ModivCare Inc - Quarter Report: 2017 March (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

OR

Commission File Number 001-34221

The Providence Service Corporation

(Exact name of registrant as specified in its charter)

(203) 307-2800

(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    ☐  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 Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or 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, a smaller reporting company or an emerging growth company. See the 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 Rule 12b-2 of the Exchange Act).    ☐  Yes    ☒  No

As of May 5, 2017, there were outstanding 13,467,098 shares (excluding treasury shares of 3,943,985) of the registrant’s Common Stock, $0.001 par value per share.

TABLE OF CONTENTS

PART I—FINANCIAL INFORMATION

The Providence Service Corporation

Condensed Consolidated Balance Sheets

(in thousands except share and per share data)

See accompanying notes to the unaudited condensed consolidated financial statements

The Providence Service Corporation

Unaudited Condensed Consolidated Statements of Income

(in thousands except share and per share data)

See accompanying notes to the unaudited condensed consolidated financial statements 

 The Providence Service Corporation

Unaudited Condensed Consolidated Statements of Comprehensive Income

(in thousands)

See accompanying notes to the unaudited condensed consolidated financial statements

The Providence Service Corporation

Unaudited Condensed Consolidated Statements of Cash Flows

(in thousands)

See accompanying notes to the unaudited condensed consolidated financial statements

The Providence Service Corporation

Notes to the Unaudited Condensed Consolidated Financial Statements

March 31, 2017

(in thousands except years, share and per share data)

1. Organization and Basis of Presentation

Description of Business

The Providence Service Corporation (“we”, the “Company” or “Providence”) is a holding company, which owns interests in subsidiaries and other companies that are primarily engaged in the provision of healthcare and workforce development services for public and private sector entities seeking to control costs and promote positive outcomes. The subsidiaries and other companies in which the Company holds interests comprise the following segments:

Basis of Presentation

The Company follows accounting standards set by the Financial Accounting Standards Board (“FASB”). The FASB establishes accounting principles generally accepted in the United States (“GAAP”). Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. References to GAAP issued by the FASB in these footnotes are to the FASB Accounting Standards Codification (“ASC”), which serves as the single source of authoritative non-SEC accounting and reporting standards to be applied by non-governmental entities. All amounts are presented in United States (“U.S.”) dollars, unless otherwise noted.

The Company’s unaudited condensed consolidated financial statements have been prepared in accordance with GAAP for interim financial information, and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and disclosures required by GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for the fair presentation of the results of the interim periods have been included.

The Company has made estimates relating to the reporting of assets and liabilities, revenues and expenses and certain disclosures to prepare these unaudited condensed consolidated financial statements in conformity with GAAP. Actual results could differ from those estimates. Operating results for the three months ended March 31, 2017 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2017. Management has evaluated events and transactions that occurred after the balance sheet date and through the date these unaudited condensed consolidated financial statements were filed, and considered the effect of such events in the preparation of these unaudited condensed consolidated financial statements.

The condensed consolidated balance sheet at December 31, 2016 has been derived from the audited financial statements at that date, but does not include all the information and footnotes required by GAAP for complete financial statements. The unaudited condensed consolidated financial statements contained herein should be read in conjunction with the audited financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

The Company holds investments that are accounted for using the equity method. The Company does not control the decision making process or business management practices of these affiliates. While the Company has access to certain information and performs certain procedures to review the reasonableness of information, the Company relies on management of these affiliates to provide accurate financial information prepared in accordance with GAAP. The Company receives audit reports relating to such financial information from the affiliates’ independent auditors on an annual basis. The Company is not aware of any errors in or possible misstatements of the financial information provided by its equity affiliates that would have a material effect on the Company’s condensed consolidated financial statements.

Reclassifications

We have reclassified certain amounts relating to our prior period results to conform to our current period presentation. On October 19, 2016, affiliates of Frazier Healthcare Partners purchased a 53.2% equity interest in CCHN Group Holdings, Inc. and its subsidiaries (“Matrix”) with Providence retaining a 46.8% equity interest (the “Matrix Transaction”). Prior to the closing of the Matrix Transaction, the financial results of Matrix were included in the Company’s Health Assessment Services (“HA Services”) segment. Operating results for this segment are reported as discontinued operations, net of tax in the condensed consolidated statements of income for the three months ended March 31, 2016. See Note 13, Discontinued Operations, for further information. See Note 2, Significant Accounting Policies and Recent Accounting Pronouncements, for additional information on other reclassifications.

2. Significant Accounting Policies and Recent Accounting Pronouncements

The Company adopted the following accounting pronouncements during the three months ended March 31, 2017:

In November 2015, the FASB issued Accounting Standards Update (“ASU”) 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes (“ASU 2015-17”), which changes how deferred taxes are classified on organizations’ balance sheets. The ASU eliminates the current requirement for organizations to present deferred tax liabilities and assets as current and noncurrent in a classified balance sheet. Instead, organizations will be required to classify all deferred tax assets and liabilities as noncurrent. The amendments apply to all organizations that present a classified balance sheet. For public companies, the amendments are effective for financial statements issued for annual periods beginning after December 16, 2016, and interim periods within those annual periods. The Company adopted ASU 2015-17 retrospectively on January 1, 2017, which resulted in the reclassification of the December 31, 2016 deferred tax assets-current balance of $6,825 and non-current deferred tax assets of $2,493 to long-term deferred tax liabilities in the amount of $9,318.

