SUNLINK HEALTH SYSTEMS INC - Quarter Report: 2019 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2019

OR

For the transition period from                      to                     

Commission File Number 1-12607

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)

Securities registered pursuant to Section 12(b) of the Act:

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 every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (of for such shorter period that the registrant was required to submit 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 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 13(a) of the Exchange Act.     ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   ☐    No  ☒

Securities registered pursuant to Section 12(b) of the Act:

 The number of Common Shares, without par value, outstanding as of November 14, 2019 was 6,986,855.

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 MONTHS ENDED SEPTEMBER 30, 2019

(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 September 30, 2019 and for the three month periods ended September 30, 2019 and 2018 have been prepared in accordance with Rule 10-01 of Regulation S-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, 2019 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 Form 10-K for the fiscal year ended June 30, 2019, filed with the SEC on September 27, 2019. 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 month period ended September 30, 2019 are not necessarily indicative of the results that may be expected for the entire fiscal year or any other interim period.

Throughout these notes to the consolidated financial statements, 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 the publicly traded Company or any particular subsidiary of the Company owns or operates any particular asset, business or property. Each operation and business described in this filing is owned and operated by a distinct and indirect subsidiaries of SunLink Health System, Inc.

Adoption of Recently Issued Accounting Standards

ASC 842, “Leases” – On July 1, 2019, the Company adopted cumulative accounting standard updates initially issued by the Financial Accounting Standards Board (“FASB”) that amend the accounting for leases and are codified as Accounting Standards Codification (“ASC”) 842. These lease accounting changes require operating leases be recorded on the balance sheet through the recognition of a liability for the discounted present value of future fixed lease payments and a corresponding right-of-use (“ROU”) asset.  The Company’s accounting for finance leases remained substantially unchanged from its prior accounting for capital leases. The ROU asset recorded at commencement of the lease represents the right to use the underlying asset over the lease term in exchange for the lease payments. Leases with an initial term of 12 months or less which do not have an option to purchase the underlying asset that is deemed reasonably certain to be exercised are not recorded on the balance sheet; rather, rent expense for these leases is recognized on a straight-line basis over the lease term, or when incurred if a month-to-month lease. When readily determinable, the Company uses the interest rate implicit in a lease to determine the present value of future lease payments. For leases where the implicit rate is not readily determinable, the Company’s incremental borrowing rate is utilized. Our lease agreements do not contain any material residual value guarantees.

The Company elected the amended transition requirements allowed for by the FASB in Accounting Standards Update (“ASU”) 2018-11, which provides relief from requirements to recast prior comparative periods under ASC 842. As a result, the prior year comparative financial statements have not been restated to reflect the adoption of ASC 842. Additionally, the Company elected the “package of practical expedients” available in ASC 842 whereby an entity need not reassess expired contracts for lease identification or classification as a finance or operating lease, or reassess the initial direct costs. The Company has not elected the practical expedient to use hindsight to determine the lease term for its leases at transition. Certain of the Company’s lease agreements have lease and non-lease components, which for the majority of leases the Company accounts for separately when the actual lease

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and non-lease components are determinable. For equipment leases with immaterial non-lease components incorporated into the fixed rent payment, the Company accounts for the lease and non-lease components as a single lease component in determining the lease payment.

The adoption of ASC 842 on July 1, 2019 resulted in the Company recording $1,423 of operating lease liabilities and an equal amount of ROU assets with no impact on retained earnings. The adoption did not have a material impact on the Company’s condensed consolidated statement of operations or condensed consolidated statement of cash flows for the three months ended September 30, 2019.   

Note 2. – Business Operations

Business Operations

SunLink Health Systems, Inc., through subsidiaries owns businesses which are providers of healthcare services in certain markets in the United States. SunLink’s business is composed of the ownership of two business segments:

Healthcare Services

Pharmacy

The Pharmacy segment, which is composed of four operational areas:

SunLink subsidiaries have conducted the Healthcare Services business since 2001 and the Pharmacy operations since 2008. Our Pharmacy segment currently is operated through Carmichael’s Cashway Pharmacy, Inc. (“Carmichael”), a subsidiary of our SunLink ScriptsRx, LLC subsidiary.

.

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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.

