SUNLINK HEALTH SYSTEMS INC - Quarter Report: 2022 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2022

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 690, 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, 2022 was 7,031,603 . 

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 SHAREHOLDERS’ EQUITY

(In thousands)

(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, 2022

(all dollar amounts in thousands except per share amounts)

(Unaudited)

Note 1. –Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements as of September 30, 2022 and for the three month periods ended September 30, 2022 and 2021 have been prepared in accordance with Rule 8-03 and Article 8-03 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, 2022 balance sheet included in this interim filing has been derived from the audited consolidated financial statements at that date but does not include all the information and related notes required by GAAP for complete consolidated 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, 2022, filed with the SEC on September 28, 2022. 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 periods ended September 30, 2022 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 condensed 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 SunLink Health Systems, Inc. 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 subsidiary of SunLink Health System, Inc.

Note 2. – Business Operations

Healthcare Services

The Health Services segment includes the following:

Pharmacy

The Pharmacy segment is composed of three operational areas:

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COVID-19 Pandemic and CARES Act Funding

COVID-19 was declared a global pandemic by the World Health Organization on March 11, 2020. We have continued to monitor the impact on our operations of the COVID-19 pandemic and its aftermath and have taken significant steps intended to minimize the risk to our employees and patients. Certain employees have been working remotely, but we believe these remote work arrangements have not materially affected our ability to maintain critical business operations, which are being conducted substantially in accordance with, among other things, our understanding of applicable government health and safety protocols and guidance issued in response to the COVID-19 pandemic, although such protocols and guidance have been subject to changes and at times have been unclear. Nevertheless, as in many healthcare environments, we have experienced disruption of our operations, COVID-19 illness, including deaths, and some employees have tested positive and were placed on leave or in quarantine. We believe the effect of the COVID-19 pandemic and certain public and certain governmental responses to it have negatively affected our last eleven quarter’s results.

In late December 2020, we began receiving allotments of COVID-19 vaccine and have vaccinated patients, providers, employees, and staff in accordance with the protocols and guidelines in the states where we operate. Not all such individuals have been vaccinated to date and some individuals have not consented to vaccination. The Company and its subsidiaries are currently developing and will implement plans to vaccinate employees to the extent required by the final rules of CMS. The Company believes the vaccine mandates have resulted in the loss of staff, including clinical staff, and together with the current state of the labor market, have negatively affected the Company’s ability to maintain the current levels of service.

In our Healthcare Segment business, we have experienced material reductions in demand and net revenues due to the COVID-19 pandemic and its aftermath. There continues to be reduced current demand for certain hospital services and for extended care, rehabilitation center and nursing home admissions and clinic visits. The availability and cost of medical supplies have adversely affected our Healthcare businesses and we continue to monitor supplies and seek additional sources of many supply items. A reduction in the availability of qualified employees accompanied by an increase in the levels of salaries, wages and benefits have occurred, and, despite good faith efforts to do so, we have not yet been able to rehire or fully replace staff reductions which were previously furloughed, laid off or retired.

During the COVID-19 pandemic and its aftermath, our Pharmacy business has experienced reduced sales trends in certain areas, increased costs and reduced staff. Many of our primary physician referral sources have been operating at reduced capacity, and until these referral sources resume operating at full capacity, we believe the COVID-19 pandemic will have continuing to effects on the demand for DME products and Retail and Institutional Pharmacy drugs and products. Reductions in employee hours have been made in response to the lower demand. Extended care facilities and rehabilitation centers, nursing homes and other customers of our Institutional Pharmacy services continue to be adversely affected by the COVID-19 pandemic. Our Institutional Pharmacy services have experienced increased costs and operational inefficiencies due to measures taken to protect our employees and by access controls and other restrictions implemented by our institutional customers. The impact of the COVID-19 pandemic and its aftermath also has and continues to have negatively affected our supply processes and costs generally.