In March 2016, the FASB issued ASU No. 2016-07, Investments - Equity Method and Joint Ventures (Topic 323): Simplifying the Transition to the Equity Method of Accounting (“ASU 2016-07”). ASU 2016-07 eliminates the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. ASU 2016-07 instead specifies that the investor should add the cost of acquiring the additional interest in the investee to the current basis of the investor’s previously held interest and apply the equity method of accounting as of the date the investment became qualified for equity method accounting. ASU 2016-07 is effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016 and should be applied prospectively. The Company adopted ASU 2016-07 on January 1, 2017. The adoption of ASU 2016-07 had no impact on the Company’s financial statements or disclosures.

In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). ASU 2016-09 is intended to improve the accounting for employee share-based payments and affect all organizations that issue share-based payment awards to their employees. Several aspects of the accounting for share-based payment award transactions are simplified, including income tax consequences, classification of awards as either equity or liabilities and classification in the statement of cash flows. For public companies, the amendments are effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The Company adopted ASU 2016-09 on January 1, 2017, and elected to recognize forfeitures as they occur. As a result, the Company recorded a cumulative effect adjustment of $850 to retained earnings as of January 1, 2017. Upon adoption, all excess tax benefits and tax deficiencies related to employee share-based payments are recognized through income tax expense prospectively. For the three months ended March 31, 2017, the Company recorded excess tax benefits of $210 as a reduction to the provision for income taxes. The Company excluded the related tax benefits when applying the treasury stock method for computing diluted shares outstanding on a prospective basis resulting in a decrease in diluted weighted average shares outstanding of 1,378 shares for the three months ended March 31, 2017.

The Company elected to apply the change in classification of cash flows resulting from excess tax benefits or deficiencies on a retrospective basis. This resulted in an increase in cash flows provided by operating activities of $41 and an increase of $41 in cash flows used in financing activities in the condensed consolidated statement of cash flows for the three months ended March 31, 2016. Additionally, ASU 2016-09 requires that employee taxes paid when an employer withholds shares for tax-withholding purposes be reported as financing activities in the consolidated statements of cash flows, which is how the Company has historically classified these amounts.

Updates to the recent accounting pronouncements as disclosed in the Company’s Form 10-K for the year ended December 31, 2016 are as follows:

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers: Topic 606 (“ASU 2014-09”). ASU 2014-09 introduced FASB Accounting Standards Codification Topic 606 (“ASC 606”). ASC 606 will supersede ASC 605, Revenue Recognition and most of the industry-specific guidance on recognizing revenue. The FASB has since issued the following updates that clarify or supplement the guidance in ASU 2014-09:

Each of these ASUs are effective for public companies for annual reporting periods (and interim reporting periods within those annual reporting periods) beginning after December 15, 2017 and permit entities to transition using either a full retrospective or modified retrospective methodology. The Company has developed an adoption plan, assembled a cross-functional project team and begun to assess the impacts of applying ASC 606 to the Company’s financial statements, information systems and internal controls. The Company has performed an initial detailed review of a significant number of its existing contracts with customers. These reviews have focused on several key considerations which could impact the Company's accounting and reporting under the new standard:

Management’s assessment is ongoing; therefore, the Company has not yet determined with certainty the impact of applying ASC 606. However, management does not believe the impact on its financial statements will be significant based on the procedures performed to date.

In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business (“ASU 2017-01”). ASU 2017-01 clarifies the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The definition of a business affects many areas of accounting including acquisitions, disposals, goodwill, and consolidation. ASU 2017-01 is effective for annual periods beginning after December 15, 2017, including interim periods within those periods. The Company is currently assessing the impact that adopting ASU 2017-01 will have on its consolidated financial statements and footnote disclosures.

In January 2017, the FASB issued ASU No. 2017-03, Accounting Changes and Error Corrections (Topic 250) and Investments - Equity Method and Joint Ventures (Topic 232) (“ASU 2017-03”). ASU 2017-03 expands required qualitative disclosures when registrants cannot reasonably estimate the impact that adoption of an ASU will have on the financial statements. Such qualitative disclosures would include a comparison of the registrant’s new accounting policies, if determined, to current accounting policies, a description of the status of the registrant’s process to implement the new standard and a description of the significant implementation matters yet to be addressed by the registrant. Other than enhancements to the qualitative disclosures regarding future adoption of new ASUs, adoption of the provisions of this standard is not expected to have any impact on the Company’s consolidated financial statements.

In January 2017, the FASB issued ASU No. 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”). ASU 2017-04 removes the requirement to compare the implied fair value of goodwill with its carrying amount as part of step two of the goodwill impairment test. As a result, under ASU 2017-04, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the impairment loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. This guidance is effective prospectively for fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed after January 1, 2017. The Company is currently assessing the impact of adoption.

There were no other significant updates to the new accounting guidance not yet adopted by the Company as disclosed in its Form 10-K for the year ended December 31, 2016.

 3. Equity Investment

Mission Providence

The Company entered into a joint venture agreement in November 2014 to form Mission Providence Pty Ltd (“Mission Providence”). Mission Providence delivers employment preparation and placement services in Australia. The Company has a 60% ownership interest in Mission Providence, and has rights to 75% of Mission Providence’s distributions of cash or profit surplus twice per calendar year.

