UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM10-Q

For the quarterly period ended March 31,September 30, 2018

OR

For the transition period from                    to                    

Commission File Number1-12607

SUNLINK HEALTH SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

900 Circle 75 Parkway, Suite 1120, Atlanta, Georgia 30339

(Address of principal executive offices)

(Zip Code)

(770)933-7000

(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 filings requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of RegulationS-T (§232.405 of this chapterchapter) during the preceding 12 months (of for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).    Yes   ☐    No  ☒

The number of Common Shares, without par value, outstanding as of May 11,November 13, 2018 was 7,416,814.7,346,814.

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

See notes to condensed consolidated financial statements.

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SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE EARNINGS (LOSS)

(In thousands, except per share amounts)

(unaudited)

See notes to condensed consolidated financial statements.

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SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See notes to condensed consolidated financial statements.

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SUNLINK HEALTH SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED MARCH 31,SEPTEMBER 30, 2018

(all dollar amounts in thousands except per share amounts)

(unaudited)

Note 1. – –Basis of Presentation and Adoption of Recently Issued Accounting Standards

Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements as of March 31,September 30, 2018 and for the three and nine month periods ended March 31,September 30, 2018 and 2017 have been prepared in accordance with Rule10-01 of RegulationS-X of the Securities and Exchange Commission (“SEC”) and, as such, do not include all information required by accounting principles generally accepted in the United States of America (“GAAP”). The condensed consolidated June 30, 20172018 balance sheet included in this interim filing has been derived from the audited financial statements at that date but does not include all of the information and related notes required by GAAP for complete financial statements. These Condensed Consolidated Financial Statements should be read in conjunction with the audited consolidated financial statements included in the SunLink Health Systems, Inc. (“SunLink”, “we”, “our”, “ours”, “us” or the “Company”) Annual Report on Form10-K for the fiscal year ended June 30, 2017,2018, filed with the SEC on September 28, 2017.25, 2018. In the opinion of management, the Condensed Consolidated Financial Statements, which are unaudited, include all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position and results of operations for the periods indicated. The results of operations for the three and nine month periodsperiod ended March 31,September 30, 2018 are not necessarily indicative of the results that may be expected for the entire fiscal year or any other interim period.

Adoption of Recently Issued Accounting Standards

ASC 606, “Revenue from Contracts with Customers”

Effective July 1, 2018, the Company adopted the provisions of Accounting Standards Codification (“ASC”) 606, “Revenue from Contracts with Customers” (“ASC 606”), which supersedes most existing revenue recognition guidance, including industry-specific healthcare guidance, by applying the full retrospective method for all periods presented. ASC 606 provides for a single comprehensive principles-based standard for the recognition of revenue across all industries through the application of the following five-step process:

Step 1: Identify the contract(s) with a customer.

Step 2: Identify the performance obligations in the contract.

Step 3: Determine the transaction price.

Step 4: Allocate the transaction price to the performance obligations in the contract.

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

The adoption of the provisions of ASC 606 had no material impact on the Company’s current or historical financial position, results of operations or cash flows. Additionally, management does not anticipate that the provisions of ASC 606 will have an impact on the amount or timing of when the Company recognizes revenue prospectively. However, in accordance with ASC 606, the Company now recognizes the majority of its previously reported provision for doubtful accounts, primarily related to itsself-pay patient population, as a direct reduction to revenues as an implicit pricing concession, instead of separately as a discrete deduction to arrive at revenue, and the related presentation of the allowance for doubtful accounts has been eliminated for all periods presented. The Company’s revenue recognition and accounts receivable policies are more fully described in Note 5.

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Note 2. – Business Operations

Business Operations

SunLink Health Systems, Inc., through subsidiaries, owns businesses which provide healthcare products and services in certain markets in the southeastern United States. Unless the context indicates otherwise, all references to “SunLink,” “we,” “our,” “ours,” “us” and the “Company” refer to SunLink Health Systems, Inc. and our consolidated subsidiaries. References to our specific operations refer to operations conducted through our subsidiaries and references to “we,” “our,” “ours,” and “us” in such context refer to the operations of our subsidiaries. Our business is composed of two business segments, the Healthcare Services segment and the Pharmacy segment. Our Healthcare Services segment subsidiaries own and operate an84-bed84- bed community hospital and a66-bed66- bed nursing home in Mississippi, a100-bed100- bed nursing home in Georgia, an IT service company based in Georgia, and healthcare facilities, which are leased to third parties. Our Pharmacy segment subsidiary operates a pharmacy business in Louisiana with four service lines.

