 with respect to its financial reports, which required the Company to restate its assets and liabilities to their fair values based upon the provisions of the Plan and certain valuations which the Company made in connection with the implementation of the Plan. The Company applied the fresh start reporting provisions as of December 31, 2003. Upon adoption of fresh start reporting, the Company created, in substance, per SOP 90-7, a new reporting entity. Accordingly, the unaudited condensed consolidated statements of operations for the three months and nine months ended September 30, 2004 and statement of cash flows for the nine months ended September 30, 2004 are not

comparable with the unaudited condensed consolidated statements of operations for the three months and nine months ended September 30, 2003 and statement of cash flows for the nine months ended September 30, 2003. Therefore, all statements of operations data for the three months and nine months ended September 30, 2004 and statement of cash flows data for the nine months ended September 30, 2004 have been disclosed herein as results of operations and cash flows of the Reorganized Company, and all statements of operations data for the three months and nine months ended September 30, 2003 and statement of cash flows data for the nine months ended September 30, 2003 have been disclosed herein as results of operations and cash flows of the Predecessor Company. Balance sheet data as of December 31, 2003 and September 30, 2004 presented herein represents balances of the Reorganized Company. All references to the Company with respect to disclosures of amounts recorded for the three months and nine months ended September 30, 2003 in relation to income statement items and recorded for the nine months ended September 30, 2003 in relation to cash flow items pertain to the Predecessor Company. All references to the Company with respect to disclosures of amounts recorded for the three months and nine months ended September 30, 2004 or to be recorded subsequent to September 30, 2004 in relation to income statement items and recorded for the nine months ended September 30, 2004 or recorded subsequent to September 30, 2004 in relation to cash flow items pertain to the Reorganized Company.
        The unaudited condensed consolidated statements of operations for the three months and nine months ended September 30, 2003 and statement of cash flows for the nine months ended September 30, 2003 in this Form 10-Q were prepared in accordance with SOP 90-7, as the Predecessor Company was under bankruptcy protection during those periods. As such, the Predecessor Company's unaudited condensed consolidated statements of operations for the three months and nine months ended September 30, 2003 and statement of cash flows for the nine months ended September 30, 2003 distinguished transactions and events that were directly associated with the reorganization from the Predecessor Company's ongoing operations. In accordance with SOP 90-7, the write-off of deferred financing fees associated with the 9.375% senior notes due 2007 (the "Old Senior Notes") and the 9% senior subordinated notes due 2008 (the "Old Subordinated Notes"), as well as certain professional fees and expenses and other amounts directly associated with the bankruptcy process, were recorded as reorganization expenses, and are included in the unaudited condensed consolidated statement of operations caption "Reorganization expense, net" for the three months and nine months ended September 30, 2003.
        ~~In accordance with SOP 90-7, the Predecessor Company's redeemable preferred stock was recorded at the amount expected to be allowed as a claim by the Bankruptcy Court. Accordingly, during the~~ three months ended March 31, ~~2003,~~2004 and 2005 due to the ~~Predecessor Company recorded~~uncertainty as to the Company’s ability to realize deferred tax assets based on its history of recent operating losses (prior to reorganization benefits) and financial restructuring activities and the lack of a ~~net $2.7 million adjustment,~~sufficient history of profitable operations subsequent to its emergence from bankruptcy.
Emergence from Chapter 11
On January 5, 2004 (the “Effective Date”), Magellan and 88 of its subsidiaries consummated their Third Joint Amended Plan of Reorganization, as modified and confirmed (the “Plan”), under chapter 11 of title 11 of the United States Bankruptcy Code (the “Bankruptcy Code”), which was ~~mainly composed~~confirmed by order of the ~~write-off~~United States Bankruptcy Court for the Southern District of ~~unamortized issuance costs~~New York (the “Bankruptcy Court”) on October 8, 2003, and accordingly the Plan became fully effective and the companies emerged from the protection of their chapter 11 proceedings. A final decree closing their chapter 11 cases was entered by the Bankruptcy Court on January 19, 2005.
All distributions required by the Plan were made as of the Effective Date except for distributions related to disputed claims for certain general unsecured creditor claims (“Other GUCs”), for which distributions were made subsequent to the ~~redeemable preferred stock. Such~~Effective Date periodically as such disputed claims were settled. As of April 22, 2005, the total amount of outstanding, disputed claims for Other GUCs is ~~reflected in "Preferred stock reorganization items, net" in the accompanying unaudited condensed consolidated statements of operations~~$4.0 million (“Disputed Claims”). The Company does not believe that it is probable that any liability for the ~~nine months ended September 30, 2003 set forth elsewhere herein.~~Disputed Claims will be incurred, and thus no liability has been recorded for the Disputed Claims as of March 31, 2005. Nonetheless, the Company has withheld from distribution 93,128 shares of Ordinary Common Stock which will be distributed in accordance with the terms of the Plan upon the final resolution of the Disputed Claims. If the Disputed Claims were to be settled for the full amount of $4.0 million, then the amount of additional consideration that the Company would be required to issue to the individual claimants that filed the Disputed Claims is cash of $0.2 million and 9.375% Series B Notes due 2008 (“Series B Notes”) of $1.0 million.
Results of Operations
The Company evaluates performance of its segments based on profit or loss from continuing operations before depreciation and amortization, interest expense, interest income, ~~reorganization expense,~~ stock compensation expense, special ~~charges, goodwill impairment~~ charges, income taxes and minority interest ("(“Segment ~~Profit"~~Profit”). Management uses ~~segment profit~~Segment Profit information for internal reporting and control purposes and considers it important in making decisions regarding the allocation of capital and other resources, risk assessment and employee