The Company determined it has a variable interest in Mission Providence. However, it does not have unilateral power to direct the activities that most significantly impact Mission Providence’s economic performance, which include budget approval, business planning, the appointment of key officers and liquidation and distribution of share capital. As a result, the Company is not the primary beneficiary of Mission Providence. The Company accounts for this investment under the equity method of accounting and the Company’s share of Mission Providence’s losses are recorded as “Equity in net loss of investees” in the accompanying condensed consolidated statements of income. Cash contributions made to Mission Providence in exchange for its equity interests are included in the condensed consolidated statements of cash flows as “Equity investments.”

The following table summarizes the carrying amounts of the assets and liabilities included in the Company’s consolidated balance sheet and the maximum loss exposure related to the Company’s interest in Mission Providence as of March 31, 2017 and December 31, 2016:

Other assets represent a loan to Mission Providence, which was made during the three months ended March 31, 2017. Summary financial information for Mission Providence on a standalone basis is as follows:

During the three months ended March 31, 2017, Mission Providence recorded restructuring and redundancy costs of $1,063.

Matrix

Prior to the closing of the Matrix Transaction on October 19, 2016, the financial results of Matrix were included in the Company’s HA Services segment. Subsequent to the closing of the Matrix Transaction, the Company owns a noncontrolling interest in Matrix. Pursuant to a Shareholder’s Agreement, affiliates of Frazier Healthcare Partners hold rights necessary to control the fundamental operations of Matrix. The Company accounts for this investment in Matrix under the equity method of accounting and the Company’s share of Matrix’s losses are recorded as “Equity in net loss of investees” in the accompanying condensed consolidated statements of income.

The carrying amount of the assets included in the Company’s condensed consolidated balance sheet and the maximum loss exposure related to the Company’s interest in Matrix as of March 31, 2017 and December 31, 2016 totaled $156,355 and $157,202, respectively.

Summary financial information for Matrix on a standalone basis is as follows:

Included in Matrix’s net loss are transaction bonuses and other transaction related costs of $2,994, equity compensation of $643, depreciation and amortization of $8,033 and interest expense of $3,607.

 4.    Prepaid Expenses and Other

Prepaid expenses and other were comprised of the following:

Escrow funds represent amounts related to potential indemnification claims for the sale of the Human Services segment, which was completed on November 1, 2015. The Company has accrued $15,000 as a contingent liability for the settlement of potential indemnification claims, which is included in “Accrued expenses” in the condensed consolidated balance sheet as of March 31, 2017. While the matter is not resolved, it is highly likely the escrow funds will be used to satisfy a portion of this settlement. See Note 11, Commitments and Contingencies, for further information.

5.    Accrued Expenses

Accrued expenses consisted of the following:

6. Restructuring and Related Reorganization Costs

As of December 31, 2016, WD Services had three ongoing redundancy programs: a redundancy plan approved in 2016 related to the termination of employees as part of a value enhancement project (“Ingeus Futures’ Program”) to better align costs at Ingeus with revenue and to improve overall operating performance; and two redundancy plans approved in 2015, including a plan related to the termination of employees delivering services under an offender rehabilitation program (“Offender Rehabilitation Program”) and a plan related to the termination of employees delivering services under the Company’s employability and skills training programs and certain other employees in the UK (“UK Restructuring Program”).  The Company recorded severance and related charges of $553 and $1,171 during the three months ended March 31, 2017 and 2016, respectively, relating to the termination benefits for employee groups and specifically identified employees impacted by these plans. The severance charges incurred are recorded as “Service expense” in the accompanying condensed consolidated statements of income.

The initial estimate of severance and related charges for the plans is based upon the employee groups impacted, average salary and benefits, and redundancy benefits pursuant to the existing policies. The charges incurred for the redundancy plans during the three months ended March 31, 2017 and 2016 related to the actualization of termination benefits for specifically identified employees impacted, as well as an increase in the number of individuals impacted by these plans. The final identification of the employees impacted by each program is subject to customary consultation procedures.

Summary of Severance and Related Charges

The total of accrued severance and related costs of $3,236 is reflected in “Accrued expenses” in the condensed consolidated balance sheet at March 31, 2017. The amount accrued as of March 31, 2017 is expected to be settled principally by the end of 2017.

7.    Stockholders’ Equity

The following table reflects changes in common stock, additional paid-in capital, retained earnings, accumulated other comprehensive loss, treasury stock and noncontrolling interest for the three months ended March 31, 2017:

8.    Stock-Based Compensation and Similar Arrangements

The Company provides stock-based compensation to employees and non-employee directors under the Company’s 2006 Long-Term Incentive Plan (“2006 Plan”). Typical awards issued under this plan include stock option awards, restricted stock awards (“RSAs”) and performance based restricted stock units (“PRSUs”). In addition, the Company has a long-term incentive plan designed to provide long-term performance based awards to certain executive officers of the Company which also falls under the 2006 Plan.

The following table reflects the amount of stock-based compensation, for share settled awards, recorded in each financial statement line item for the three months ended March 31, 2017 and 2016:

Stock-based compensation, for share settled awards, includes $1,042 and $621 for the three months ended March 31, 2017 and 2016, respectively, related to the Company’s 2015 Holding Company LTI Program (the “HoldCo LTIP”). No shares will be distributed under the HoldCo LTIP unless the volume weighted average of Providence’s stock price over a 90-day period ending on December 31, 2017 exceeds $56.79.