The business strategy of SunLink is to focus its efforts on expanding the services and improving the operations and profitability of its existing Healthcare Services and Pharmacy businesses.business while seeking to sell certain of its subsidiaries’ underperforming assets. The Company is investing in upgrades and improvements to certain of its Healthcare Services and Pharmacy businesses, while seeking to sell certain of its subsidiaries’ underperforming assets.businesses.

The Company has used a portion of the cash proceeds from recent dispositions of assets to pay down debt and certain other liabilities, and to repurchase common shares in tender offers completed in February and December 2017. 2017, and to make improvements to its Healthcare Services businesses.

The Company may also use existing cash, as well as any net proceeds from future dispositions, if any, to improve its existing businesses, make acquisitions of Healthcare Services and Pharmacy businesses, prepay debts, return capital to shareholders including through potential public or private purchases of shares, improve its existing businesses, make selective acquisitions of Healthcare Services and Pharmacy businesses and for other general corporate purposes. There is no assurance that any further dispositions will be authorized by the Company’s Board of Directors or, if authorized, that any such transactions will be completed or, if completed, will result in net cash proceeds to the Company on a before or after tax basis.

The Company considers the disposition of business segments, facilities and operations based on a variety of factors in addition to under-performance, including asset values, return on investments, competition from existing and potential competitors, capital improvement needs, the prevailing reimbursement environment under various Federal and state programs (e.g., Medicare and Medicaid) and private payors, and other corporate objectives. The Company believes certain facilities in its Healthcare Services segment as well as its Pharmacy segment continue to under-perform, and the Company has engaged advisors to assist it in evaluating the possible sale of assets in its Healthcare Services and its Pharmacy business lines.

On JanuaryOctober 11, 2018, Carmichael’s Cashway Pharmacy, Inc., a wholly owned subsidiary of the Company sold a vacant medical office building and approximately two adjacent acres of undeveloped land. After expenses, the assetsCompany received net proceeds from the sale of a retail pharmacy operationapproximately $935 which will be retained for approximately $410. Aworking capital and general corporate purposes.The pre-tax gain gain of $183 on the sale of these assetsproperty is includedestimated to be approximately $452 and will be reported in the results for the three monthsCompany’s fiscal quarter ended MarchDecember 31, 2018.

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Throughout these notes to the consolidated financial statements, all references to “SunLink,” “we,” “our,” “ours,” “us” and the “Company” refer to SunLink Health Systems, Inc. and our consolidated subsidiaries. References to our specific operations refer to operations conducted through our subsidiaries and references to “we,” “our,” “ours,” and “us” in such context refer to the operations.

Note 3. – Discontinued Operations

All of the businesses discussed in the note below are reported as discontinued operations and the condensed consolidated financial statements for all prior periods have been adjusted to reflect this presentation.

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Results for all of the businesses included in discontinued operations are presented in the following table:

Chestatee Hospital – On August 19, 2016, Southern Health Corporation of Dahlonega, Inc., (“Chestatee”), a wholly owned subsidiary of the Company, sold substantially all of the assets and certain liabilities of Chestatee Regional Hospital in Dahlonega, Georgia through an asset purchase agreement for $15,000 subject to adjustment for the book value of certain assets and certain liabilities assumed at the sale date. Thepre-tax gain on sale of $7,270 is subject to adjustment for various purchase price adjustments. A purchase price adjustment of $328 is due to the Company from the hospital buyer as a post-closing adjustment to the purchase price as confirmed by a binding decision of an independent accountant rendered pursuant to the purchase agreement. Chestatee retained certain liabilities, including certain employee related liabilities and certain Medicare and Medicaid liabilities, relating to the period it owned and operated the hospital. A portion of the net proceeds was used for the repayment of debt.

Other Sold Hospitals– Subsidiaries of the Company sold substantially all of the assets of threefour hospitals (“Other Sold Hospitals”) during the period July 2, 2012 to DecemberAugust 31, 2014.2016. The earnings (loss) before income taxes of the Other Sold Hospitals results primarily from prior year Medicare and Medicaid cost report settlements.retained professional liability claims expenses.

Life Sciences and Engineering Segment – —SunLink retained a defined benefit retirement plan which covered substantially all of the employees of this segment when the segment was sold in fiscal 1998. Effective February 28, 1997, the plan was amended to freeze participant benefits and close the plan to new participants. Pension expense and related tax benefit or expense is reflected in the results of operations for this segment for the three and nine months ended March 31,September 30, 2018 and 2017.

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The components of pension expense for the three and nine months ended MarchSeptember 31, 2018 and 2017, respectively, were as follows:

SunLink contributed $105$25 to the plan in the ninethree months ended March 31,September 30, 2018 and expects to contribute an additional $35$75 during the last three fiscal quarter of the fiscal year ending June 30, 2018.2019.