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

Parkside Nursing Home — On March 17, 2019, a subsidiary of the Company sold its Parkside Ellijay Nursing Home (“Parkside”) and related real estate for $7,300 subject to adjustment for the book value of certain assets and liabilities on the sale date. The pre-tax gain on the sale was $2,136 in the fiscal year ended June 30, 2019.  The net proceeds of the sale were retained for working capital and general corporate purposes.

Sold Hospitals – Subsidiaries of the Company have sold substantially all of the assets of four hospital (“Sold Hospitals”) during the period July 2, 2012 to August 19, 2016. The loss before income taxes of the Sold Hospitals results primarily from the effects of retained professional liability insurance and 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 months ended September 30, 2019 and 2018, respectively.

The components of pension expense for the three months ended September 30, 2019 and 2018, respectively, were as follows:

SunLink contributed $33 to the plan in the three months ended September 30, 2019 and expects to contribute an additional $100 during the remaining three fiscal quarters of the fiscal year ending June 30, 2020.

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Note 4. – Shareholders’ Equity

2018 Common Share Repurchase Program – On November 29, 2018, the Company announced a share repurchase program (“2018 Program”) approved by its Board of Directors, which authorized the Company to purchase up to 300,000 shares of its common shares.  On December 13, 2018, the Company announced it had purchased the 300,000 shares authorized under the 2018 Program, and that its Board of Directors had authorized an additional 450,000 shares to be purchased under the 2018 Program.  As of September 30, 2019, a total of 359,959 shares had been repurchased at a cost of $372, excluding fees and expenses relating to the offer. A total of 359,959 shares were purchased in open market transactions or privately negotiation transactions pursuant to the 2018 Program before its termination on October 3, 2019.   The chart below shows by month the total shares repurchased and average price per share paid for the 2018 Program prior to its termination.

2019 Common Share Repurchase Program – On October 8, 2019, the Company announced a share repurchase program (“2019 Program”) approved by its Board of Directors which authorizes the Company to purchase up to $750 of its common shares in the open market.  As of the date of this filing, no shares have been repurchased under the 2019 Program.

Stock-Based Compensation – For the three months ended September 30, 2019 and 2018, the Company recognized $28 and $1, 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 50,000 share options granted under the 2011 Director Stock Option Plan during the three months ended September 30, 2019, and no shares granted under the 2011 Director Stock Option Plan during the three months ended September 30, 2018.

Note 5. – Revenue and Accounts Receivables

Revenues by payor were as follows for the three months ended September 30, 2019 and 2018:

Summary information for accounts receivable is as follows:

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The following is a summary of the activity in the allowance for concession adjustments for the Healthcare Services Segment and the Pharmacy Segment for the three months ended September 30, 2019 and 2018:

Note 6. – Intangible Assets

Intangibles consist of the following, net of amortization:

Amortization expense was $29 and $29 for the three months ended September 30, 2019 and 2018, respectively.

Note 7. –Long-Term Debt

Long-term debt consisted of the following:

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Trace RDA 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.  The Trace RDA Loan interest rate is the prime rate (as published in the Wall Street Journal) plus 1% with a floor of 5.5%, (6.0% at September 30, 2019). The Trace RDA Loan is collateralized by real estate and equipment of Trace and is partially guaranteed under the U.S. Department of Agriculture, Rural Development Business and Industry Program.

The Trace RDA Loan contains various covenants, terms and conditions, including financial restrictions and limitations, and affirmative and negative covenants and is guaranteed by SunLink.  The covenants include financial covenants measured on a quarterly basis that 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. At June 30, 2019, Trace was not in compliance with the debt service coverage, fixed charge coverage and funded debt to EBITDA ratios.  The Company is discussing with the lender a waiver of this non-compliance but a waiver of non-compliance has not been received as of the date of filing this report. Trace was in compliance with the covenants as measured at September 30, 2019, but since the non-compliance for June 30, 2019 has not been waived, the entire amount of the Trace RDA loan is classified as current at September 30, 2019.  No event of default has been declared by the lender as of the date of the filing of this report nor is such a declaration currently anticipated. The ability of Trace to continue to make the required debt service payments under the Trace RDA Loan depends on, among other things, available cash resources and its ability to retain or generate sufficient cash, including from operating activities and asset sales. If available cash resources were at any time insufficient or Trace were unable to retain or 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.  

On October 7, 2019, the Company made a $2,500 pre-payment on the Trace RDA loan.  The pre-payment was made with cash on hand.  The Company expects to report in the quarter ended December 31, 2019 a non-cash loss on early extinguishment of debt relating to the pre-payment of approximately $160.