At March 31, 2017, the Company had 313,741 stock options outstanding with a weighted-average exercise price of $37.78. The Company also had 71,373 shares of unvested RSAs outstanding at March 31, 2017 with a weighted-average grant date fair value of $44.35 and 19,200 unvested PRSUs outstanding.

The Company also grants stock equivalent unit awards (“SEUs”) and stock option equivalent units that are cash settled awards and are not included as part of the 2006 Plan. During the three months ended March 31, 2017 and 2016, respectively, the Company recorded $667 and $730 of stock-based compensation expense for cash settled awards which is included as “General and administrative expense” in the accompanying condensed consolidated statements of income. As the awards are cash settled, a significant amount of the expense recorded for the three months ended March 31, 2017 and 2016 is attributable to the Company’s increase in stock price from the previous reporting period. The liability for unexercised cash settled share-based payment awards of $2,225 and $1,764 at March 31, 2017 and December 31, 2016, respectively, are reflected in “Accrued expenses” in the condensed consolidated balance sheets. At March 31, 2017, the Company had 6,671 SEUs and 200,000 stock option equivalent units outstanding.

The Company also provides cash settled long-term incentive plans for executive management and key employees of its operating segments. For the three months ended March 31, 2017 and 2016, $590 and $1,015, respectively, of expense is included as “Service expense” in the condensed consolidated statements of income related to these plans. The liabilities for long-term incentive plans of the Company’s operating segments of $2,386 and $1,841 at March 31, 2017 and December 31, 2016, respectively, are reflected in “Other long-term liabilities” in the condensed consolidated balance sheets.     

9.    Earnings Per Share

The following table details the computation of basic and diluted earnings per share:

Income allocated to participating securities is calculated by allocating a portion of net income attributable to Providence, less dividends on convertible stock, to the convertible preferred stock holders on a pro-rata as converted basis; however, the convertible preferred stockholders are not required to absorb losses.

The following weighted average shares were not included in the computation of diluted earnings per share as the effect of their inclusion would have been anti-dilutive:

10.    Income Taxes

The Company’s effective tax rate from continuing operations for the three months ended March 31, 2017 and 2016 was 56.8% and 73.4%, respectively. The effective tax rates for these periods exceeded the U.S. federal statutory rate of 35% primarily due to foreign net operating losses (including equity investment losses) for which the future income tax benefit currently cannot be recognized, significant losses in foreign jurisdictions with tax rates lower than the U.S. rate of 35%, state income taxes and certain non-deductible expenses. The Company recorded excess tax benefits of $210 as a reduction to the provision for income taxes for the three months ended March 31, 2017 as a result of applying the guidance in ASU 2016-09 as further discussed in Note 2, Significant Accounting Policies and Recent Accounting Pronouncements.

11.    Commitments and Contingencies

Legal proceedings

On June 15, 2015, a putative stockholder class action derivative complaint was filed in the Court of Chancery of the State of Delaware (the “Court”), captioned Haverhill Retirement System v. Kerley et al., C.A. No. 11149-VCL (“Haverhill Litigation”).

On October 10, 2016, the Court granted an extension of the stay of the proceeding from November 20, 2016 until January 20, 2017, in order to allow the special litigation committee, created by the Company’s Board of Directors, additional time to complete its investigation, review and evaluation of the facts, circumstances and claims asserted in or relating to this action and determine the Company’s response thereto. On January 20, 2017, the special litigation committee advised the Court that the parties to the litigation and the special litigation committee had reached an agreement in principle to settle all of the claims in the litigation. The parties are working to finalize and document the settlement, which will then be presented to the Court for approval.

For further information regarding this legal proceeding please see Note 19, Commitments and Contingencies, in the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

In addition to the matter described above, in the ordinary course of business, the Company is a party to various lawsuits. Management does not expect these lawsuits to have a material impact on the liquidity, results of operations, or financial condition of Providence.

Indemnifications related to Haverhill Litigation

The Company completed a rights offering on February 5, 2015 (the “Rights Offering”) providing all of the Company’s existing common stock holders the non-transferrable right to purchase their pro rata share of $65,500 of convertible preferred stock at a price equal to $100.00 per share (“Preferred Stock”). Stockholders exercised subscription rights to purchase 130,884 shares of the Company's Preferred Stock. Pursuant to the terms and conditions of the Standby Purchase Agreement (the “Standby Purchase Agreement”) between Coliseum Capital Partners, L.P., Coliseum Capital Partners II, L.P., Coliseum Capital Co-Invest, L.P. and Blackwell Partners, LLC (collectively, the “Standby Purchasers”) and the Company, the remaining 524,116 shares of the Company’s Preferred Stock were purchased by the Standby Purchasers at the $100.00 per share subscription price. The Company has indemnified the Standby Purchasers from and against any and all losses, claims, damages, expenses and liabilities relating to or arising out of (i) any breach of any representation, warranty, covenant or undertaking made by or on behalf of the Company in the Standby Purchase Agreement and (ii) the transactions contemplated by the Standby Purchase Agreement and the 14.0% Unsecured Subordinated Note in aggregate principal amount of $65,500, except to the extent that any such losses, claims, damages, expenses and liabilities are attributable to the gross negligence, willful misconduct or fraud of such Standby Purchaser.