compensation, among other matters. See Note I—"“Business Segment ~~Information"~~Information” to the ~~Company's~~Company’s unaudited condensed consolidated financial statements set forth elsewhere herein.

The following tables summarize, for the periods indicated, operating results by business segment (in thousands):

Predecessor Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Three Months Ended September 30, 2003
Net revenue $ 205,740 $ 38,837 $ 129,130 $ — $ 373,707
Cost of care 107,626 9,792 105,406 — 222,824
Direct service costs 44,766 19,085 13,236 — 77,087
Other operating expenses — — — 31,676 31,676
Equity in (earnings) loss of unconsolidated subsidiaries (1,797 ) — 435 — (1,362 )

Segment profit (loss) $ 55,145 $ 9,960 $ 10,053 $ (31,676 ) $ 43,482

Reorganized Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Three Months Ended September 30, 2004
Net revenue $ 233,769 $ 32,991 $ 191,194 $ — $ 457,954
Cost of care 126,681 8,981 167,706 — 303,368
Direct service costs 41,483 15,785 10,746 — 68,014
Other operating expenses — — — 22,992 22,992
Equity in earnings of unconsolidated subsidiaries (1,863 ) — — — (1,863 )

Segment profit (loss) $ 67,468 $ 8,225 $ 12,742 $ (22,992 ) $ 65,443

Predecessor Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Nine Months Ended September 30, 2003
Net revenue $ 654,787 $ 121,329 $ 396,835 $ — $ 1,172,951
Cost of care 372,936 34,496 326,049 — 733,481
Direct service costs 135,810 60,213 39,064 — 235,087
Other operating expenses — — — 83,434 83,434
Equity in (earnings) loss of unconsolidated subsidiaries (4,751 ) — 1,590 — (3,161 )

Segment profit (loss) $ 150,792 $ 26,620 $ 30,132 $ (83,434 ) $ 124,110

Reorganized Company

Health
Plan
Solutions
Employer
Solutions
Public
Sector
Solutions
Corporate
and
Other
Consolidated

Nine Months Ended September 30, 2004
Net revenue $ 684,094 $ 102,254 $ 563,886 $ — $ 1,350,234
Cost of care 370,254 29,028 499,513 — 898,795
Direct service costs 128,981 49,981 31,190 — 210,152
Other operating expenses — — — 73,234 73,234
Equity in earnings of unconsolidated subsidiaries (5,561 ) — — — (5,561 )

Segment profit (loss) $ 190,420 $ 23,245 $ 33,183 $ (73,234 ) $ 173,614

Health
Plan
Solutions

Employer
Solutions

Public
Sector
Solutions

Corporate
and
Other

Consolidated

Three Months Ended March 31, 2004

Net revenue

$
223,139

$
35,269

$
181,768

$
—

$
440,176

Cost of care

123,010

10,227

160,967

—

294,204

Direct service costs

44,372

18,192

10,273

—

72,837

Other operating expenses

—

—

—

26,887

26,887

Equity in earnings of unconsolidated subsidiaries

(1,844
)
—

—

—

(1,844
)

Segment profit (loss)

$
57,601

$
6,850

$
10,528

$
(26,887
)