Note 8. – Income Taxes

Income tax benefit of $0 ($0 federal  and state tax  expense) and income tax expense of $0 ($0 federal tax expense and state tax expense) was recorded for continuing operations for the three months ended September 30, 2019 and 2018, 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.

At September 30, 2019, consistent with the above process, we evaluated the need for a valuation against our deferred tax assets and determined that it was more likely than not that none of our deferred tax assets would be realized. As a result, in accordance with ASC 740, we recognized a valuation allowance of $8,673 against the deferred tax asset so that there is no net long-term deferred income tax asset or liability at September 30, 2019. 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 September 30, 2019 that all the deferred tax assets should have full valuation allowances was the three-year cumulative pre-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 September 30, 2019, the Company had approximately $18,200 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 fiscal 2023 through fiscal 2038; however, with the enactment of the TCJA on December 22, 2017, federal net operating loss carryforwards generated in taxable years beginning after December 31, 2017 now have no expiration date. The Company’s returns for the periods prior to the fiscal year ended June 30, 2016 are no longer subject to potential federal and state income tax examination.

Note 9. – Leases

The Company has operating leases and a financing lease relating to its pharmacy operations, medical office buildings, certain medical equipment and office equipment. All lease agreements generally require the Company to pay maintenance, repairs, property taxes and insurance costs, which are variable amounts based on actual costs. Variable lease costs also include escalating rent payments that are not fixed at commencement but are based on an index  determined in future periods over the lease term based on changes in the Consumer Price Index or other measure of cost inflation. Some leases include one or more options to renew the lease at the end of the initial term, with renewal terms that generally extend the lease at the then market rental rates. Leases may also include an option to buy the underlying asset at or a short time prior to the termination of the lease. All such options are at the Company’s discretion and are evaluated at the commencement of the lease, with only those that are reasonably certain of exercise included in determining the appropriate lease term. The components of lease cost and rent expense for the three months ended September 30, 2019 are as follows:  

Supplemental balance sheet information to leases was as follows:

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Supplemental cash flow and other information related to leases as of and for the three months ended September 30, 2019 are as follows:

Commitments relating to non-cancellable operating and finance leases as of September 30, 2019 for each of the next five years and thereafter are as follows:

Note 10. – Commitments and Contingencies

Contractual obligations, commitments and contingencies related to outstanding debt and interest on outstanding debt from continuing operations at September 30, 2019 were as follows:

Contingencies do not reflect potential amounts for claims, litigation and other uncertainties, which matters are not probable or cannot be estimated, such as for certain professional liabilities and contract matters, including those relating to prior assets sales.

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Note 11. – 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 $118 and $76 for legal services to this law firm in the three months ended September 30, 2019 and 2018, respectively.  Included in the Company’s condensed consolidated balance sheets at September 30, 2019 and June 30, 2019 is $100 and $47, respectively, of amounts payable to this law firm.        

Note 12. – Asset Sale

On September 9, 2019, the Company sold approximately 11.4 acres of undeveloped land in Fulton, MO. After expenses, the Company received net proceeds from the sale of $348, which was retained for working capital and general corporate purposes. The pre-tax gain on the sale of property was $100 and is included in the Company’s three months results ended September 30, 2019.

Note 13. – 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.

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 September 30, 2019 and 2018 and for the three months then ended is as follows:

Note 14. – Subsequent Events

2019 Common Share Repurchase Program – On October 8, 2019, the Company announced a share repurchase program approved by its Board of Directors that authorizes the Company to purchase up to $750 of its common shares in the open market.  As of the date of this filing, no shares have been repurchased under this program.

Trace RDA Prepayment – On October 7, 2019, the Company made a $2,500 pre-payment to the Trace RDA loan.  The pre-payment was made with cash on hand.  The Company expects to report, in the quarter ended

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December 31, 2019, a non-cash loss on early extinguishment of debt relating to the pre-payment of approximately $160.

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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 Annual 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,” “seeks to”, “expect,” “project,” “estimate,” “anticipate,” “plan” or “continue.” These forward-looking statements are based on the 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. 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. Healthcare services, pharmacy operations and other 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 that 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

Operational Factors

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Liabilities, Claims, Obligations and Other Matters

Regulation and Governmental Activity

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Dispositions, Acquisition and Renovation Related Matters

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 Form 10-K.