The Company has also indemnified other third parties from and against any and all losses, claims, damages, expenses and liabilities arising out of or in connection with the Company’s acquisition of CCHN Group Holdings, Inc. (operating under the tradename Matrix, and formerly included in our HA Services segment) in October 2014 and related financing commitments, except to the extent that any such losses, claims, damages, expenses and liabilities are found in a final, non-appealable judgment by a court of competent jurisdiction to have resulted from the gross negligence, bad faith or willful misconduct of such third parties, or a material breach of such third parties’ obligations under the related agreements.

The Company recorded $132 and $106 of such indemnified legal expenses related to the Haverhill Litigation during the three months ended March 31, 2017 and 2016, respectively, which is included in “General and administrative expenses” in the condensed consolidated statements of income. Of this amount, $115 and $106 for the three months ended March 31, 2017 and 2016, respectively, were indemnified legal expenses of related parties. Other legal expenses of the Company related to the Haverhill Litigation are covered under the Company’s insurance policies, subject to applicable deductibles and customary review of the expenses by the carrier. The Company recognized related expense of $11 for the three months ended March 31, 2017. While the carrier typically remits payment directly to the respective law firm, the Company accrues for the cost and records a corresponding receivable for the amount to be paid by the carrier. The Company has recognized an insurance receivable of $945 and $1,645 in “Other receivables” in the condensed consolidated balance sheets at March 31, 2017 and December 31, 2016, respectively, with a corresponding liability amount recorded to “Accrued expenses”.

Other Indemnifications

The Company has provided certain standard indemnifications in connection with the sale of the Human Services segment to Molina Healthcare Inc. (“Molina”) effective November 1, 2015. All representations and warranties made by the Company in the Membership Interest Purchase Agreement (the “Purchase Agreement”) to sell the Human Services segment survive through the 15th month following the closing date, and ended on February 1, 2017. However, claims made prior to February 1, 2017 by the purchaser of Human Services against these representations and warranties may survive until the claims are settled. In addition, certain representations, including tax representations, survive until the expiration of applicable statutes of limitation, and healthcare representations survive until the third anniversary of the closing date. The Company received indications from the purchaser of the Human Services segment prior to the February 1, 2017 deadline regarding potential indemnification claims. One such potential indemnification claim relates to Rodriguez v. Providence Community Corrections, a complaint filed in the District Court for the Middle District of Tennessee, Nashville Division (the “Rodriquez Litigation”), against Providence Community Corrections, Inc. (“PCC”), an entity sold under the Purchase Agreement. Molina announced in September 2016 that the parties to the Rodriguez Litigation accepted a mediation proposal for settlement pursuant to which PCC would pay the plaintiffs $14,000, and the parties are in the process of finalizing the settlement agreement, which remains subject to court approval.

Molina and the Company are in discussions regarding a settlement of an indemnification claim by Molina with respect to the Rodriguez Litigation and other matters. Based on these discussions, the $6,000 accrual established in 2016 with respect to an estimate of loss for potential indemnification claims has been increased to $15,000, and thus the condensed consolidated statement of income for the three months ended March 31, 2017 reflects a pre-tax charge of $9,000 within “Discontinued operations, net of tax”. The Company expects to recover a substantial portion of the settlement through insurance coverage, although this cannot be assured.

Litigation is inherently uncertain and the actual losses incurred in the event that the related legal proceedings were to result in unfavorable outcomes could have a material adverse effect on the Company’s business and financial performance.

The Company has provided certain standard indemnifications in connection with its Matrix stock subscription transaction whereby Mercury Fortuna Buyer, LLC (“Subscriber”), Providence and Matrix entered into a stock subscription agreement (the “Subscription Agreement”), dated August 28, 2016.  The representations and warranties made by the Company in the Subscription Agreement survive through the 15th month following the closing date; however, certain fundamental representations survive through the 36th month following the closing date.  The covenants and agreements of the parties to be performed prior to the closing survive through the 15th month following the closing date, and all other covenants and agreements survive until the expiration of the applicable statute of limitations in the event of a breach, or for such lesser periods specified therein. 

As of March 31, 2017, Matrix has certain malpractice claims that arose prior to the Company’s purchase of Matrix. The Company believes it is reasonably possible that a loss has occurred; however, it is not able to reliably estimate the amount of such loss. Although the Company does not believe that the aggregate amount of liability reasonably possible with respect to these matters would have a material adverse effect on its financial results, litigation is inherently uncertain and the actual losses incurred in the event that the Company’s legal proceedings were to result in unfavorable outcomes could have a material adverse effect on the Company’s business and financial performance. The Company is not aware of any indemnification liabilities with respect to Matrix that require accrual at March 31, 2017.

Deferred Compensation Plan

The Company has one deferred compensation plan for highly compensated employees of NET Services as of March 31, 2017. The deferred compensation plan is unfunded, and benefits are paid from the general assets of the Company. The total of participant deferrals, which is reflected in “Other long-term liabilities” in the condensed consolidated balance sheets, was $1,694 and $1,430 at March 31, 2017 and December 31, 2016, respectively.