$
48,092

Health
Plan
Solutions

Employer
Solutions

Public
Sector
Solutions

Corporate
and
Other

Consolidated

Three Months Ended March 31, 2005

Net revenue

$
224,902

$
31,660

$
196,192

$
—

$
452,754

Cost of care

121,728

7,860

174,620

—

304,208

Direct service costs

39,582

15,705

7,587

—

62,874

Other operating expenses

—

—

—

25,847

25,847

Equity in earnings of unconsolidated subsidiaries

(1,449
)
—

—

—

(1,449
)

Segment profit (loss)

$
65,041

$
8,095

$
13,985

$
(25,847
)

$
61,274

The segment financial information disclosed for the three ~~and nine~~ months ended ~~September 30, 2003~~March 31, 2004 in the tables above is different than that which was previously reported in the Quarterly Report on Form 10-Q for the quarter ended ~~September 30, 2003,~~March 31, 2004, due to certain reclassifications between segments. See Note I—"”Business Segment ~~Information"~~Information�� to the ~~unaudited~~ condensed consolidated financial statements set forth elsewhere herein for further discussion of the segment reclassifications.
The following table reconciles Segment Profit ~~as calculated above~~ to consolidated ~~net~~ income ~~(loss) for the periods indicated~~from continuing operations before income taxes and minority interest (in thousands):

Predecessor Company
Reorganized Company
Predecessor Company
Reorganized Company

Three Months Ended
September 30, 2003
Three Months Ended
September 30, 2004
Nine Months Ended
September 30, 2003
Nine Months Ended
September 30, 2004

Segment profit $ 43,482 $ 65,443 $ 124,110 $ 173,614
Depreciation and amortization (11,593 ) (10,712 ) (36,265 ) (31,478 )
Interest expense (4,748 ) (9,109 ) (31,474 ) (27,499 )
Interest income 670 1,760 2,173 3,593
Reorganization expense, net (4,540 ) — (32,245 ) —
Stock compensation expense — (2,580 ) — (15,898 )
Special charges (3,230 ) (1,770 ) (5,322 ) (4,304 )
Goodwill impairment charges (28,780 ) — (28,780 ) —

Income (loss) from continuing operations before income taxes and minority interest (8,739 ) 43,032 (7,803 ) 98,028
Provision for income taxes 20,825 15,712 24,258 28,976

Income (loss) from continuing operations before minority interest (29,564 ) 27,320 (32,061 ) 69,052
Minority interest, net 3 157 170 526

Income (loss) from continuing operations (29,567 ) 27,163 (32,231 ) 68,526

Discontinued operations:
Income (loss) from discontinued operations(1) (25,233 ) (579 ) (25,849 ) (509 )
Income (loss) on disposal of discontinued operations(1) 4,271 (28 ) 6,421 (99 )
Reorganization benefit, net(1) 314 — 3,481 —

(20,648 ) (607 ) (15,947 ) (608 )