Our Healthcare and Pharmacy segments have received approximately $6,182 in general and targeted Provider Relief Funds ("PRF") during the period April 1, 2020 through September 30, 2022 under the CARES Act, which was enacted in March 2020 in response to the COVID-19 pandemic. The PRF distributions have been accounted for as government grants, and a total of $5,715 have been recognized since April l, 2020 as other income under the gain contingency recognition method.

During the quarter ended June 30, 2020, our Healthcare and Pharmacy segments received $3,234 in Paycheck Protection Plan (“PPP”) loans provided under the CARES Act. These loans were forgivable upon

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compliance with conditions specified under the PPP loan program. As of September 30, 2022, all our PPP loans have been forgiven.

The Taxpayer Certainty and Disaster Tax Relief Act of 2020, enacted December 27, 2020, made a number of changes to employer retention tax credits previously made available under the CARES Act, including modifying and extending the Employee Retention Credit ("ERC") for the six calendar months ending June 30, 2021. As a result of such legislation, the Company qualified for ERC for the first and second calendar quarters of 2021 due to the decrease in its gross receipts and has applied for ERC of $3,586 through amended quarterly payroll tax filings for the applicable quarters. Through the date of this filing, the Company has received $1,803 of ERC which we applied for. We continue to monitor compliance with the terms and conditions of the ERC and PPP programs and developing interpretations and enforcement of the ERC and PPP program rules and the regulations.   

    PRF distributions are subject to Federal audits and Single Audits and not subject to repayment provided we are able to attest to and comply with the terms and conditions of the funding, including demonstrating that the funds received have been used for designated, allowable healthcare-related expenses and capital expenditures attributable to COVID-19 and for "Lost Revenues" as defined by the department of “HHS”. We continue to monitor compliance with the terms and conditions of the PRF and developing interpretations and enforcement of PRF rules and regulations, as well as the impact of the pandemic on our revenues and expenses. If we are unable to attest to or comply with current or future terms and conditions, and there is no assurance we will be able to do so, our ability to retain some or all of the PRF received may be impacted, and we may have to return the unutilized portion of those funds, if any, in the future. The Company filed its Schedule of Grant Income of HHS awards and audit report  for the year ended June 30, 2021 with the Health Resources and Services Administration (“HRSA”) agency of HHS on September 30, 2022.

The Company is unable to determine the extent to which the COVID-19 pandemic and its aftermath will continue to affect its assets and operations. Our ability to make estimates of the effect of the COVID-19 pandemic on revenues, expenses or changes in accounting judgments that have had or are reasonably likely to have a material effect on our financial statements is currently limited. The nature and extent of the continuing effect of the COVID-19 pandemic and its aftermath on our balance sheet and results of operations will depend on the severity and length of the pandemic or to evolving strains of COVID-19; any further government actions to address the pandemic's continuing effect; regulatory changes in response to the pandemic, especially those that affect our hospital, extended care, rehabilitation center, nursing home, clinics, and our pharmacy operations; existing and potential government assistance that may be provided; and the requirements of PRF, including our ability to retain such PRF received.

Note 3. – Discontinued Operations

Sold Hospitals and Nursing Home– Subsidiaries of the Company have sold substantially all the assets of five hospitals (“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 and settlement of a lawsuit.

Life Sciences and Engineering Segment —SunLink retained a defined benefit retirement plan which covered substantially all 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, 2022 and 2021, respectively.

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The components of pension expense for the three months ended September 30, 2022 and 2021, respectively, were as follows:

SunLink contributed $22  to the plan in the three months ended September 30, 2022 and expects to contribute an additional $66 during the last nine months of the fiscal year ending June 30, 2023.

Note 4. – Shareholders’ Equity

Stock-Based Compensation – For the three months ended September 30, 2022 and 2021, the Company recognized  no  stock-based compensation for options issued to employees and directors of the Company. There were 77,452 shares issued as a result of options exercised during the three months ended September 30, 2022.

Note 5. – Revenue

Revenues by payor were as follows for the three months ended September 30, 2022 and 2021:

No settlements of prior year Medicare and Medicaid cost reports were recorded in the three months ended September 30, 2022 and 2021, respectively.

