SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
For the fiscal year ended December 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
For the transition period from ____________ to ____________.
Commission File Number 1-10670
HANGER ORTHOPEDIC GROUP, INC.
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(Exact name of registrant as specified in its charter.)
Delaware 84-0904275
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
Two Bethesda Metro Center (Suite 1200), Bethesda, MD 20814
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(Address of principal executive offices) (Zip Code)
Registrant's phone number, including area code: (301) 986-0701
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Securities registered pursuant to Section 12(b) of the Act:
Common Stock, par value $0.01 per share
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(Title of Class)
Securities registered pursuant to Section 12(g) of the Act: None.
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes X No
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The aggregate market value of the registrant's Common Stock, par value
$0.01 per share, held as of March 17, 2003 by non-affiliates of the registrant
was $229,070,461 based on the $11.15 closing sale price per share of the Common
Stock on the New York Stock Exchange on such date.
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12G-2): YES X No .
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As of March 17, 2003, the registrant had 20,544,436 shares of its Common
Stock issued and outstanding.
Indicate by check mark if disclosure of delinquent filers pursuant to item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
DOCUMENTS INCORPORATED BY REFERENCE
The information called for by Part III of the Form 10-K is incorporated by
reference from the registrant's definitive proxy statement or amendment hereto
which will be filed not later than 120 days after the end of the fiscal year
covered by this report.
ITEM 1. BUSINESS.
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Business Overview
We are the largest owner and operator of orthotic and prosthetic ("O&P")
patient-care centers in the United States. In our orthotics business, we design,
fabricate, fit and maintain a wide range of standard and custom-made braces and
other devices (such as spinal, knee and sports-medicine braces) that provide
external support to patients suffering from musculoskeletal disorders, such as
ailments of the back, extremities or joints and injuries from sports or other
activities. In our prosthetics business, we design, fabricate, fit and maintain
custom-made artificial limbs for patients who are without limbs as a result of
traumatic injuries, vascular diseases, diabetes, cancer or congenital disorders.
O&P devices are increasingly technologically advanced and are custom-designed to
add functionality and comfort to patients' lives, shorten the rehabilitation
process and lower the cost of rehabilitation. We are also a leading distributor
of branded and private label O&P devices and components in the United States,
all of which are manufactured by third parties.
At December 31, 2002, we operated 583 O&P patient-care centers in 44 states
and the District of Columbia and employed 872 certified O&P practitioners.
Patients are referred to our local patient-care centers directly by physicians
as a result of our relationships with them or through our agreements with
managed care providers. Certified O&P practitioners and technicians staff our
patient-care centers. Our practitioners generally design and fit patients with,
and the technicians fabricate, O&P devices as prescribed by the referring
physician. Following the initial design, fabrication and fitting of our O&P
devices, our technicians conduct regular, periodic maintenance of O&P devices as
needed. Our practitioners are also responsible for managing and operating our
patient-care centers and are compensated, in part, based on their success in
managing costs and collecting accounts receivable. We provide centralized
administrative, marketing and materials management services to take advantage of
economies of scale and to increase the time practitioners have to provide
patient care. In areas where we have multiple patient-care centers, we also
utilize shared fabrication facilities where technicians fabricate devices for
practitioners in that area.
We have increased our net sales through acquisitions, by opening new
patient-care centers and through same-center net sales growth, the latter being
achieved primarily through physician referral marketing and branding
initiatives. We strive to improve our local market position to enhance operating
efficiencies and generate economies of scale by implementing our disciplined
growth strategy. We generally acquire small and medium-sized O&P patient-care
businesses and open new patient-care centers to achieve greater density in our
existing markets.
We acquired NovaCare Orthotics and Prosthetics, Inc. ("NovaCare O&P") in
July 1999, which more than doubled our number of O&P patient-care centers and
certified O&P practitioners and made us the largest operator of O&P patient-care
centers in the United States. Our acquisition of NovaCare O&P also significantly
expanded our presence in the western United States and allowed us to achieve a
greater density of operations in the eastern United States.