Net income (loss) $ (50,215 ) $ 26,556 $ (48,178 ) $ 67,918

~~(1)~~
~~Net of related income taxes.~~

Three Months Ended
March 31,

2004

2005

Segment profit

$
48,092

$
61,274

Depreciation and amortization

(10,249
)
(11,218
)
Interest expense

(9,334
)
(8,639
)
Interest income

781

3,033

Stock compensation expense

(10,777
)
(3,750
)
Special charges

(1,908
)
—

Income from continuing operations before income taxes and minority interest

$
16,605

$
40,700

~~Reorganized Company quarter~~Quarter ended ~~September 30, 2004 ("~~March 31, 2005 (“Current Year ~~Quarter"~~Quarter”), compared to the ~~Predecessor Company~~ quarter ended ~~September 30, 2003 ("~~March 31, 2004 (“Prior Year ~~Quarter"~~Quarter”)
Health Plan Solutions
Net Revenue
Net revenue related to the Health Plan Solutions segment increased by ~~13.6~~0.8 percent or ~~$28.0~~$1.8 million from the Prior Year Quarter to the Current Year Quarter. The increase in revenue is mainly due to net favorable rate changes of $10.2 million, increased membership from existing customers of ~~$11.1~~$4.7 million, favorable ~~rate changes~~performance revenue due to timing of ~~$10.3 million, favorable contractual settlements with customers in the Current Year Quarter related to prior periods of $5.5~~$1.8 million, and other net changes totaling ~~$7.3~~$0.6 million, which increases were partially offset by decreases due to terminated contracts of ~~$6.2~~$15.5 million.
Cost of Care
Cost of care ~~increased~~decreased by ~~17.7~~1.0 percent or ~~$19.1~~$1.3 million from the Prior Year Quarter to the Current Year Quarter. The ~~increase~~decrease in cost of care is primarily due to terminated contracts of $10.0 million, and favorable prior period medical claims development recorded in the Current Year Quarter of $1.7 million, which decreases were offset by net increased membership from existing customers of ~~$6.3~~$1.4 million, favorable prior period medical claims development recorded in the Prior Year Quarter ~~relating to periods prior to the Prior Year Quarter~~ of ~~$8.2~~$2.3 million, and estimated higher costs due to care trends and other net changes of $17.9 million, which increases were partially offset by terminated contracts of $1.8 million, and favorable medical claims development affecting the Prior Year Quarter recorded subsequent to the Prior Year Quarter of $11.5$6.7 million. Cost of care ~~increased~~decreased as a percentage of risk revenue from ~~65.9~~69.0 percent in the Prior Year Quarter to ~~67.6~~67.9 percent in the Current Year Quarter, mainly due to ~~higher costs due to care trends.~~the net favorable performance revenue and rate changes discussed above, as well as changes in business mix.
Direct Service Costs
Direct service costs decreased by ~~7.3~~10.8 percent or ~~$3.3~~$4.8 million from the Prior Year Quarter to the Current Year Quarter. The decrease in direct service costs is primarily due to the effect of cost reduction efforts undertaken by the Company ~~including the shutdown of several regional service centers, as well as lower costs required to support the Company's decrease~~ in ~~net membership.~~2004. Direct service costs decreased as a percentage of revenue from ~~21.8~~19.9 percent ~~for the Predecessor Company~~ in the Prior Year Quarter to ~~17.7~~17.6 percent for ~~the Reorganized Company in~~ the Current Year Quarter. The decrease in the percentage of direct service costs in relationship to revenue is mainly due to the aforementioned cost reduction efforts undertaken by the ~~Company and rate and other revenue increases since the Prior Year Quarter.~~Company.
Equity in ~~(Earnings) Loss~~Earnings of Unconsolidated Subsidiaries
Equity in ~~(earnings)~~earnings of unconsolidated subsidiaries ~~increased 3.7~~decreased 21.4 percent or ~~$0.1~~$0.4 million from the Prior Year Quarter to the Current Year Quarter. The ~~increase~~decrease relates to ~~an increase~~a decrease in equity in earnings related to the ~~Company's~~Company’s investment in Royal Health Care, LLC ~~("Royal"~~(“Royal”), mainly due to ~~increased Royal membership.~~a decrease in Royal’s rates with its customers.
Employer Solutions
Net Revenue
Net revenue related to the Employer Solutions segment decreased by ~~15.1~~10.2 percent or ~~$5.8~~$3.6 million from the Prior Year Quarter to the Current Year Quarter. The decrease in revenue is mainly due to terminated contracts of ~~$6.5~~$4.0 million, and other net unfavorable changes of $1.3 million (mainly due to rates and program changes), which ~~decrease was~~decreases were partially offset by ~~membership~~revenue from new customers ~~and other net changes~~ of ~~$0.7~~$1.7 million.
27

Predecessor Company
Reorganized Company

Three Months Ended
September 30, 2003
Three Months Ended
September 30, 2004

Healthcare provider and franchising segments $ 2,956 $ (28 )
Specialty managed healthcare segment 1,367 —
Human services segment (52 ) —

$ 4,271 $ (28 )

Predecessor Company
Reorganized Company

Three Months Ended
September 30, 2003
Three Months Ended
September 30, 2004
Healthcare provider and franchising segments $ 289 $ —
Specialty managed healthcare segment 25 —

$ 314 $ —

Predecessor Company
Reorganized Company

Nine Months Ended
September 30, 2003
Nine Months Ended
September 30, 2004

Healthcare provider and franchising segments $ (25,733 ) $ (145 )
Specialty managed healthcare segment (116 ) 80
Human services segment — (444 )

$ (25,849 ) $ (509 )

Predecessor Company
Reorganized Company

Nine Months Ended
September 30, 2003
Nine Months Ended
September 30, 2004

Healthcare provider and franchising segments $ 4,418 $ (99 )
Specialty managed healthcare segment 2,003 —

$ 6,421 $ (99 )

Predecessor Company
Reorganized Company

Nine Months Ended
September 30, 2003
Nine Months Ended
September 30, 2004
Healthcare provider and franchising segments $ (55 ) $ —
Specialty managed healthcare segment 3,536 —

$ 3,481 $ —

PART II—OTHER INFORMATION

Item 1.1. Legal Proceedings.