Note 6. – Intangible Assets

Intangibles consist of the following, net of amortization:

Amortization expense was $6 and $7 for the three months ended September 30, 2022 and 2021, respectively.

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Note 7. – Long-Term Debt

Long-term debt consisted of the following:

CARES Act Paycheck Protection Plan Loans— The CARES Act was enacted by the U.S. government on March 27, 2020. As part of the CARES Act, the PPP loan program was established and administered by the SBA. In April and May 2020, subsidiaries of the Company received approximately $3,234 of PPP loans through its regular bank. Forgiveness of PPP loans was generally available if the loans were used to pay wages, rent, utilities and interest on certain debt during the 24-week period following receipt of the loan proceeds, subject to other federally-established terms and conditions. As of June 30, 2022, all our PPP loans have been forgiven by the SBA. During the quarter ended September 30, 2021, $2,972 of our PPP loans and $ 38 of related accrued interest were forgiven by the SBA and $3,010 was recorded as other income.

Note 8. – Income Taxes

No income tax expense and income tax expense of $2  (all state taxes) was recorded for continuing operations for the three months ended September 30, 2022 and 2021, respectively. 

Of the CARES Act provisions, the currently most material income tax considerations related to the Company are related to the amounts for ERC and amounts received as general and targeted PRF. Based on the latest published IRS guidance as of the preparation of the September 30, 2022 financial statements, PRF (to the extent the applicable terms and conditions required to retain the funds are met “Retainable PRF”) are fully includable in taxable income in the Company’s tax returns in the fiscal year received. ERC are included in taxable income in the quarter in which the payroll expenses which the credits offset are deductible. ERC results in qualified wages being disallowed as a deduction for the portion of the wages paid equal to the sum of the payroll tax credit taken in the associated quarter. For amounts received and forgiven under the PPP loans, due to the enactment of the Consolidated Appropriations Act, 2021, on December 27, 2020, Congress specifically allowed the deduction of any expenses associated with forgiven PPP loan proceeds. It is the Company’s assumption at September 30, 2022 that all PPP loan associated expenses will be deductible for income tax.

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, 2022, consistent with the above process, we evaluated the need for a valuation allowance 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 $8,278 against the deferred tax asset so that there is no net long-term deferred income tax asset at September 30, 2022. 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 performance. A long-term deferred tax liability of $69 is recorded September 30, 2022 to reflect the deferred tax liability for the non-amortizing trade name intangible asset.  

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The principal negative evidence that led us to determine at September 30, 2022 that all the deferred tax assets should have full valuation allowances was the projected current fiscal year tax loss. For purposes of evaluating our valuations allowances, we have disregarded unusual items associated with the CARES Act discussed above, the Company’s history of losses, as well as the underlying negative business conditions for rural healthcare in which our Healthcare Services operates, and we have recognized none of our federal income tax net operating loss carry-forward of approximately $23,143.

For federal income tax purposes, at September 30, 2022, the Company had approximately $23,143 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 Tax Cut and Jobs Act 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, 2018 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, all of 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, 2022 and 2021 are as follows:  

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Supplemental balance sheet information relating to leases was as follows:

Supplemental cash flow and other information related to leases as of and for the three months ended September 30, 2022 and 2021 are as follows:

Commitments relating to non-cancellable operating and finance leases as of September 30, 2022 for each of the next five years and thereafter are as follows:

Note 10. – Accrued Sales Tax

During the fiscal year ended June 30, 2019, the Pharmacy segment business amended its sales tax position to claim exemption from state and local sales taxes in Louisiana on revenues from the sales of products and services