Note 4. – Economic Damages Claim

The Pharmacy Segment subsidiary asserted claims for economic damages in connection with the Deepwater Horizon Settlement Program related to the event which occurred in 2010. In January 2018, these claims were settled and payments of approximately $944 (net of costs and attorneys’ fees) were received. The net settlements are recognized as a gain in the Condensed Consolidated Statements of Operations and Comprehensive Earnings (Loss) for the nine months ended March 31, 2018.

Note 5. – Restricted Cash

Under the Fourth Amendment to the Trace RDA Loan dated January 7, 2017 (see Note 9. Long-Term Debt), a deposit of $1,000 in a blocked interest bearing account was held by the lender. Under the Fifth Amendment to the Trace RDA Loan dated December 26, 2017, the blocked account was eliminated and a prepayment was made on the Trace RDA loan.

Note 6. – Shareholders’ Equity

Common Share Purchase Tender Offer–On November 21, 2017, SunLink commenced a tender offer for the purchase of a portion of its common shares at a price of $1.60 per share (the “Offer”). The offer expired on December 21, 2017 with 3,725,656 common shares tendered. In accordance with the terms and conditions of the Offer, the Company accepted for payment a total of approximately 1,745,751 shares at a price of $1.60 per share for a total cost of approximately $2,794, excluding fees and expenses relating to the Offer.

Stock-Based Compensation–For the three months ended March 31,September 30, 2018 and 2017, the Company recognized $1 and $5, respectively, in stock based compensation for options issued to employees and directors of the Company. For the nine months ended March 31, 2018 and 2017, the Company recognized $7 and $59, respectively, in stock based compensation for options issued to employees and directors of the Company. The fair value of the share options granted was estimated using the Black-Scholes option pricing model. There were 0 and 72,000no share options granted under the 2011 Director Stock Option Plan during the ninethree months ended March 31,September 30, 2018 and 2017, respectively.respectively, and the Company does not have any option plans with authorized shares available for grants.

Note 7.5. – Revenue Recognition and Accounts Receivables

The Company’s subsidiaries recognize revenuesRevenue Recognition

Effective July 1, 2018, the Company adopted the provisions of Accounting Standards Codification (“ASC”) 606, “Revenue from Contracts with Customers” which supersedes most existing revenue recognition guidance, including industry-specific healthcare guidance, by applying the full retrospective method for all periods presented. ASC 606 provides for a single comprehensive principles-based standard for the recognition of revenue across all industries through the application of the following five-step process:

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Step 1: Identify the contract(s) with a customer.

Step 2: Identify the performance obligations in the periodcontract.

Step 3: Determine the transaction price.

Step 4: Allocate the transaction price to the performance obligations in which services are provided. Accounts receivable primarily consistthe contract.

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

The adoption of amounts due from third-party payors and patients. Thethe provisions of ASC 606 had no material impact on the Company’s subsidiaries’ ability to collect outstanding receivables is critical to theircurrent or historical financial position, results of operations andor cash flows. AmountsAdditionally, management does not anticipate that the Company’s subsidiaries receiveprovisions of ASC 606 will have an impact on the amount or timing of when the Company recognizes revenue prospectively. However, in accordance with ASC 606 the Company now recognizes the majority of its previously reported provision for treatmentdoubtful accounts, primarily related to itsself-pay patient population, as a direct reduction to revenues as an implicit pricing concession, instead of patients covered by governmental programs suchseparately as Medicarea discrete deduction to arrive at revenue, and Medicaid and other third-party payors such as health maintenance organizations (“HMOs”), preferred provider organizations (“PPOs”) and other private insurers are generally less than the Company’s subsidiaries’ established billing rates. Additionally, to provide for accounts receivable that could become uncollectible inrelated presentation of the future an allowance for doubtful accounts has been eliminated for all periods presented.

Disaggregation of Revenue

The Company disaggregates revenue from contracts with its patients by reportable operating segments and payors. The Company determines that disaggregating revenue into these categories achieves the disclosure objectives to depict how the nature, amount, timing and uncertainty of revenue and cash flows are affected by economic factors. A reconciliation of disaggregated revenue to segment revenue is establisheddisclosed in Note 12, Financial Information by Segment.

The Company’s service specific revenue recognition policies are as follows:

Healthcare Services

The Company’s revenue is derived primarily from providing healthcare services to reducepatients and is recognized on the carrying valuedate services are provided at amounts billable to individual patients, adjusted for estimates for variable consideration. For patients under reimbursement arrangements with third-party payors, including Medicaid, Medicare and private insurers, revenue is recorded based on contractually agreed-upon amounts or rates, adjusted for estimates for variable consideration, on a per patient, daily basis or as services are performed.