Business Strategy: Operations, Dispositions and Acquisitions

The business strategy of SunLink is to focus its efforts on improving the operations, services and profitability of its existing 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, to repurchase common shares, including through tender offers completed in February and December 2017, a private purchase and open market repurchases of its common shares in December 2018, and to make improvements to its Healthcare Services and Pharmacy businesses. The Company may also use existing cash, as well as any net proceeds from future dispositions, if any, to, among other things, 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, Pharmacy or other 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 portions in its Healthcare Services segment as well as its Pharmacy segment continue to under-perform.

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 it requires assumptions to be made that were uncertain at the time the estimate was made; and changes in the estimate or different estimates that could have been made could have a material impact on our consolidated results of operations or financial condition.

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Our critical accounting estimates are more fully described in our 2019 Annual Report on Form 10-K and continue to include the following areas: receivables – net and provision for doubtful accounts; revenue recognition and net patient service revenues; goodwill, intangible assets and accounting for business combinations; professional and general liability claims; and accounting for income taxes.

Financial Summary

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

Results of Operations

Our net revenues are from our two business segments, Healthcare Services and Pharmacy.  The Company’s revenues by payor were as follows for the three months ended September 30, 2019 and 2018:

The Healthcare Services segment in the current year is composed of one hospital, one nursing home, a subsidiary which provides information technology services to outside customers and SunLink subsidiaries, a leased medical office building and unimproved land. Healthcare Services net revenues increased $541, or 14.7%, for the three months ended September 30, 2019 compared to net revenues for the comparable prior year period. The increase in net revenues for the first fiscal quarter this year resulted from increased hospital and nursing home net revenues that were only partially offset by decreased information technology services net revenues. Hospital patient days increased 2% while nursing home resident days increased 10% in this year’s first fiscal quarter compared to the prior year. There were no prior years’ Medicare and Medicaid cost report settlements for the three months ended September 30, 2019 and 2018.

Pharmacy segment net revenues for the three months ended September 30, 2019 increased $904, or 14% from the three months ended September 30, 2018. The increased net revenues included a 24% increase in Institutional Pharmacy net revenues, a 9% increase in Durable Medical Equipment (“DME”) net revenues and a 5% increase in Retail Pharmacy net revenues. The Institutional Pharmacy servicing for new institutional contracts resulted in a 22% increase in scripts filled this quarter over the comparable prior year period. DME sales orders increased 15% this quarter due to an increase in demand for nutrition and respiratory products.  

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Costs and expenses, including depreciation and amortization, were $11,872 and $10,934 for the three months ended September 30, 2019 and 2018, respectively. 

All expense categories except purchase services and rent decreased as a percent of net revenues for the three months ended September 30, 2019 compared to same period last fiscal year primarily due to the higher net revenues this year. Purchased services increased this year primarily due to the addition of a contracted new service line at a hospital.

Operating Loss

The Company reported an operating loss of $220 for the three months ended September 30, 2019 compared to an operating loss of $727 for the three months ended September 30, 2018. The reduced operating loss for the three months ended September 30, 2019 compared to the operating loss for the prior year’s three month period was primarily a result of the 14% increase in net revenues this year.

Asset Sales

On September 9, 2019, the Company sold approximately 11.4 acres of undeveloped land. After expenses, the Company received net proceeds from the sale of $348, which was retained for working capital and general corporate purposes. The pre-tax gain on the sale of property was $100 and is included in the Company’s three months results ended September 30, 2019.

Interest Expense -Net

Interest expense was $30 and $61 for the three months ended September 30, 2019 and 2018, respectively. The decrease in interest expense for the three month period this year resulted from lower debt outstanding in the current fiscal year net of interest income on short-term investments.

Income Taxes

No income tax benefit (federal or state tax  expense) or  income tax benefit  (federal tax expense or state tax expense) was recorded for continuing operations for the three months ended September 30, 2019 and 2018, 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.

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At September 30, 2019, consistent with the above process, we evaluated the need for a valuation against our deferred tax assets and determined that it was more likely than not that none of our deferred tax assets would be realized. As a result, in accordance with ASC 740, we recognized a valuation allowance of $8,673 against the deferred tax asset so that there is no net long-term deferred income tax asset or liability at September 30, 2019. 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.