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to beneficiaries of government insurance programs to the extent reimbursed by the administrators of such programs. No such sales taxes for any period subsequent to June 30, 2019 have been paid on the related reimbursement received with respect to sales of such products and services from the government payers’ insurance programs. The Company has filed amended sales tax returns for periods still open under the applicable statutes of limitations claiming refunds of such sales taxes paid. Refunds have been received from two taxing authorities in the amounts claimed on amended returns. Accordingly, amounts claimed and received from these two taxing authorities were recorded as revenues in the fiscal year ended June 30, 2020 in the amount of $359. Refunds from two different taxing authorities totaling approximately $1,500 are under audit. The Company’s position with respect to such refunds claimed from the two other local taxing authorities is still uncertain as these claims are under audit by such local taxing authorities and such claims have not yet been determined probable of collection; therefore, no amount has been recorded as a receivable or in income by the Company at September 30, 2022 in respect of such other local taxing authorities. In addition, the Company has continued to accrue the amounts for sales tax estimates from these two other taxing authorities in amounts it believes would be payable if its amended returns and continuing position is challenged and the Company does not prevail. The unpaid sales tax accrued as a liability at September 30, 2022 was $2,777 compared to $2,600 at June 30, 2022.

Note 11. – Commitments and Contingencies

Contractual obligations, commitments and contingencies related to outstanding debt and interest (excluding leases, see Note 9) in continuing operations at September 30, 2022 were as follows:

Note 12. – 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 $55 and $50 for legal services to this law firm in the three months ended September 30, 2022 and 2021, respectively. Included in the Company’s condensed consolidated balance sheets at September 30, 2022 and June 30, 2022 is $50 and $15, respectively, of amounts payable to this law firm.

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.

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We evaluate performance of our operating segments based on revenue and operating profit (loss). Segment information as of September 30, 2022 and 2021 and for the three months then ended is as follows:

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

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

Forward-Looking Statements

This Quarterly Report and the documents that are incorporated by reference in this Quarterly Report contain certain forward-looking statements within the meaning of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all statements that do not relate solely to historical or current facts and may be identified by the use of words such as “may,” “believe,” “will,” “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 this annual report and the notes to the condensed 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 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

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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.

Business Strategy: Operations, Dispositions and Acquisitions

The business strategy of SunLink is to focus its efforts on improving its operations and services generally and achieving and maintaining profitability in its existing Healthcare Services and Pharmacy businesses. While the Company intends primarily to pursue its business strategy of improving its operations and services and achieving and maintaining profitability in its existing businesses, subject to available capital and other resources, the Company also intends to pursue growth by selective healthcare and pharmacy acquisitions. We believe; however, the COVID-19 pandemic and its aftermath has resulted in substantial additional uncertainties and risks in our businesses which are not subject to reliable estimation at this time, particularly because the COVID-19 is novel in nature, uncertain in duration, and materially affected by government actions related to the pandemic and its aftermath. In response to the pandemic, the Company has discontinued certain services, laid off or furloughed employees where necessary, reduced cash outlays where practicable, and deferred other strategic activities. Our ability to resume the pursuit of our normal business strategy, including growth initiatives, has been challenging and will depend on the effect of, among other things, the nature, extent and timing of the existing effects of COVID-19 pandemic, the end thereof, potential new COVID-19 or other pandemics, and government actions in response thereto.

The Company expects to use existing cash primarily to sustain it operations in response to the continuing impact of the COVID-19 pandemic, for growth initiatives, including acquisitions, when available and appropriate, and for other general corporate purposes. There is no assurance that any acquisitions or dispositions of assets will be authorized by the Company’s Board of Directors or, if authorized, that any such transactions will be completed. Although the Company believes certain portions of its businesses continue to under-perform, and the Company periodically entertains overtures for the purchase of its businesses, the Company is not currently offering any of its businesses for sale.

COVID-19 Pandemic and CARES Act Funding

COVID-19 was declared a global pandemic by the World Health Organization on March 11, 2020. We have continued to monitor the impact on our operations of the COVID-19 pandemic and its aftermath and have taken significant steps intended to minimize the risk to our employees and patients. Certain employees have been working remotely, but we believe these remote work arrangements have not materially affected our ability to maintain critical business operations, which are being conducted substantially in accordance with our understanding of applicable

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government health and safety protocols and guidance issued in response to the COVID-19 pandemic, although such protocols and guidance have been subject to frequent changes and at times have been unclear. Nevertheless, as in many healthcare environments, we have experienced disruption of our operations, COVID-19 illness, including deaths, and some employees have tested positive and were placed on leave or in quarantine. We believe the effect of the COVID-19 pandemic and certain public and certain governmental responses to it have negatively affected our last eleven quarter’s results.