Pharmacy

The Company’s revenue is derived primarily from providing pharmacy services to patients and is recognized on the date services are provided at amounts billable to individual patients, adjusted for estimates for variable consideration. Revenue is recognized when control of suchthe promised goods or services are transferred to customers, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. Each prescription claim represents a separate performance obligation of the Company, separate and distinct from other prescription claims under customer arrangements. Significant portions of the revenue from sales of pharmaceutical and medical products are reimbursed by the federal Medicare Part D program and, to a lesser extent, state Medicaid programs. The Company monitors its revenues and receivables from these reimbursement sources, as well as other third-party insurance payors, and reduces revenue at the revenue recognition date, to their estimated net realizable value.properly account for the variable consideration due to anticipated differences between billed and reimbursed amounts. Accordingly, the total net revenues and accounts receivablereceivables reported in the accompanying unaudited condensed consolidatedCompany’s financial statements are recorded at the net amount expected to be received.ultimately received from these payors.

Medicare Revenue

Net healthcare services revenue is recorded under the Medicare prospective payment system based on an episode payment rate that is subject to adjustment based on certain variables including, but not limited to: (a) an outlier payment if patient care was unusually costly; (b) a low utilization payment adjustment if the number of visits was fewer than five; (c) a partial payment if the patient transferred to another provider or the Company received a patient from another provider before completing the episode; (d) a payment adjustment based upon the level of therapy services required; (e) the number of episodes of care provided to a patient, regardless of whether the same provider provided care for the entire series of episodes; (f) changes in the base episode payments established by the Medicare program; (g) adjustments to the base episode payments for case mix and geographic wages; and (h) recoveries of overpayments.

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The Company makes adjustments to Medicare revenue on completed episodes to reflect differences between estimated and actual payment amounts, an inability to obtain appropriate billing documentation or authorizations acceptable to the payor and other reasons unrelated to credit risk. Revenue is also adjusted for estimates for variable consideration. Therefore, the Company believes that its reported net service revenue and patient accounts receivable will be the net amounts to be realized from Medicare for services rendered.

In addition to revenue recognized on completed services, the Company also recognizes a portion of revenue associated with services in progress. Services in progress are days of care that begin during the reporting period but were not completed as of the end of the period. As such, the Company estimates revenue and recognizes it on a daily basis. The primary factors underlying this estimate are the number of services in progress at the end of the reporting period, expected Medicare revenue per episode and its estimate of the average percentage complete based on services performed.

Non-Medicare Revenue

The Company recognizes revenue in a similar manner as it recognizes Medicare revenue for service-based rates that are paid by other insurance carriers, including Medicare Advantage programs; however, these rates can vary based upon the negotiated terms.

Revenue is recorded on an accrual basis based upon the date of service at amounts equal to its established or estimatedper-visit rates, and adjusted for estimates for variable consideration, as applicable.

Impact of New Revenue Guidance on Financial Statement Line Items

The following tables summarize the impacts of adopting ASC 606 on the Company’s condensed consolidated statements of operations and comprehensive earnings (loss). There was no impact to the condensed consolidated balance sheet as of June 30, 2018 or condensed consolidated statements of cash flows for the year ended June 30, 2018 and for the year ended June 30, 2017, respectively. The majority of what was previously presented as bad debt expense of the Pharmacy Segment under operating expenses has been incorporated as an implicit price concession factored into the calculation of net revenues. Subsequent material events that alter the payor’s ability to pay are recorded as bad debt expense.

There is no material change, related to the adoption of ASC 606, for the presentation of the Company’s Fiscal 2018 revenues or prior years. Historically, the Company only presented total revenue for all revenue services in “Operating Revenues”. What was previously presented as provision for bad debts of Pharmacy segment under operating expenses has been incorporated as an implicit price concession factored into the calculation of net revenues, as shown in the “Adjustments” line in the table below. The Condensed Consolidated Statement of Operations and Comprehensive Earnings (Loss) for the three months ended September 30, 2017 has been restated to reflect the adoption of ASC 606. Subsequent material events that alter the payor’s ability to pay are recorded as bad debt expense.

Prior period results reflect reclassifications, for comparative purposes, related to the adoption of ASC 606, for the presentation of the Company’s revenues. Historically, the Company only presented total revenue for all revenue services. This reclassification had no effect on the reported results of operations.