The principal negative evidence that led us to determine at September 30, 2019 that all the deferred tax assets should have full valuation allowances was the three-year cumulative pre-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 September 30, 2019, the Company had approximately $18,200 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 fiscal 2023 through fiscal 2038; however, with the enactment of the TCJA on December 22, 2017, federal net operating loss carryforwards generated in taxable years beginning after December 31, 2017 now have no expiration date. The Company’s returns for the periods prior to the fiscal year ended June 30, 2016 are no longer subject to potential federal and state income tax examination.

         The Company has in effect a Tax Benefits Preservation Rights Plan (TBPRP) designed to preserve its net operating loss carry forwards (NOLs) so that they may be used in the future if the Company achieves net  taxable income arising from, among other things, operations, gains from asset sales or other corporate transactions, if any. The Company’s ability to use its NOLs would be substantially limited if an “ownership change” under Section 382 of the Internal Revenue Code were to occur. Ownership changes under Section 382 generally relate to the cumulative change in ownership among shareholders with an ownership interest of 5% or more (as determined under Section 382’s rules) over a rolling three year period. The TBPRP is designed to reduce the likelihood of an “ownership change” occurring. Under the TBPRP, if any person or group acquires 4.9% or more of the outstanding common shares of the Company without the approval of the Board of Directors, there would be a triggering event causing significant dilution in the ownership interest of such person or group. Shareholders who owned 4.9% or more of the outstanding common shares of the Company as of September 29, 2016 will trigger a dilutive event only if they acquire additional shares, subject to specified exceptions. The TBPRP is similar to rights plans adopted by other public companies with significant net operating losses.

Loss from Continuing Operations after Income Taxes

Loss from continuing operations after income tax was $143 for the three months ended September 30, 2019 as compared to a loss from continuing operations after income tax of $786 for the three months ended September 30, 2018. The lower loss from continuing operations resulted from the $1,445 increase in net revenues this quarter and the $107 gains on sale of assets this quarter.

Loss from Discontinued Operations after Income Taxes

The loss from discontinued operations after income taxes was $118 for the three months ended September 30, 2019 and $94 for the three months ended September 30, 2018.

Net Loss

Net loss for the three months ended September 30, 2019 was $261 (a loss of $0.04 per fully diluted share) as compared to a net loss of $880 (a loss of $0.12 per fully diluted share) for the three months ended September 30, 2018.

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Liquidity and Capital Resources

Overview

Our primary source of liquidity is unrestricted cash on hand, which was $7,670 at September 30, 2019. Currently, the Company’s ability to raise capital (debt or equity) in the public or private markets on what it considers acceptable terms is uncertain. We from time to time nevertheless seek options to obtain financing for the liquidity needs of the Company or individual subsidiaries based on anticipated needs. The Company and its subsidiaries currently are funding working capital needs primarily from cash on hand and from the sale of assets.

Subject to the risks and uncertainties discussed herein, we believe we have adequate financing and liquidity to support our current level of operations through the next twelve months.

Subsidiary Loans

Trace RDA 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. The Trace RDA Loan interest rate is the prime rate (as published in the Wall Street Journal) plus 1% with a floor of 5.5%, (6.0% at September 30, 2019). The Trace RDA Loan is collateralized by real estate and equipment of Trace, and is partially guaranteed under the U.S. Department of Agriculture, Rural Development Business and Industry Program.

The Trace RDA Loan contains various covenants, terms and conditions, including financial restrictions and limitations, and affirmative and negative covenants and is guaranteed by SunLink.  The covenants include financial covenants measured on a quarterly basis that 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. At June 30, 2019, Trace was not in compliance with the debt service coverage, fixed charge coverage and funded debt to EBITDA ratios.  The Company is discussing with the lender a waiver of this non-compliance but a waiver of non-compliance has not been received as of the date of filing this report. Trace was in compliance with the covenants as measured at September 30, 2019, but since the non-compliance for June 30, 2019 has not been waived, the entire amount of the Trace RDA loan is classified as current at September 30, 2019.  No event of default has been declared by the lender as of the date of the filing of this report nor is such a declaration currently anticipated. The ability of Trace to continue to make the required debt service payments under the Trace RDA Loan depends on, among other things, available cash resources and its ability to retain or generate sufficient cash, including from operating activities and asset sales. If available cash resources were at any time insufficient or Trace were unable to retain or 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.  