In late December 2020, we began receiving allotments of COVID-19 vaccine and have vaccinated patients, providers, employees, and staff in accordance with the protocols and guidelines in the states where we operate. Not all such individuals have been vaccinated to date and some individuals have not consented to vaccination. The Company and its subsidiaries are currently developing and will implement plans to vaccinate employees to the extent required by the final rules of CMS. The Company believes the vaccine mandates have resulted in the loss of staff, including clinical staff, and together with the current state of the labor market, have negatively affected the Company’s ability to maintain the current levels of service.

In our Healthcare Segment business, we have experienced material reductions in demand and net revenues due to the COVID-19 pandemic and its aftermath. There continues to be reduced current demand for certain hospital services and for extended care, rehabilitation center and nursing home admissions and clinic visits. The availability and cost of medical supplies have adversely affected our Healthcare businesses and we continue to monitor supplies and seek additional sources of many supply items. A reduction in the availability of qualified employees accompanied by an increase in the levels of salaries, wages and benefits have occurred, and, despite good faith efforts to do so, we have not yet been able to rehire or fully replace staff reductions which were previously furloughed, laid off or retired.

During the COVID-19 pandemic and aftermath, our Pharmacy business has experienced reduced sales trends in certain areas, increased costs and reduced staff. Many of our primary physician referral sources have been operating at reduced capacity, and until these referral sources resume operating at full capacity, we believe the COVID-19 pandemic will have continuing to effects on the demand for DME products and Retail and Institutional Pharmacy drugs and products. Reductions in employee hours have been made in response to the lower demand. Extended care facilities and rehabilitation centers, nursing homes and other customers of our Institutional Pharmacy services continue to be adversely affected by the COVID-19 pandemic. Our Institutional Pharmacy services have experienced increased costs and operational inefficiencies due to measures taken to protect our employees and by access controls and other restrictions implemented by our institutional customers. The impact of the COVID-19 pandemic and its aftermath also has and continues to negatively affected our supply processes and costs generally.

Our Healthcare and Pharmacy segments have received approximately $6,182 in general and targeted Provider Relief Funds ("PRF") during the period April 1, 2020 through September 30, 2022 under the CARES Act, which was enacted in March 2020 in response to the COVID-19 pandemic. The PRF distributions have been accounted for as government grants, and a total of $5,715 have been recognized since April l, 2020 as other income under the gain contingency recognition method.

During the quarter ended June 30, 2020, our Healthcare and Pharmacy segments received $3,234 in Paycheck Protection Plan (“PPP”) loans provided under the CARES Act. These loans were forgivable upon compliance with conditions specified under the PPP loan program. As of September 30, 2022, all our PPP loans have been forgiven.

The Taxpayer Certainty and Disaster Tax Relief Act of 2020, enacted December 27, 2020, made a number of changes to employer retention tax credits previously made available under the CARES Act, including modifying and extending the Employee Retention Credit ("ERC") for the six calendar months ending June 30, 2021. As a result of such legislation, the Company qualified for ERC for the first and second calendar quarters of 2021 due to the decrease in its gross receipts and has applied for ERC of $3,586 through amended quarterly payroll tax filings for the applicable quarters. Through the date of this filing, the Company has received $1,803 of ERC which we applied for. We continue to monitor compliance with the terms and conditions of the ERC and PPP programs and developing interpretations and enforcement of the ERC and PPP program rules and the regulations.   