Revenues for the fiscal quarter ended September 30, 2017 and the fiscal years ended June 30, 2018 and June 30, 2017 are summarized in the following tables:

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Practical Expedients and Exemptions

The Company’s contracts with its patients have an original duration of one year or less, therefore, the Company uses the practical expedient applicable to its contracts and does not consider the time value of money. Further, because of the short duration of these contracts, the Company has not disclosed the transaction price for the remaining performance obligations as of the end of each reporting period or when the Company expects to recognize this revenue. In addition, the Company has applied the practical expedient provided by ASC 340, Other Assets and Deferred Costs, and all incremental customer contract acquisition costs are expensed as they are incurred because the amortization period would have been one year or less.

Revenues by payor were as follows for the three and nine months ended March 31,September 30, 2018 and 2017:

The net revenues of the Pharmacy Segment are presented net of contractual adjustments. The provision for bad debts of the Pharmacy Segment is presented as a component of operating expenses in the Condensed Consolidated Statements of Operations and Comprehensive Earnings (Loss).

Summary information for accounts receivable is as follows:

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The following is a summary of the activity in the allowance for doubtful accountsconcession adjustments for the Healthcare Services Segment and the Pharmacy Segment for the three and nine months ended March 31,September 30, 2018 and 2017:

New Accounting Pronouncement for Revenue Recognition

In May 2014, the Financial Accounting Standards Board (“FASB��) issued Accounting Standards Update (“ASU”) 2014-09, which outlines a single comprehensive model for recognizing revenue and supersedes most existing revenue recognition guidance, including guidance specific to the healthcare industry. This ASU provides companies the option of applying a full or modified retrospective approach upon adoption. This ASU is effective for fiscal years beginning after December 15, 2017, with early adoption permitted for annual periods beginning after December 15, 2016. The Company expects to adopt this ASU on July 1, 2018 and is currently implementing its plan for adoption and evaluating the impact on its revenue recognition policies, procedures and control framework and the resulting impact on its consolidated financial position, results of operations and cash flows. A significant element of executing this plan is the process of reviewing sources of revenue and evaluating the patient account population to determine the appropriate distribution of patient accounts into portfolios with similar collection experience that, when evaluated for collectability, will result in a materially consistent revenue amount for such portfolios as if each patient account was evaluated on a contract-by-contract basis. The Company is currently evaluating the appropriate portfolios to apply in its collectability analysis and is considering the impact of applying the new standard when its patient accounts are evaluated in those portfolios. The Company expects this process will be completed later in 2018.

Additionally, the adoption of the new accounting standard will impact the presentation on the Company’s statement of operations for a significant component of its provision for bad debts. After adoption of the new standard, the majority of what is currently classified as the provision for bad debts will be reflected as an implicit price concession as defined in the standard and therefore an adjustment to net patient revenue. The Company will continue to evaluate certain changes in collectability on its self-pay patient accounts receivable resulting from certain credit and collection issues not assessed at the date of service, including bankruptcy, and recognize such amounts in the provision for bad debts included in operating expenses on the statement of operations. The Company cannot reasonably estimate at this time the quantitative impact that the adoption of this accounting standard will have on the financial statements of the Company.

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Note 8.6. – Intangible Assets

Intangibles consist of the following, net of amortization:

Amortization expense was $29 and $35$29 for the three months ended March 31,September 30, 2018 and 2017, respectively.    Amortization expense was $87 and $106 for the nine months ended March 31, 2018 and 2017, respectively.

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Note 9. – Long-Term7. –Long-Term Debt

Long-term debt consisted of the following:

Trace RDA Loan –Loan—Southern Health Corporation of Houston, Inc. (“Trace”) a wholly owned subsidiary of the Company, closed on a $9,975 Mortgage Loan Agreement (“Trace RDA Loan”) with a bank, dated as of July 5, 2012. The Trace RDA Loan has a term of 15 years with level monthly payments of principal and interest until repaid. On December 26, 2017, the Fifth Amendment to Loan Agreement, Modification of Note and Waiver (“Modification”) was entered into by Trace and the bank. Under the Modification, Trace made a $3,548 prepayment on the Trace RDA Loan. The monthly principal and interest payments on the RDA Loan were reduced, to $39 per month, the interest rate was reduced to the prime rate (as published in the Wall Street Journal) plus 1% with a floor of 5.5%, (5.75%(6.25% at March 31,September 30, 2018) and certain loan covenants were modified. The Modification also included a waiverManagement was not aware of covenantany violations for the quarters ended June 30 and September 30, 2017. Trace was in compliance with the amended financial covenants at March 31,September 30, 2018. In connection with the modification and prepayment, an existing deposit of $1,000 in a blocked, interest bearing account with the lender was released. The Trace RDA Loan is collateralized by real estate and equipment of Trace in Houston, MS, is guaranteed by the Company, and is partially guaranteed under the U.S. Department of Agriculture, Rural Development Business and Industry Program.