12.    Transactions with Related Parties

The Company incurred legal expenses under an indemnification agreement with the Standby Purchasers as further discussed in Note 11, Commitments and Contingencies. Convertible preferred stock dividends earned by the Standby Purchasers during the three months ended March 31, 2017 and 2016 totaled $1,039 and $1,047, respectively. In addition, during the three months ended March 31, 2017, the Company made a loan to Mission Providence. The balance as of March 31, 2017 of $573 is included within “Other assets” in the Company’s condensed consolidated balance sheet.

13.  Discontinued Operations

On November 1, 2015, the Company completed the sale of the Human Services segment. During the three months ended March 31, 2017, the Company recorded additional expenses related to the Human Services segment, principally related to legal proceedings as described in Note 11, Commitment and Contingences, related to an indemnified legal matter.

Effective October 19, 2016, the Company completed the Matrix Transaction. Prior to the closing of the Matrix Transaction, the financial results of Matrix were included in the Company’s HA Services segment, which have been reflected as a discontinued operation for the three months ended March 31, 2016. Following the Matrix Transaction, the Company has a continuing involvement with Matrix through its 46.8% ownership interest in Matrix, which is accounted for as an equity method investment. Matrix’s pretax loss for the three months ended March 31, 2017 totaled $2,599. There have been no cash inflows or outflows from or to Matrix subsequent to the closing of the Matrix Transaction, other than the payment of working capital adjustments, and management fees associated with its ongoing relationship with Matrix, of which $185 was received during the three months ended March 31, 2017. $235 and $185 is included in “Other receivables” in the condensed consolidated balance sheets at March 31, 2017 and December 31, 2016, respectively, related to management fees receivable.

Results of Operations

The following table summarizes the results of operations classified as discontinued operations, net of tax, for the three months ended March 31, 2017 and 2016.

General and administrative expenses for the three months ended March 31, 2017 includes an accrual of $9,000 for an estimated settlement of indemnified claims related to the sale of the Human Services segment, as well as related legal expenses of $406. See Note 11, Commitments and Contingencies, for additional information.

Interest expense, net

The Company allocated interest expense, including amortization of deferred financing fees, to discontinued operations based on the portion of debt that was required to be paid with the proceeds from the sale of the Matrix Transaction. The total allocated interest expense was $3,143 for the three months ended March 31, 2016 and is included in “Interest expense, net” in the table above.

Cash Flow Information

The following table presents depreciation, amortization and capital expenditures of the discontinued operations for the three months ended March 31, 2016:

14.    Segments

The Company is a holding company, which owns interests in subsidiaries and other companies that are primarily engaged in the provision of healthcare and workforce development services. The subsidiaries and other companies in which the Company holds interests comprise the following segments:

Effective October 19, 2016, pursuant to the Matrix Transaction, the Company no longer owns a controlling interest in Matrix, which historically constituted the HA Services segment as further discussed in Note 13, Discontinued Operations. As the HA Services segment, through October 19, 2016, is presented as a discontinued operation, it is not reflected in the Company’s segment disclosures.  However, the Company accounts for its noncontrolling interest in Matrix from October 19, 2016 through present as an equity method investment, which solely comprises Matrix Investment in the table below.

The following table sets forth certain financial information from continuing operations attributable to the Company’s business segments for the three months ended March 31, 2017 and 2016:

Geographic Information

Domestic service revenue, net, totaled 82.0% and 77.2% of service revenue, net for the three months ended March 31, 2017 and 2016, respectively. Foreign service revenue, net, totaled 18.0% and 22.8% of service revenue, net for the three months ended March 31, 2017 and 2016, respectively.

At March 31, 2017 and December 31, 2016, $82,862 and $76,579, respectively, of the Company’s net assets were located in countries outside of the U.S.

The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and accompanying notes for the three months ended March 31, 2017 and 2016, as well as our consolidated financial statements and accompanying notes and management’s discussion and analysis of financial condition and results of operations included in our Form 10-K for the year ended December 31, 2016. For purposes of “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” references to Q1 2017 and Q1 2016 mean the three months ended March 31, 2017 and the three months ended March 31, 2016, respectively.

Overview of our business

The Providence Service Corporation is a holding company which owns interests in subsidiaries and other companies that are primarily engaged in the provision of healthcare and workforce development services. The subsidiaries and other companies in which we hold interests comprise the following segments:

Business Outlook and Trends

Our performance is affected by a number of trends that drive the demand for our services. In particular, the markets in which we operate are exposed to various trends such as healthcare industry and demographic dynamics in the United States (“U.S.”) and international government outsourcing and employment dynamics. Over the long term, we believe there are numerous factors that could affect growth within the industries in which we operate, including:

Historically, our segments have grown through organic expansion into new markets and service lines, organic expansion within existing markets and service lines, increases in the number of members served under contracts we have been awarded, the securing of new contracts and acquisitions. We continue to selectively identify and pursue the acquisition of attractive businesses that are complementary to our business strategies. In addition, as demonstrated in 2016 with the Matrix Transaction (as defined below) and in 2015 with the sale of our Human Services segment, we also may enter into strategic partnerships or dispose of current or future investments, based on a variety of factors, including availability of alternative opportunities to deploy capital, maximize shareholder value or other strategic considerations.

Critical accounting estimates and policies

As of March 31, 2017, there has been no change in our critical accounting policies, other than for stock-based compensation, as discussed below. For further discussion of our critical accounting policies see management’s discussion and analysis of financial condition and results of operations contained in our Form 10-K for the year ended December 31, 2016.