    PRF distributions are subject to Federal audits and Single Audits and not subject to repayment provided we are able to attest to and comply with the terms and conditions of the funding, including demonstrating that the funds

19

received have been used for designated, allowable healthcare-related expenses and capital expenditures attributable to COVID-19 and for "Lost Revenues" as defined by the department of “HHS”. We continue to monitor compliance with the terms and conditions of the PRF and developing interpretations and enforcement of PRF rules and regulations, as well as the impact of the pandemic on our revenues and expenses. If we are unable to attest to or comply with current or future terms and conditions, and there is no assurance we will be able to do so, our ability to retain some or all of the PRF received may be impacted, and we may have to return the unutilized portion of those funds, if any, in the future. The Company filed its Schedule of Grant Income of HHS awards and audit report  for the year ended June 30, 2021 with the Health Resources and Services Administration (“HRSA”) agency of HHS on September 30, 2022.

The Company is unable to determine the extent to which the COVID-19 pandemic and its aftermath will continue to affect its assets and operations. Our ability to make estimates of the effect of the COVID-19 pandemic on revenues, expenses or changes in accounting judgments that have had or are reasonably likely to have a material effect on our financial statements is currently limited. The nature and extent of the continuing effect of the COVID-19 pandemic and its aftermath on our balance sheet and results of operations will depend on the severity and length of the pandemic or to evolving strains of COVID-19; any further government actions to address the pandemic's continuing effect; regulatory changes in response to the pandemic, especially those that affect our hospital, extended care, rehabilitation center, nursing home, clinics, and our pharmacy operations; existing and potential government assistance that may be provided; and the requirements of PRF receipts, including our ability to retain such PRF received.

For additional discussion of the risks presented by continuing effects of the COVID-19 pandemic to our results, see Risk Factors in Part II, Item 1A of this Form 10-Q.

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.

Our critical accounting estimates are more fully described in our 2022 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. There have been no material changes in our critical accounting estimates for the periods presented other than amounts readily computable from the financial statements included in this form 10-Q.

Financial Summary

The Company’s operations for the three months ended September 30, 2022 continued to be impacted by the effects of the COVID-19 pandemic, including among other factors, difficulty hiring qualified employees, rising labor

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costs and supply chain challenges resulting in inability to obtain pharmacy and DME products on a timely, cost effective basis.

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, 2022 and 2021:

The Healthcare Services segment in the current year is composed of one hospital, one extended care and rehabilitation center and four clinics, a subsidiary which provides information technology services to outside customers and SunLink subsidiaries and two subsidiaries holding undeveloped real estate. Healthcare Services net revenues increased $286, or 8%, for the three months period ended September 30, 2022 compared to the prior year period. Increased revenues from increased hospital and extended care patient days and increased clinic visit resulted in the net revenue increase this year.

Pharmacy segment net revenues for the three months period ended September 30, 2022 increased $226, or 3.2% from the three months period ended September 30, 2021. Institutional pharmacy sales increased 10.7% for the three month period ended September 30, 2022 from the prior year period due to a 4.3% increase in per script net revenues and 8.4% increase in scripts filled. Retail pharmacy sales increased 6.2%  for the three month period ended September 30, 2022 from the prior year period due to a 12.8% increase in revenue per script filled. Durable Medical Equipment (“DME”) sales decreased 6.5% for the three month period ended September 30, 2022 from the prior year period primarily due to lower sales orders filled, despite a 1.9% increase in revenue  per DME orders filled.

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Costs and expenses, including depreciation and amortization, were $12,650 and $11,518 for the three months ended September 30, 2022 and 2021, respectively.

Cost of goods sold as a percent of net revenues increased  0.9% in the three months ended September 30, 2022 compared to the prior fiscal year due to the higher cost of certain pharmaceuticals and DME products which resulted from supply chain issues. Salaries, wages and benefits expense as a percent of net revenues increased 3.7% this year compared to the prior fiscal quarter due to higher salaries and wages required in connection with current labor markets and operating challenges of labor allocation relating to the pandemic, including the use of contract labor. Purchased services cost increased this year due to increased cost of fuel, outsourcing at our Healthcare Services facility of certain services (due to challenges in hiring labor locally) and increased costs of software support services. Other operating expenses decreased 0.4% of net revenues due to decreased professional liability insurance expense. Depreciation expense also increased as a percentage of net revenue this year due to the $3,190 of capital expenditures last fiscal year.