The Trace RDA Loan contains various terms and conditions, including financial restrictions and limitations, and affirmative and negative covenants. The covenants include financial covenants measured on a quarterly basis which require Trace to comply with a ratio of current assets to current liabilities, debt service coverage, fixed charge ratio, and funded debt to EBITDA, all as defined in the Trace RDA Loan. The ability of Trace to continue to make the required debt service payments under the Trace RDA Loan depends on, among other things, its ability to generate sufficient cash, including from operating activities and asset sales. If Trace is unable to generate sufficient cash to meet debt service payments on the Trace RDA Loan, including in the event the lender were to declare an event of default and accelerate the maturity of the indebtedness, such failure could have material adverse effects on the Company. The Trace RDA Loan is guaranteed by the Company and one subsidiary.

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Note 10.8. – Income Taxes

Income tax benefitexpense of $0 ($0 federal taxexpense and $0 state tax expense) and income tax benefitexpense of $8$0 ($320 federal tax benefitexpense and $24$0 state tax expense) was recorded for continuing operations for the three months ended March 31, 2018 and 2017, respectively. Income tax benefit of $296 ($296 federal tax benefit and $0 state tax expense) and income tax benefit of $236 ($221 federal tax benefit and $15 state tax benefit) was recorded for continuing operations for the nine months ended March 31,September 30, 2018 and 2017, respectively.

In accordance with the Financial Accounting Standards Board Accounting Standards Codification (‘ASC”) 740, we evaluate our deferred taxes quarterly to determine if adjustments to our valuation allowance are required based on the consideration of available positive and negative evidence using a “more likely than not” standard with respect to whether deferred tax assets will be realized. Our evaluation considers, among other factors, our historical operating results, our expectation of future results of operations, the duration of applicable statuary carryforward periods and conditions of the healthcare industry. The ultimate realization of our deferred tax assets depends primarily on our ability to generate future taxable income during the periods in which the related temporary differences in the financial basis and the tax basis of the assets become deductible. The value of our deferred tax assets will depend on applicable income tax rates.

The Tax Cut and Jobs Act (“TCJA”) was enacted on December 22, 2017. Under ASC 740, the impact of changes in tax law must be recorded in the financial statements in the reporting period that included the date of enactment. However,In addition, in conjunction with the TCJA, on December 22, 2017, the SEC and the FASB both recognize that the magnitude of this law change will require extensive analysis and calculations to conform to the new provisions. The SECstaff issued Staff Accounting Bulletin (‘SAB”)No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (SAB 118), which provides guidance on December 22, 2017.accounting for the tax effects of the TCJA. SAB 118 provides registrants with guidance on when and how to report the impactallows for recording certain effects of the law change when not all necessary information is available.TCJA as “provisional” during a one-year measurement period, which for the Company will end in the second quarter of fiscal 2019.

At March 31,September 30, 2018, consistent with the above processes,process, we evaluated the need for a valuation allowance against our deferred tax assets and determined that it was more likely than not that onlynone of our federal alternative minimumdeferred tax (“AMT”) tax credits of $296assets would be realized. The AMT credit representsAs a provisional amount that will be finalized upon the filing of the Company’s federal income tax return for the year ended June 30, 2017. The filing of this return will occur prior to the Company’s fiscal year end which is within the measurement period. Under TCJA, AMT tax credits will now become refundable in conjunction with the repeal of the corporate AMT. For tax years beginning after December 31, 2017 and before January 1, 2022, the AMT credit is refundable in an amount equal to 50% (100% for the 2021 tax year) of the excess of the credit for the tax year over the amount of the credit allowable for the year against regular tax liability. This results in the Company receiving its entire AMT credit of $296 as a refund no later than fiscal 2022 and as such a valuation allowance is no longer needed for the AMT credit carryforward. However,result, in accordance with ASC 740, we recognized a valuation allowance of $8,071$8,610 against all other netthe deferred tax asset itemsso that there is no net long-term deferred income tax asset or liability at March 31,September 30, 2018. We conducted our evaluation by considering available positive and negative evidence to determine our ability to realize our deferred tax assets. In our evaluation, we gave more significant weight to evidence that was objective in nature as compared to subjective evidence. Also, more significant weight was given to evidence that directly related to our current financial performance as compared to less current evidence and future plans.

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The principal negative evidence that led us to determine at March 31,September 30, 2018 that $8,071 ofall the net deferred tax assets resulting fromnon-AMT credit carryforwards should have full valuation allowances was the three-year cumulativepre-tax loss from continuing operations as well as the underlying negative business conditions for rural healthcare businesses in which our Healthcare Services Segment businesses operate.