The management and administration of the delivery of managed behavioral healthcare services entails significant risks of liability. From time to time, the Company is subject to various actions and claims arising from the acts or omissions of its employees, network providers or other parties. In the normal course of business, the Company receives reports relating to suicides and other serious incidents involving patients enrolled in its programs. Such incidents occasionally give rise to malpractice, professional negligence and other related actions and claims against the Company or its network providers. Many of these actions and claims received by the Company seek substantial damages and therefore require the defendant to incur significant fees and costs related to their defense. To date, claims and actions against the Company alleging professional negligence have not resulted in material liabilities and the Company does not believe that any such pending action against it will have a material adverse effect on the Company. However, there can be no assurance that pending or future actions or claims for professional liability (including any judgments, settlements or costs associated therewith) will not have a material adverse effect on the Company.

The Company is subject to or party to certain class action suits, litigation and claims relating to its operations and business practices. ~~Litigation~~Except as otherwise provided under the Plan, litigation asserting claims against the Company and its subsidiaries that were parties to the chapter 11 proceedings for pre-petition obligations (the ~~"Pre-petition Litigation"~~“Pre-petition Litigation”), was enjoined as of the Effective Date as a consequence of the confirmation of the Plan inby the ~~Company's chapter 11 proceedings.~~Bankruptcy Court. The Company believes that ~~except as otherwise provided by the Plan,~~ the Pre-petition Litigation claims constitute pre-petition general unsecured claims and, to the extent allowed by the ~~bankruptcy court,~~Bankruptcy Court, would be resolved as ~~other general unsecured claims under~~Other General Unsecured Claims as defined by the Plan.

In the opinion of management, the Company has recorded reserves that are adequate to cover litigation, claims or assessments that have been or may be asserted against the Company, and for which the outcome is probable and reasonably estimable. Management believes that the resolution of such litigation and claims will not have a material adverse effect on the ~~Company's~~Company’s financial position or results of operations; however, there can be no assurance in this regard.

Item 2.2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3.3. Defaults Upon Senior Securities.

None.

Item 4.4. Submission of Matters to a Vote of Security Holders.

None.

Item 5.5. Other Information.

The Company entered into an amendment, effective as of October 25, 2004, of its Credit Agreement to reduce the annual interest rate on borrowings under the Term Loan Facility and to reduce the commitment fee on the Credit-Linked Facility, as further discussed in Note D—"Long-Term Debt and Capital Lease Obligations" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein.None.

Item 6.6. Exhibits

31.1

~~10.1~~

~~Amendment to Credit Agreement effective as of October 25, 2004.~~

~~31.1~~

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2

~~31.2~~

Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1

~~32.1~~

Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2

~~32.2~~

Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

35

SIGNATURES
~~SIGNATURES~~

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: ~~October 29, 2004~~April 28, 2005	MAGELLAN HEALTH SERVICES, INC. ~~(Registrant)~~
	(Registrant)
	/s/ MARK S. DEMILIO
	Mark S. Demilio
	Executive Vice President and Chief Financial Officer
	(Principal Financial Officer and Duly Authorized Officer)

						Page No.
PART I—Financial Information:
	Item 1:		Financial Statements		3
		Condensed Consolidated Balance Sheets—December 31, ~~2003~~2004 and ~~September 30, 2004~~March 31, 2005		3
		Condensed Consolidated Statements of ~~Operations—~~Income—For the Three Months Ended March 31, 2004 and ~~Nine Months Ended September 30, 2003 for the Predecessor Company and for the Three Months and Nine Months Ended September 30, 2004 for the Reorganized Company~~2005		4
		Condensed Consolidated Statements of Cash Flows—For the ~~Nine~~Three Months Ended ~~September 30, 2003 for the Predecessor Company~~March 31, 2004 and ~~for the Nine Months Ended September 30, 2004 for the Reorganized Company~~2005		5
		Notes to Condensed Consolidated Financial Statements		6
	Item 2:		~~Management's~~Management’s Discussion and Analysis of Financial Condition and Results of Operations		20
	Item 3:		Quantitative and Qualitative Disclosures About Market Risk		34
	Item 4:		Controls and Procedures		34
PART II—Other Information:
	Item 1:		Legal Proceedings		35
	Item 2:		Unregistered Sales of Equity Securities and Use of Proceeds		35
	Item 3:		Defaults Upon Senior Securities		35
	Item 4:		Submission of Matters to a Vote of Security Holders		35
	Item 5:		Other Information		35
	Item 6:		Exhibits		35
Signatures			~~Signatures~~	36