Operating Loss

The Company reported an operating loss of $1,613 for the three months period ended September 30, 2022 compared to an operating loss of $993 for the three month period ended September 30, 2022. Such operating loss for the three month periods ended September 30, 2022 was primarily a result of higher operating costs not covered by the increased revenues.

Forgiveness of PPP loans and accrued interest

              During the three months ended September 30, 2021, $2,972 of our PPP loans and related $38  of accrued interest were forgiven by the SBA and $3,010 was recorded as income relating to PPP loan.

Other Income – Federal Stimulus – Provider relief funds

As part of the CARES Act, two subsidiaries have received PRF payments. The Company recognized $61 and $0 during the three months ended September 30, 2022 and 2021, respectively.

Income Taxes

No income tax expense and income tax expense of $2  (all state taxes) was recorded for continuing operations for the three months ended September 30, 2022 and 2021, respectively.

Of the CARES Act provisions, the currently most material income tax considerations related to the Company are related to the amounts for ERC and amounts received as general and targeted PRF. Based on the latest published IRS guidance as of the preparation of the September 30, 2022 financial statements, PRF (to the extent the applicable terms and conditions required to retain the funds are met “Retainable PRF”) are fully includable in taxable income in the Company’s tax returns in the fiscal year received. ERC are included in taxable income in the quarter in which the payroll expenses which the credits offset are deductible. ERC results in qualified wages being disallowed as a deduction for the portion of the wages paid equal to the sum of the payroll tax credit taken in the associated quarter. For amounts received and forgiven under the PPP loans, due to the enactment of the Consolidated Appropriations Act, 2021, on December 27, 2020, Congress specifically allowed the deduction of any expenses associated with

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forgiven PPP loan proceeds. It is the Company’s assumption at September 30, 2022 that all PPP loan associated expenses will be deductible for income tax.

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

The principal negative evidence that led us to determine at September 30, 2022 that all the deferred tax assets should have full valuation allowances was the projected current fiscal year tax loss. For purposes of evaluating our valuation allowances, we have disregarded unusual items associated with the CARES Act discussed above, the Company’s history of losses, as well as the underlying negative business conditions for rural healthcare businesses in which our Healthcare Services Segment businesses operate and have recognized none of our federal income tax net operating loss carry-forward of approximately $23,143.

For federal income tax purposes, at September 30, 2022, the Company had approximately $23,143 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 Tax Cut and Jobs Act 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, 2018 are no longer subject to potential federal and state income tax examination.

Earnings (Loss) from Continuing Operations after Income Taxes

The loss from continuing operations after income tax was $1,544 for the three months ended September 30, 2022 as compared to income from continuing operations after income tax of $2,006 for the three months ended September 30, 2021. The loss from continuing operations this year compared to the prior year income from continuing operations was due to the non-reoccurrence of the PPP loan forgiveness this year.

Loss from Discontinued Operations after Income Taxes

The loss from discontinued operations after income taxes was $14 for the three month period ended September 30, 2022 compared to a loss from discontinued operations after income taxes of $67 for the three months period ended September 30, 2021.

Discontinued Operations

Sold Hospitals and Nursing Homes– Subsidiaries of the Company have sold substantially all the assets of four hospitals and a nursing home (“Sold Facilities”) during the period July 2, 2012 to March 17, 2019. The loss before income taxes on the Sold Facilities results primarily from the effects of retained professional liability insurance and claims expenses and settlement of a lawsuit.

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, 2022 and 2021, respectively.

Net Earnings (Loss)

Net loss for the three months period ended September 30, 2021 was $1,558 (a loss of $0.22 per fully diluted share) as compared to net income of $1,939 ($0.27 per fully diluted share) for the three months period ended September 30, 2021.

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Liquidity and Capital Resources

Overview

Our primary source of liquidity is unrestricted cash on hand, which was $4,951 at September 30, 2022. The Company and its subsidiaries currently are funding working capital needs primarily from cash on hand. From time-to-time, we may, nevertheless, seek to obtain financing for the liquidity needs of the Company or individual subsidiaries based on anticipated need. However, 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.