For Federal income tax purposes, at March 31,September 30, 2018, the Company had approximately $13,400$16,100 of estimated net operating loss carry-forwards available for use in future years subject to the limitations of the provisions of Internal Revenue Code Section 382. These net operating loss carryforwards expire primarily in 2025. Withfiscal 2023 through fiscal 2038; however with the enactment of TCJA, Federalthe Tax Cut and Jobs Act (“TCJA”) on December 22, 2017, federal net operating loss carryforwards generated in taxable years endingbeginning after December 31, 2017 now have no expiration date.

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Note 11.9. – Commitments and Contingencies

Contractual obligations, commitments and contingencies related to outstanding debt,non-cancelable operating leases and interest on outstanding debt from continuing operations at March 31,September 30, 2018 were as follows:

On September 8, 2017, the Georgia Survey agency of the Georgia Department of Community Health (“DCH“) conducted a Complaint Investigation survey to determine whether our nursing home in Ellijay, Georgia was in compliance with federal program requirements for nursing homes participating in Medicare and/or Medicaid programs. As a result of this survey, the nursing home received from the DCH a notice of deficiencies which were identified as posing an immediate jeopardy to resident health and safety and which had to be corrected immediately. DCH also notified the nursing home of its intent to recommend civil monetary penalties. In response to the survey findings, the nursing home adopted a succession of plans to remedy the matters identified. On November 6, 2017, DCH advised the nursing home that its latest plan of correction was accepted and on November 20, 2017, DCH advised the nursing home that it was in substantial compliance with its long-term care requirements; however the nursing home anticipates further surveys to evaluate its implementation of the plans of correction. A Civil Money Penalty (“CMP”) was imposed by the Department of Health & Human Services Centers for Medicare and Medicaid Services on January 4, 2018 which resulted in $170 expensed in the nine months ended March 31, 2018. The CMP was paid January 18, 2018.

Note 12.10. – Related Party Transactions

A director of the Company is a member of a law firm which provides services to SunLink. The Company expensed an aggregate of $25$76 and $109$65 for legal services to this law firm in the three months ended March 31, 2018 and 2017, respectively. The Company expensed an aggregate of $215 and $481 for legal services to this law firm in the nine months ended March 31,September 30, 2018 and 2017, respectively. Included in the Company’s condensed consolidated balance sheets at March 31,September 30, 2018 and June 30, 20172018 is $12$65 and $38,$10, respectively, of amounts payable to this law firm.

Note 13.11. – Sale of AssetsSubsequent Events

On JanuaryOctober 11, 2018, Carmichael’s Cashway Pharmacy, Inc., a wholly owned subsidiary of the Company sold a vacant medical office building and approximately two adjacent acres of undeveloped land. After expenses, the assetsCompany received net proceeds from the sale of a retail pharmacy operation it operatesapproximately $935 which will be retained for approximately $410. Aworking capital and general corporate purposes.The pre-tax gain gain on the sale of the assets ofproperty is estimated to be approximately $183 is included$452 and will be reported in the results for the three monthsCompany’s fiscal quarter ended MarchDecember 31, 2018.

Note 14.12. – Financial Information by Segment

Under ASC Topic No. 280, Segment Reporting, operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision-making group is composed of SunLink’s chief executive officer and other members of SunLink’s senior management. Our two reportable operating segments are Healthcare Services and Pharmacy.

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We evaluate performance of our operating segments based on revenue and operating profit (loss). At the beginning of the current fiscal year, the Company modified the approach to certain assets, and expense allocations to calculate segment assets, operating profit and depreciation and amortization. All prior year amounts have been changed to consistently apply the changed allocation method used in the current year. Segment information as of March 31,September 30, 2018 and 2017 and for the three and nine months then ended is as follows:

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

(Dollars in thousands, except per share and admissions data)

Forward-Looking Statements

This Quarterly Report and the documents that are incorporated by reference in this Quarterly Report contain certain forward-looking statements within the meaning of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all statements that do not relate solely to historical or current facts and may be identified by the use of words such as “may,” “believe,” “will,” “expect,” “project,” “estimate,” “anticipate,” “plan” or “continue.” Throughout item 2, SunLink Health Systems, Inc., and its consolidated subsidiaries are referred to on a collective basis as “SunLink”, “we”, “our”, “ours”, “us” or the “Company.” This drafting style is not meant to indicate that SunLink Health Systems, Inc. or any particular subsidiary of SunLink Health Systems, Inc. owns or operates any asset, business, or property. Trace, Parkside Ellijay, pharmacy operations and businesses described in this filing are owned and operated by distinct and indirect subsidiaries of SunLink Health System, Inc. These forward-looking statements are based on current plans and expectations and are subject to a number of risks, uncertainties and other factors which could significantly affect current plans and expectations and our future financial condition and results. These factors, which could cause actual results, performance and achievements to differ materially from those anticipated, include, but are not limited to:

General Business Conditions

co-insurance, or other terms of health insurance coverage resulting in higher bad debt amounts;

Liabilities, Claims, Obligations and Other Matters

Regulation and Governmental Activity

The foregoing are significant factors we think could cause our actual results to differ materially from expected results. However, there could be additional factors besides those listed herein that also could affect SunLink in an adverse manner.