							December 31,				March 31,
			December 31, 2003		September 30, 2004		2004				2005
					(Unaudited)						(unaudited)
ASSETS	ASSETS
Current Assets:	Current Assets:
	Cash and cash equivalents		$	206,948	$	313,890
	Stock subscriptions receivable			146,871		—
	Accounts receivable, less allowance for doubtful accounts of $5,178 at December 31, 2003 and $2,690 at September 30, 2004			83,919		92,896
	Restricted cash, investments and deposits			161,923		179,044
	Other current assets			30,562		11,831

		Total current assets		630,223		597,661
Cash and cash equivalents								$	45,390			$	37,053
Restricted cash								104,414				116,328
Accounts receivable, less allowance for doubtful accounts of $2,107 and $2,213 at December 31, 2004 and March 31, 2005, respectively								58,850				59,870
Short-term investments (restricted investments of $35,600 and $31,554 at December 31, 2004 and March 31, 2005, respectively)								294,803				341,090
Other current assets (restricted deposits of $17,098 and $18,231 at December 31, 2004 and March 31, 2005, respectively)								37,038				28,473
Total Current Assets								540,495				582,814
Property and equipment, net	Property and equipment, net			122,082		112,099		120,604				117,759
Long-term investments (restricted investments of $592 and $3,255 at December 31, 2004 and March 31, 2005, respectively)								51,287				45,435
Investments in unconsolidated subsidiaries	Investments in unconsolidated subsidiaries			13,034		15,773		10,989				12,438
Deferred income taxes								14,362				14,774
Other long-term assets	Other long-term assets			18,334		23,487		14,078				13,056
Goodwill	Goodwill			450,244		450,244		392,267				377,163
Other intangible assets, net	Other intangible assets, net			58,100		47,717		44,256				40,795

			$	1,292,017	$	1,246,981

LIABILITIES AND STOCKHOLDERS' EQUITY
Total Assets								$	1,188,338			$	1,204,234
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:	Current Liabilities:
	Accounts payable		$	23,355	$	16,810
	Accrued liabilities			205,868		170,837
	Medical claims payable			177,141		200,891
	Current maturities of long-term debt and capital lease obligations			24,785		23,543
	Debt paid upon consummation of the Plan			92,382		—

		Total current liabilities		523,531		412,081
Accounts payable								$	13,146			$	11,299
Accrued liabilities								99,366				81,663
Medical claims payable								194,638				209,937
Current maturities of long-term debt and capital lease obligations								75,158				74,170
Total Current Liabilities								382,308				377,069
Long-term debt and capital lease obligations	Long-term debt and capital lease obligations			376,532		360,308		304,320				297,960
Deferred credits and other long-term liabilities	Deferred credits and other long-term liabilities			1,802		1,751		1,825				1,802
Minority interest	Minority interest			2,241		2,990		2,832				2,949
Stockholders' Equity:
	Preferred stock, par value $0.01 per share; Authorized—10,000 shares—Issued and outstanding—none at December 31, 2003 and September 30, 2004			—		—
	Ordinary common stock, par value $0.01 per share; Authorized—100,000 shares—26,552 shares issued and outstanding at December 31, 2003 and 26,883 shares issued and outstanding at September 30, 2004			265		269
	Multi-Vote common stock, par value $0.01 per share; Authorized—40,000 shares—8,553 shares issued and outstanding at December 31, 2003 and 8,488 shares issued and outstanding at September 30, 2004			86		85
Other Stockholders' Equity:
	Additional paid-in capital			379,067		393,086
	Retained earnings			—		67,918
	Warrants outstanding			8,493		8,493

		Total stockholders' equity		387,911		469,851

			$	1,292,017	$	1,246,981

Total Liabilities								691,285				679,780
Commitments and Contingencies
Stockholders’ Equity:
Preferred stock, par value $.01 per share
Authorized—10,000 shares at December 31, 2004 and March 31, 2005—Issued and outstanding—none at December 31, 2004 and March 31, 2005								—				—
Ordinary common stock, par value $.01 per share
Authorized—100,000 shares at December 31, 2004 and March 31, 2005—Issued and outstanding—26,883 shares and 27,006 shares at December 31, 2004 and March 31, 2005, respectively								269				270
Multi-Vote common stock, par value $.01 per share
Authorized—40,000 shares at December 31, 2004 and March 31, 2005—Issued and outstanding—8,488 shares and 8,506 shares at December 31, 2004 and March 31, 2005, respectively								85				85
Other Stockholders’ Equity:
Additional paid-in capital								400,340				405,058
Retained earnings								88,372				111,988
Warrants outstanding								8,493				8,489
Accumulated other comprehensive loss								(506		)		(1,436		)
Total Stockholders’ Equity								497,053				524,454
Total Liabilities and Stockholders’ Equity								$	1,188,338			$	1,204,234