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Industry Overview
We estimate the O&P patient-care market in the United States represented
approximately $2.3 billion in revenues in 2002, of which we accounted for
approximately 23%. The O&P patient-care services market is highly fragmented and
is characterized by local, independent O&P businesses, with the majority
generally having annual revenues of less than $1.0 million and a single
facility. According to the most recent American Orthotic and Prosthetic
Association study, which was conducted in 1999, there are an estimated 3,300
certified prosthestists and/or orthotists and approximately 2,850 O&P
patient-care centers in the United States. We do not believe that any of our
competitors account for a market share of more than 2% of the country's total
estimated O&P patient-care services revenue.
The care of O&P patients is part of a continuum of rehabilitation services
including diagnosis, treatment and prevention of future injury. This continuum
involves the integration of several medical disciplines that begins with the
attending physician's diagnosis. Once a course of treatment is determined
generally by an orthopedic surgeon, vascular surgeon or physiatrist, they write
a prescription and refer the patient to an O&P patient-care services provider
for treatment. An O&P practitioner then, using the prescription, consults with
both the referring physician and the patient to formulate the design of an
orthotic or prosthetic device to meet the patient's needs.
The O&P industry is characterized by stable, recurring revenues, primarily
resulting from the need for periodic replacement and modification of O&P
devices. Based on our experience, the average replacement time for orthotic
devices is one to three years, while the average replacement time for prosthetic
devices is three to five years. There is also an attendant need for continuing
patient-care services. In addition to the inherent need for periodic replacement
and modification of O&P devices and continuing care, we expect the demand for
O&P services will continue to grow as a result of several key trends, including:
Aging U.S. Population. The growth rate of the over-65 age group is nearly
triple that of the under-65 age group. There is a direct correlation between age
and the onset of diabetes and vascular disease, which is the leading cause of
amputations. With broader medical insurance coverage, increasing disposable
income, longer life expectancy, greater mobility, expectations and improved
technology of O&P devices, we believe the elderly will seek orthopedic
rehabilitation services and products more often.
Growing Physical Health Consciousness. The emphasis on physical fitness,
leisure sports and conditioning, such as running and aerobics is growing, which
has led to increased injuries requiring orthopedic rehabilitative services and
products. These trends are evidenced by the increasing demand for new devices
that provide support for injuries, prevent further or new injuries or enhance
physical performance.
Increased Efforts to Reduce Healthcare Costs. O&P services and devices have
enabled patients to become ambulatory more quickly after receiving medical
treatment in the hospital. We believe that significant cost savings can be
achieved through the early use of O&P service and products. The provision of O&P
services and products in many cases reduces the need for more expensive
treatments, thus representing a cost savings to third-party payors.
Advancing Technology. The range and effectiveness of treatment options for
patients requiring O&P services have increased in connection with the
technological sophistication of O&P devices. Advances in
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design technology and lighter, stronger and more cosmetically acceptable
materials have enabled patients to replace older O&P devices with new O&P
products that provide greater comfort, protection and patient acceptability. As
a result, treatment can be more effective and of shorter duration, giving the
patient greater mobility and a more active lifestyle. Advancing technology has
also increased the prevalence and visibility of O&P devices in many sports,
including skiing, running and tennis.