You should read this Quarterly Report completely and with the understanding that actual future results may be materially different from what we expect. You are cautioned not to unduly rely on forward-looking statements when evaluating the information presented in this Quarterly Report or our other disclosures because current plans, anticipated actions, and future financial conditions and results may differ from those expressed in any forward-looking statements made by or on behalf of SunLink.

We have not undertaken any obligation to publicly update or revise any forward-looking statements. All of our forward-looking statements speak only as of the date of the document in which they are made or, if a date is specified, as of such date. We disclaim any obligation or undertaking to provide any updates or revisions to any forward-looking statement to reflect any change in our expectations or any changes in events, conditions, circumstances or information on which the forward-looking statement is based, except as required by applicable law. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the foregoing factors and the other risk factors set forth elsewhere in this report and in our Annual Report on Form10-K.

Business Strategy: Operations, Dispositions and Acquisitions

The business strategy of SunLink is to focus its efforts on improving the operations and expanding the services and improving the operations and profitability of its existing Healthcare Services and Pharmacy businesses. The Company is investing in upgrades and improvements to certain of its Healthcare Services and Pharmacy businesses, while seeking to sell certain of its subsidiaries’ underperforming assets.

The Company has used a portion of the cash proceeds from recent dispositions of assets to pay down debt and certain other liabilities, and to repurchase common shares in tender offers completed in February and December 2017.2017 and to make improvements to its Healthcare Services businesses. The Company may also use existing cash, as well as any net proceeds from future dispositions, if any, to improve its existing businesses, make acquisitions of Healthcare Services and Pharmacy businesses, prepay debts, return capital to shareholders including through potential public or private purchases of shares, improve its existing businesses, make selective acquisitions of Healthcare Services and Pharmacy businesses and for other general corporate purposes. There is no assurance that any further dispositions will be authorized by the Company’s Board of Directors or, if authorized, that any such transactions will be completed or, if completed, will result in net cash proceeds to the Company on a before or after tax basis.

The Company considers the disposition of business segments, facilities and operations based on a variety of factors in addition to under-performance, including asset values, return on investments, competition from existing and potential competitors, capital improvement needs, the prevailing reimbursement environment under various Federal and state programs (e.g., Medicare and Medicaid) and private payors, and other corporate objectives. The Company believes certain facilities in its Healthcare Services segment as well as its Pharmacy segment continue to under-perform, and the Company has engaged advisors to assist it in evaluating the possible sale of its Pharmacy business lines.

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On January 11, 2018, Carmichael’s Cashway Pharmacy, Inc., a wholly owned subsidiary of the Company, sold the assets of a retail pharmacy operation it operates for $410. Apre-tax gain on the sale of the assets of $183 iswas included in the results for the three monthsfiscal year ended MarchJune 30, 2018.On October 11, 2018, the Company sold a vacant medical office building and approximately two adjacent acres of undeveloped land. After expenses, the Company received net proceeds from the sale of approximately $935 which will be retained for working capital and general corporate purposes.The pre-tax gain on the sale of property is estimated to be approximately $450 and will be reported in the Company’s fiscal quarter ending December 31, 2018.

A subsidiary of the Company has received an indication of interest to purchase one of the Company’s nursing homes for approximately $7,300 and, on August 29, 2018, entered into a non-binding letter of intent (“LOI”) and exclusivity agreement with a potential buyer. The non-binding LOI provides that any transaction will be subject to various terms and conditions to be negotiated, including reaching agreement on a contract, satisfactory due diligence and other matters. Accordingly there can be no assurance that a transaction will be completed on any terms or at any specific price.

Critical Accounting Estimates

The preparation of financial statements in accordance with U.S. GAAP requires us to make estimates and assumptions that affect reported amounts and related disclosures. We consider an accounting estimate to be critical if:

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Our critical accounting estimates are more fully described in our 2017 Annual Report on Form10-K and continue to include the following areas:

Financial Summary

The results of continuing operations shown in the financial summary below are for our two business segments, Healthcare Services and Pharmacy.