				Predecessor Company			Reorganized Company			Three Months Ended March 31,
				Nine Months Ended September 30, 2003			Nine Months Ended September 30, 2004			2004			2005
Cash flows from operating activities:	Cash flows from operating activities:
	Net income (loss)			$	(48,178	)	$	67,918
	Adjustments to reconcile net income (loss) to net cash from operating activities:
		(Gain) loss on sale of assets			(4,460	)		141
		Depreciation and amortization			36,265			31,478
		Goodwill impairment charges			28,780			—
		Equity in earnings of unconsolidated subsidiaries			(3,161	)		(5,561	)
		Non-cash reorganization expense			12,464			—
		Non-cash interest expense			3,668			1,197
		Non-cash stock compensation expense			—			13,021
		Cash flows from changes in assets and liabilities:
			Accounts receivable, net		14,233			(8,977	)
			Restricted cash, investments and deposits		7,503			(17,121	)
			Net cash flows related to unconsolidated subsidiaries		(16	)		2,822
			Income taxes payable and deferred income taxes		1,503			—
			Other assets		(12,795	)		19,803
			Accounts payable and accrued liabilities		110,972			(41,576	)
			Medical claims payable		(7,618	)		23,750
			Other liabilities		(1,063	)		(51	)
			Minority interest, net of dividends paid		231			749
			Other		2,151			718

Net income										$	12,938		$	23,616
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization										10,249			11,218
Equity in earnings of unconsolidated subsidiaries										(1,844		)	(1,449		)
Non-cash interest expense										401			347
Non-cash stock compensation expense										7,900			3,750
Non-cash income tax expense										—			14,712
Cash flows from changes in assets and liabilities:
Restricted cash										(6,806		)	(11,914		)
Accounts receivable, net										5,197			(1,020		)
Other assets										27,114			2,240
Net cash flows related to unconsolidated subsidiaries										1,135			—
Accounts payable and accrued liabilities										(66,395		)	(19,322		)
Medical claims payable										6,251			15,299
Other liabilities										(11		)	(23		)
Minority interest, net of dividends paid										164			116
Other										2			187
Total adjustments	Total adjustments				188,657			20,393		(16,643		)	14,141

		Net cash from operating activities			140,479			88,311

Net cash (used in) provided by operating activities										(3,705		)	37,757
Cash flows from investing activities:	Cash flows from investing activities:
	Capital expenditures				(15,228	)		(12,445	)
	Acquisitions and investments in businesses				(3,731	)		—
	Proceeds from sale of assets, net of transaction costs				2,588			2,302

		Net cash from investing activities			(16,371	)		(10,143	)

Capital expenditures										(4,626		)	(5,047		)
Purchase of investments										—			(118,081		)
Maturity of investments										—			77,002
Proceeds from note receivable										—			7,000
Net cash used in investing activities										(4,626		)	(39,126		)
Cash flows from financing activities:	Cash flows from financing activities:
	Proceeds from issuance of new equity, net of issuance costs				—			147,871
	Proceeds from issuance of debt, net of issuance costs				49			92,806
	Payments on long-term debt				—			(203,632	)
	Payments on capital lease obligations				(2,556	)		(8,271	)
	Proceeds from stock issued under employee stock purchase plan				25			—

		Net cash from financing activities			(2,482	)		28,774

Net increase in cash and cash equivalents					121,626			106,942
Proceeds from issuance of new equity, net of issuance costs										147,871			—
Proceeds from issuance of debt, net of issuance costs										92,580			—
Payments on long-term debt										(196,132		)	(5,625		)
Payments on capital lease obligations										(776		)	(1,788		)
Proceeds from exercise of stock options and warrants										—			445
Net cash provided by (used in) financing activities										43,543			(6,968		)
Net increase (decrease) in cash and cash equivalents										35,212			(8,337		)
Cash and cash equivalents at beginning of period	Cash and cash equivalents at beginning of period				62,488			206,948		206,948			45,390

Cash and cash equivalents at end of period	Cash and cash equivalents at end of period			$	184,114		$	313,890		$	242,160		$	37,053