Competitive Strengths
We believe that the combination of the following competitive strengths will
enable us to continue to increase our net sales, EBITDA and market share:
o Leading market position, with an approximate 23% share of total
industry revenues, in a fragmented industry;
o National scale of operations, which has better enabled us to:
- establish our brand name and generate economies of scale;
- implement best practices throughout the country;
- utilize shared fabrication facilities;
- contract with national and regional managed care entities;
- identify and test emerging technology;
- train O&P practitioners to utilize leading O&P device technology;
and
- increase our influence on, and input into, regulatory trends;
o Distribution of, and purchasing power for, O&P components and finished O&P
products, which enables us to:
- negotiate greater purchasing discounts from manufacturers and
freight providers;
- reduce patient-care center inventory levels and improve inventory
turns through centralized purchasing control;
- quickly access prefabricated and finished O&P products;
- promote the usage by our patient-care centers of clinically
appropriate products that also enhance our profit margins; and
- engage in co-marketing and O&P product development programs with
suppliers;
o Full O&P product offering, with a balanced mix between orthotics services
and products, which represented 43.1% of our patient-care net sales, and
prosthetics services and products, which
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represented 52.2% of our patient-care net sales during the year ended
December 31, 2002. (Other services and products represented 4.7% of our
patient-care net sales);
o Practitioner bonus plan that financially rewards practitioners for their
efficient management of accounts receivable collections, labor, materials,
and other costs, and encourages cooperation among our practitioners within
the same local market area;
o Proven ability to rapidly incorporate technological advances in O&P
devices;
o History of successful integration of small and medium-sized O&P business
acquisitions, including 68 O&P businesses since 1992, excluding our
acquisition of NovaCare O&P, with purchase prices ranging from less than
$100,000 to $50 million and representing over 237 patient-care centers;
o Highly trained O&P practitioners, whom we provide with the highest level of
continuing education and training through programs designed to inform our
O&P practitioners of the latest technological developments in the O&P
industry, and our certification program located at the University of
Connecticut; and
o Experienced and committed management team.
Business Strategy
Our goal is to continue to provide superior patient care and to be the most
cost-efficient, full service, national O&P operator. The key elements of our
strategy to achieve this goal are to:
o Continue to improve our performance by:
- improving the utilization and efficiency of administrative and
corporate support services; and
- enhancing margins;
o Increase our market share and net sales by:
- contracting with national and regional managed care providers, who we
believe select us as a preferred provider because of our reputation,
national reach, density of our patient-care centers in certain markets
and our ability to help reduce administrative expenses;
- increasing our volume of business through enhanced comprehensive
marketing programs aimed at referring physicians and patients, such as
our Patient Evaluation Clinics program, which reminds patients to have
their devices serviced or replaced and informs them of technological
improvements of which they can take advantage; and
- improving billing for services provided by our O&P patient-care
centers through the implementation of standardized billing procedures,
which will improve the accuracy and timeliness of invoices for
services we render to our customers;
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o Selectively acquire small and medium-sized O&P patient-care service
businesses and open satellite patient-care centers primarily to expand our
presence within an existing market and secondarily to enter into new
markets; and
o Provide our O&P practitioners with:
- training and continuing education;
- career development and increased compensation opportunities;
- a wide array of O&P products from which to choose; and
- administrative and corporate support services that enable them to
focus their time on providing superior patient care.
Business Description
Patient-Care Services
As of December 31, 2002, we provided O&P patient-care services through 583
O&P patient-care centers and 872 patient-care practitioners in 44 states and the
District of Columbia. Substantially all of our practitioners are certified
practitioners or candidates for formal certification by the O&P industry
certifying boards. One or more certified practitioners closely supervise each of
our patient-care centers. Our patient-care centers also employ highly trained
technical personnel who assist in the provision of services to patients and
fabricate various O&P devices.
A patient in need of O&P patient-care services is referred to one of our
patient-care centers via a prescription upon a determination by the attending
physician of a course of treatment. One of our practitioners then, using the
prescription, consults with both the referring physicians and the patient with a
view toward assisting in the formulation of the prescription for, and design of,
an orthotic or prosthetic device to meet the patient's need.
The fitting process involves several stages in order to successfully
achieve desired functional and cosmetic results. The practitioner creates a cast
and takes detailed measurements of the patient to ensure an anatomically correct
fit. All of the prosthetic devices are custom fabricated and fit by skilled
practitioners. The majority of the orthotic devices provided by us are custom
designed, fabricated and fit and the balance is prefabricated but custom fit.
Custom devices are fabricated by our skilled technicians using the
castings, measurements and designs made by our practitioners. Technicians use
advanced materials and technologies to fabricate a custom device under quality
assurance guidelines. Custom designed devices that cannot be fabricated at the
patient-care centers are fabricated at several central fabrication facilities.