CARES Act Funds - The CARES Act was enacted by the U.S. government on March 27, 2020. Among the relief provided to health care providers under the CARES Act are grants under PRF and forgivable loans under PPP. We have received a total of $9,416 under the CARES Act programs consisting of $6,182 in general and targeted PRF and $3,234 of PPP loans. During the first two calendar quarters of 2021, the Company became eligible for, and we applied for $3,586 of ERC through amended quarterly payroll tax filings. Through the date of this filing, we have received $1,803 of ERC for which we filed amended payroll tax returns.

Subject to the effects, risks and uncertainties associated with the COVID-19 pandemic and our ability to retain the CARES funds described above, we believe we have adequate financing and liquidity to support our current level of operations through the next twelve months.

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, 2022 were as follows:

As of September 30, 2022, we had outstanding debt of $44 of capital lease debt.

         The Company expects to purchase approximately $1,000 of capitalizable DME by the Pharmacy segment (to be rented to customers) during the next twelve months. The timing and actual amount which will be expended is difficult to predict due to various factors including varying demand for such equipment as well as its availability given current supply sourcing challenges. Other capital expenditures for replacement and upgrade of current facilities and equipment of the Healthcare Services and Pharmacy segments will be needed during the next twelve months although there is no estimate of those expenditures. The Company anticipates funding such expenditures primarily from cash on hand. The Company has filed for $3,586 of ERC through filing amended payroll tax returns of which we have collected $1,803 through the date of this filing. We expect to collect the remaining $1,783 receivable in the next 12 months. Other cash expenditures for the next 12 months currently are expected to be in-line with expenditures for the quarter ended September 30, 2022, subject to further operating and administrative cost increases, and other settlements of cost reports in the ordinary course of business, and the Company’s ability to retain unrecognized CARES Act grants, PPP funds and ERC funds received or previously received. Other than reported above, there have been no material changes outside the ordinary course of business relating to our upcoming cash obligations which have occurred during the three months ended September 30, 2022. Other than with respect to scheduled cash expenditures (based on current operating levels) for long-term debt, operating leases, and interest on current outstanding debt, the debt, the specific items previously disclosed here, as well as continued uncertainties relating to the continuing impact of the COVID-19 pandemic, the Company is currently unaware of other trends or unusual uncertainties that are likely to cause a material change in its cash expenditures in periods beyond the next twelve months. See Notes 7, 9, 10, and 11 to our financial statements. The Company is also unaware of events that are reasonably likely to cause a material change in the relationship between its costs and revenues (such as known or reasonably likely future increases in costs of labor or

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materials, price increases or inventory adjustments, beyond those discussed herein); however, we are unable to predict with any degree of accuracy when, or the extent to which, recent inflationary price trends, labor disruptions and supply chain challenges in 2021 and 2022 will mitigate.

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 $55 and $50 for legal services to this law firm in the three months ended September 30, 2022 and 2021, respectively. Included in the Company’s condensed consolidated balance sheets at September 30 , 2022 and June 30, 2022 is $50 and $15, 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, 2022.

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, 2022. The effect, if any, of the COVID-19 pandemic on the effectiveness of current disclosure controls and procedures in future periods is uncertain and we intend to revise the same, if any and to the extent deemed appropriate.

Changes in Internal Control Over Financial Reporting

There were no changes during the quarter ended September 30, 2022 in our internal control over financial reporting that materially affected, or is likely to materially affect, our internal controls over financial reporting. Notwithstanding staff absences and turnover and challenges hiring new and replacement staff, including in our financial departments, to date, we do not believe the COVID-19 pandemic has had any material effect on the effectiveness of our disclosure controls and procedures, however we cannot assure you that our internal controls will not be effected in the case of other pandemics or an intensified COVID-19 pandemic.

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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 other 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 any current pending legal proceedings 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 legal proceedings, 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, 2022. We believe there have been no material changes from the risk factors previously disclosed in such Annual Report  and as set forth herein.

In addition to the matters set forth herein, the reader 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.

ITEM 6.EXHIBITS

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, 2022

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