Weighted average number of common shares outstanding—basic (See Note E)			35,319			35,371			35,300			35,365

Weighted average number of common shares outstanding—diluted (See Note E)			35,319			36,594			35,300			36,235

Income (loss) per common share available to common stockholders—basic:
	Income (loss) from continuing operations	$	(0.84	)	$	0.77		$	(1.02	)	$	1.94

	Income (loss) from discontinued operations	$	(0.58	)	$	(0.02	)	$	(0.45	)	$	(0.02	)

	Net income (loss)	$	(1.42	)	$	0.75		$	(1.47	)	$	1.92

Income (loss) per common share available to common stockholders—diluted:
	Income (loss) from continuing operations	$	(0.84	)	$	0.74		$	(1.02	)	$	1.89

	Income (loss) from discontinued operations	$	(0.58	)	$	(0.01	)	$	(0.45	)	$	(0.02	)

	Net income (loss)	$	(1.42	)	$	0.73		$	(1.47	)	$	1.87

		Predecessor Company
		Three Months Ended September 30, 2003			Nine Months Ended September 30, 2003
Continuing operations:
	Deferred financing costs	$	—		$	18,459
	Professional fees and expenses		7,112			17,019
	Net benefit from lease rejections		(331	)		(599	)
	Net benefit from resolution of claims through Bankruptcy Court proceedings		(1,920	)		(1,920	)
	Interest income		(321	)		(714	)

		$	4,540		$	32,245

Discontinued operations, before taxes:
	Net benefit from lease rejections		(259	)		(3,426	)
	Net benefit from resolution of claims through Bankruptcy Court proceeding		(29	)		(29	)

		$	(288	)	$	(3,455	)

	Amortized Cost		Gross Unrealized Gains			Gross Unrealized Losses				Estimated Fair Value
U.S. Government and agency securities	$	220,091		$	—		$	(474	)	$	219,617
Corporate debt securities	126,376			—			(370		)	126,006
Certificates of deposit	467			—			—			467
Total investments at December 31, 2004	$	346,934		$	—		$	(844	)	$	346,090

	Amortized Cost		Estimated Fair Value
Due in 2005	$	312,322	$	311,621
Due in 2006	75,639		74,904
Total investments at March 31, 2005	$	387,961	$	386,525

Balance as of December 31, 2004	$	392,267
Adjustment to goodwill as a result of the projected realization of net operating loss carryforwards subsequent to fresh-start reporting(1)	(15,104		)
Balance as of March 31, 2005	$	377,163

Type of Cost	Balance December 31, 2003		Additions		Payments			Adjustments(1)		Balance September 30, 2004
Employee severance and termination benefits	$	4,702	$	2,613	$	(5,183	)	$	48	$	2,180
Lease termination and other costs		146		1,802		(353	)		—		1,595

	$	4,848	$	4,415	$	(5,536	)	$	48	$	3,775

Type of Cost	Balance December 31, 2004			Additions			Payments				Balance March 31, 2005
Employee severance and termination benefits		$	866		$	—		$	(661	)		$	205
Lease termination and other costs		1,448			—			(143		)		1,305
		$	2,314		$	—		$	(804	)		$	1,510

	Predecessor Company
	Health Plan Solutions			Employer Solutions		Public Sector Solutions		Corporate and Other			Consolidated
Three Months Ended September 30, 2003
Net revenue	$	205,740		$	38,837	$	129,130	$	—		$	373,707
Cost of care		107,626			9,792		105,406		—			222,824
Direct service costs		44,766			19,085		13,236		—			77,087
Other operating expenses		—			—		—		31,676			31,676
Equity in (earnings) loss of unconsolidated subsidiaries		(1,797	)		—		435		—			(1,362	)

Segment profit (loss)	$	55,145		$	9,960	$	10,053	$	(31,676	)	$	43,482

	Predecessor Company			Reorganized Company			Three Months Ended March 31,
	Three Months Ended September 30, 2003			Three Months Ended September 30, 2004			2004				2005
Healthcare provider and franchising segments	$	(25,117	)	$	(121	)		$	(11	)	$	(72	)
Specialty managed healthcare segment		(116	)		(14	)		41			(5		)
Human services segment		—			(444	)		—			125
								$	30		$	48
	$	(25,233	)	$	(579	)

31.1	~~10.1~~	~~Amendment to Credit Agreement effective as of October 25, 2004.~~
	~~31.1~~	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	~~31.2~~	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	~~32.1~~	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	~~32.2~~	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.