On October 7, 2019, the Company made a $2,500 pre-payment on the Trace RDA loan.  The pre-payment was made with cash on hand.  The Company expects to report in the quarter ended December 31, 2019 a non-cash loss on early extinguishment of debt relating to the pre-payment of approximately $160.

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Contractual Obligations, Commitments and Contingencies

Contractual obligations, commitments and contingencies related to outstanding debt, noncancelable operating leases and interest on outstanding debt from continuing operations at September 30, 2019 were as follows:

At September 30, 2019, we had outstanding debt of $3,076 consisting of $2,928 under the Trace RDA Loan and $148 of capital lease debt.

Discontinued Operations

Sold Hospitals and Nursing Homes– Subsidiaries of the Company have sold substantially all of the assets of four hospital (“Sold Facilities”) during the period July 2, 2012 to March 17, 2019. The loss before income taxes of the Sold Facilities results primarily from the effects of retained professional liability insurance and 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 months ended September 30, 2019 and 2018, respectively.

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 $118 and $76 for legal services to this law firm in the three months ended September 30, 2019 and 2018, respectively. Included in the Company’s condensed consolidated balance sheets at September 30, 2019 and June 30, 2019 is $100 and $47, respectively, of amounts payable to this law firm.        

We have not entered into any transactions using derivative financial instruments or derivative commodity instruments and believe that our exposure to market risk associated with other financial instruments (such as investments and borrowings) and interest rate risk is not material.

Evaluation of Disclosure Controls and Procedures

As required by Rule 13a-15 and Rule 15d-15(e) under the Securities Exchange Act of 1934 (the “ Exchange Act ”), as of the end of the period covered by this report, we carried out an evaluation of the effectiveness of the design and operation of our Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) and the changes in our disclosure controls and procedures during the quarter. Under the direction of our chief executive officer and chief financial officer, we evaluated our disclosure controls and procedures and internal control over financial reporting and concluded that our disclosure controls and procedures were effective as of September 30, 2019.

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Disclosure controls and procedures and other procedures are designed to ensure that information required to be disclosed in our reports or submitted under the Exchange Act, such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time period specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to management, including our principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

Based on an evaluation of the effectiveness of disclosure controls and procedures performed in connection with the preparation of this Form 10-Q, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective as of September 30, 2019.

Changes in Internal Control Over Financial Reporting

There were no changes during the quarter ended September 30, 2019 in our internal control over financial reporting that materially affected, or is likely to materially affect, our internal controls over financial reporting.

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PART II. OTHER INFORMATION

Items required under Part II not specifically shown below are not applicable.

ITEM 1.      LEGAL PROCEEDINGS

The Company and its subsidiaries are subject to various claims and litigation that arise from time to time in the ordinary course of business, including, among other things, tax, contract, workers compensation and medical malpractice claims and litigation. Medical malpractice and certain other claims are generally covered by malpractice, general liability or other insurance but are subject to provisions under which the Company retains a portion of the risk, which retention, particularly in the case of claims of medical malpractice, can be material.  Based on current knowledge, the Company’s management does not believe that current pending claims and litigation will have a material adverse effect on the Company’s consolidated financial position or its liquidity.  However, in light of the uncertainties involved and indeterminate damages sought in some such claims and litigation, an adverse outcome could be material to our results of operations or cash flows in any reporting period.

Risk Factors Relating to an Investment in SunLink

Information regarding risk factors appears in “MD&A – Forward-Looking Statements,” in Part I – Item 2 of this Form 10-Q and in “MD&A -Risks Factors Relating to an Investment in SunLink” in Part I – Item 1A of the Company’s Annual Report on Form 10-K for the year ended June 30, 2019. While we believe there have been no material changes from the risk factors previously disclosed in such Annual Report except as set forth herein, you should carefully consider, in addition to the other information set forth in this report, the risk factors discussed in our Annual Report that could materially affect our business, financial condition or future results. Such risk factors are expressly incorporated herein by reference. The risks described in our Annual Report are not the only risks facing our Company. In addition to risks and uncertainties inherent in forward-looking statements contained in this Report on Form 10-Q, additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results. Whenever we refer to “SunLink,” “Company”, “we,” “our,” or “us” in this Item 1A, we mean SunLink Health Systems, Inc. and its subsidiaries, unless the context suggests otherwise.

Exhibits:

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SIGNATURES

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

Dated: November 14, 2019

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