Stock-Based Compensation

Our primary forms of employee stock-based compensation are stock option awards and restricted stock awards, including certain awards which vest based upon performance conditions. We measure the value of stock option awards on the date of grant at fair value using the appropriate valuation techniques, including the Black-Scholes and Monte Carlo option-pricing models. We recognize the fair value as stock-based compensation expense over the remaining term on a straight-line basis. The pricing models require various highly judgmental assumptions including volatility and expected option term. If any of the assumptions used in the models change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

As a result of the adoption of Accounting Standards Update No. 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), effective January 1, 2017, we no longer record stock-based compensation expense net of estimated forfeitures and the tax effects of awards are treated as discrete items in the period in which tax windfalls or shortfalls occur. The adoption also impacted the presentation of cash flows and the computation of earnings per share.

The adoption of ASU 2016-09 will subject our tax rate to quarterly volatility from the effects of stock award exercises and vesting activities, including the adverse impact on our income tax provision for awards which result in a tax deduction less than the amount recorded for financial reporting purposes based upon the fair value of the award at the grant date. For example, no shares will be distributed under the Company’s 2015 Holding Company LTI Program (the “HoldCo LTIP”) unless the volume weighted average of Providence’s stock price over a 90-day period ending on December 31, 2017 exceeds $56.79. If this market condition is not satisfied, a significant tax shortfall will result, causing an adverse impact on our tax provision.

Results of operations

Segment reporting. Our operations are organized and reviewed by management along our segment lines. We operate in two principal business segments: NET Services and WD Services. Our investment in CCHN Group Holdings, Inc. and its subsidiaries (“Matrix”) is also a reportable segment referred to as the “Matrix Investment”.

On October 19, 2016, affiliates of Frazier Healthcare Partners purchased a 53.2% equity interest in Matrix, with Providence retaining a 46.8% equity interest (the “Matrix Transaction”), resulting in our ownership of a noncontrolling interest in our historical Health Assessment Services (“HA Services”) segment. The HA Services segment results of operations for the periods through October 19, 2016 are separately discussed in the “Discontinued operations, net of tax” section set forth below and are separately discussed in the “Equity in net loss of investees” section set forth below for the subsequent period through March 31, 2017. Additionally, effective November 1, 2015, we completed the sale of our Human Services segment. The Human Services segment results of operations are separately discussed in the “Discontinued operations, net of tax” section set forth below.

Segment results are based on how our chief operating decision maker manages our business, makes operating decisions and evaluates operating performance. The operating results of the two principal business segments include revenue and expenses incurred by the segment, as well as an allocation of certain direct expenses incurred by our corporate division on behalf of the segment. Indirect expenses, including unallocated corporate functions and expenses, such as executive, finance, accounting, human resources, insurance administration, internal audit, process improvement, information technology and legal, as well as the results of our captive insurance company (the “Captive”) and elimination entries recorded in consolidation are reflected in “Corporate and Other”.

Consolidated Results. The following table sets forth results of operations and the percentage of consolidated total revenues represented by items in our unaudited condensed consolidated statements of income for Q1 2017 and Q1 2016 (in thousands):

Service revenue, net. Consolidated service revenue, net for Q1 2017 increased $17.5 million, or 4.6%, compared to Q1 2016. Revenue for Q1 2017 compared to Q1 2016 included an increase in revenue attributable to NET Services of $33.1 million. This increase in revenue was partially offset by a decrease in revenue attributable to WD Services of $15.6 million. Excluding the effects of changes in currency exchange rates, consolidated service revenue increased 6.5% for Q1 2017 compared to Q1 2016.

Total operating expenses. Consolidated operating expenses for Q1 2017 increased $19.0 million, or 5.1%, compared to Q1 2016. Operating expenses for Q1 2017 compared to Q1 2016 included an increase in expenses attributable to NET Services of $39.6 million. This increase in operating expenses was partially offset by a decrease in operating expenses of WD Services of $19.8 million and a decrease in operating expenses of Corporate and Other of $0.8 million.

Operating income. Consolidated operating income for Q1 2017 decreased $1.5 million, or 18.3%, compared to Q1 2016. The decrease was primarily attributable to a decrease in operating income in Q1 2017 as compared to Q1 2016 attributable to NET Services of $6.5 million. This decrease was partially offset by an increase in WD Services operating income of $4.3 million and a decrease in Corporate and Other operating loss of $0.7 million.

Interest expense, net. Consolidated interest expense, net for Q1 2017 decreased $0.1 million, or 28.7%, compared to Q1 2016.

Equity in net loss of investees. Equity in net loss of investees primarily relates to our investments in Mission Providence and Matrix. Mission Providence, which is part of WD Services, began providing services in July 2015. We record 75% of Mission Providence’s profit or loss in equity in net loss of investees. We began reporting Matrix as an equity investment effective October 19, 2016, upon the completion of the Matrix Transaction, and record 46.8% of Matrix’s profit or loss in net loss of investees. Our equity in net loss of investees related to WD Services and Matrix totaled $1.4 million and $0.7 million, respectively, for Q1 2017. Included in Mission Providence’s results are restructuring and redundancy costs of $1.1 million. Included in Matrix’s results are transaction bonuses and other transaction related costs of $3.0 million, equity compensation of $0.6 million, depreciation and amortization of $8.0 million and interest expense of $3.6 million.

Gain on foreign currency transactions. The foreign currency gains of $0.1 for Q1 2017 and Q1 2016 were primarily due to translation adjustments of our foreign subsidiaries.

Provision for income taxes. Our effective tax rate from continuing operations for Q1 2017 and Q1 2016 was 56.8% and 73.4%, respectively. The effective tax rate exceeded the U.S. federal statutory rate of 35% for these periods primarily due to foreign net operating losses (including equity investment losses) for which the future income tax benefit currently cannot be recognized, significant losses in foreign jurisdictions with tax rates lower than the U.S. rate of 35%, state income taxes, and certain non-deductible expenses. Q1 2017 also included excess tax benefits of $0.2 million as a reduction to the provision for income taxes as a result of applying the guidance in ASU 2016-09. The adoption of ASU 2016-09 will subject our tax rate to quarterly volatility from the effects of stock award exercises and vesting activities, including the adverse impact on our income tax provision for awards which result in a tax deduction less than the amount recorded for financial reporting purposes based upon fair value of the award at the grant date.

Discontinued operations, net of tax. Discontinued operations, net of tax, includes the activity of our former Human Services segment and our former HA Services segment, composed entirely of our 100% equity interest in Matrix until the completion of the Matrix Transaction on October 19, 2016. For Q1 2017, discontinued operations, net of tax for our Human Services segment was a loss of $5.9 million, which primarily related to the accrual of a contingent liability of $9.0 million related to the settlement of indemnification claims and associated legal costs of $0.4 million. For Q1 2016, discontinued operations, net of tax for our HA Services segment was net income of $0.8 million. See Note 13, Discontinued Operations, to our condensed consolidated financial statements for additional information.

Net (income) loss attributable to noncontrolling interests. Net (income) loss attributable to noncontrolling interests primarily relates to the minority interest associated with our company servicing the offender rehabilitation contract in our WD Services segment.

Segment Results. The following analysis includes discussion of each of our segments.

NET Services

NET Services segment financial results are as follows for Q1 2017 and Q1 2016 (in thousands):

Service revenue, net. Service revenue, net for NET Services in Q1 2017 increased $33.1 million, or 11.4%, compared to Q1 2016.  The increase was primarily related to the impact of new contracts which contributed $28.7 million of revenue in Q1 2017, including contracts in California, Florida, Iowa and New York, in addition to net increased revenue from existing contracts of $19.8 million due to the net impact of membership and rate changes. These increases were partially offset by the impact of contracts we no longer serve which resulted in a decrease in revenue of $15.5 million.  

Service expense, net. Service expense for our NET Services segment included the following for Q1 2017 and Q1 2016 (in thousands):

Service expense for Q1 2017 increased $39.2 million, or 14.7%, compared to Q1 2016. The increase in service expense was primarily attributable to the impact of new contracts in California, Florida, Iowa and New York. Purchased services as a percentage of revenue increased from 74.7% in Q1 2016 to 77.9% in Q1 2017 primarily attributable to an increase in utilization across multiple contracts and contract start-up cost overruns in California. The higher utilization was in part driven by increased Medicaid reimbursement in New Jersey for certain medical services, which in turn increased demand for transportation services, as well as lower cancellation rates across multiple contracts, which we believe was primarily due to milder winter weather conditions.

Additionally, our payroll and related costs increased for Q1 2017 as compared to Q1 2016 primarily due to additional employees to support new contracts and increased call volume associated with increased revenue, partially offset by a decrease in incentive compensation. As a percentage of revenue, payroll and related costs decreased from 13.9% in Q1 2016 to 13.1% in Q1 2017 due to efficiencies gained from process improvement initiatives and a decrease in incentive compensation. Other operating expenses also increased for Q1 2017 as compared to Q1 2016 primarily attributable to $1.3 million of value enhancement and related costs incurred for external resources used in the design and implementation of NET Services member experience and value enhancement initiatives.

General and administrative expense. General and administrative expense in Q1 2017 increased $0.1 million, or 1.9%, as compared to Q1 2016, due to increased facility costs resulting from the overall growth of our operations. As a percentage of revenue, general and administrative expense decreased slightly from 1.0% for Q1 2016 to 0.9% for Q1 2017.

Depreciation and amortization. Depreciation and amortization increased $0.3 million primarily due to the addition of long-lived assets in our call centers. As a percentage of revenue, depreciation and amortization remained constant at 1.0%.

WD Services

WD Services segment financial results are as follows for Q1 2017 and Q1 2016 (in thousands):

Service revenue, net. Service revenue, net in Q1 2017 decreased $15.6 million, or 17.1%, compared to Q1 2016. Excluding the effects of changes in currency exchange rates, service revenue decreased 9.1% in Q1 2017 compared to Q1 2016. This decrease was primarily related to declining referrals under the segment’s primary employability program in the UK, partially offset by increases across various employability contracts outside the UK, including Saudi Arabia, France and Germany, and increases under the offender rehabilitation program in the UK. Q1 2017 includes the impact of $5.2 million of revenue recognized under the offender rehabilitation program related to the finalization of a contractual adjustment for the contract year ended March 31, 2017.

Service expense. Service expense for our WD Services segment included the following for Q1 2017 and Q1 2016 (in thousands):