After final adjustments to the device by the practitioner, the patient is
instructed in the use, care and maintenance of the device. A program or
scheduled follow-up and maintenance visits are used to provide post-fitting
treatment, including adjustments or replacements as the patient's physical
condition and lifestyle change.
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To provide timely service to our patients, we employ technical personnel
and maintain laboratories at most of our patient-care centers. We have earned a
strong reputation within the O&P industry for the development and use of
innovative technology in our products, which has increased patient comfort and
capability, and can significantly shorten the rehabilitation process. The
quality of our products and the success of our technological advances have
generated broad media coverage, enhancing our brand equity among payors,
patients, and referring physicians.
We offer technologically advanced O&P products. The products include: (i)
the Otto Bock C-Leg TM, an advanced computerized prosthetic knee system that
allows patients to walk and to ascend or descend stairs with a normal stride;
(ii) Comfort-Flex TM sockets, which are flexible sockets that are more
comfortable for patients to wear; and (iii) a myo-electric upper extremity
prosthesis, which is a neuromuscular-activated upper extremity prosthesis.
A substantial portion of our O&P services involves treatment of a patient
in a non-hospital setting, such as our patient-care centers, a physician's
office, an out-patient clinic or other facility. In addition, O&P services are
increasingly rendered to patients in hospitals, nursing homes, rehabilitation
centers and other alternate-site healthcare facilities. In a hospital setting,
the practitioner works with a physician to provide either orthotic devices or
temporary prosthetic devices that are later replaced by permanent prosthetic
devices.
Patient-Care Center Administration
We provide all senior management, accounting, accounts payable, payroll,
sales and marketing, management information systems and human resources services
for our patient-care centers on either a centralized or out-sourced basis. As a
result, we are able to provide these services more efficiently and
cost-effectively than if these services had to be generated at each center.
Moreover, the centralization or out-sourcing of these services permits our
certified practitioners to allocate a greater portion of their time to
patient-care activities by reducing their administrative responsibilities. Each
individual patient-care center is responsible for its own billing and
collections of accounts receivable, which are also monitored centrally. On a
case-by-case basis, we assume responsibility for collecting past due
receivables, either by pursuing collections ourselves or outsourcing collections
to a third party.
We also develop and implement programs designed to enhance the efficiency
of our clinical practices. These programs include: (i) sales and marketing
initiatives to attract new-patient referrals by establishing relationships with
physicians, therapists, employers, managed care organizations, hospitals,
rehabilitation centers, out-patient clinics and insurance companies; (ii)
professional management and information systems to improve efficiencies of
administrative and operational functions; (iii) professional education programs
for practitioners emphasizing new developments in the increasingly sophisticated
field of O&P clinical therapy; (iv) the establishment of shared fabrication and
centralized purchasing activities, which provides access to component parts and
products within two business days at prices that are typically lower than
traditional procurement methods; and (v) access to expensive, state-of-the-art
equipment that is financially more difficult for smaller, independent businesses
to obtain.
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Distribution Services
We distribute O&P components and finished patient-care products to the O&P
market as a whole and to our own patient-care centers through our wholly-owned
subsidiary, Southern Prosthetic Supply, Inc., which is one of the nation's
leading O&P distributors. For the year ended December 31, 2002, 35.7% or
approximately $29.5 million of Southern Prosthetic Supply's distribution sales
were to third-party O&P services providers. The balance of Southern Prosthetic
Supply's distribution sales amounted to approximately $53.2 million for the year
ended December 31, 2002 and represented internal sales to our patient-care
centers. Southern Prosthetic Supply inventories over 14,000 items, substantially
all of which are manufactured by other companies and distributed by us through
Southern Prosthetic Supply. Southern Prosthetic Supply maintains distribution
facilities in California, Georgia, and Texas, which allows us to deliver
components and finished products via ground shipment to anywhere in the United
States within two business days.
Our distribution business enables us to:
o lower our material costs by negotiating purchasing discounts from
manufacturers;
o reduce out patient-care center inventory levels and improve inventory
turns through centralized purchasing control;
o quickly access prefabricated and finished O&P products;
o perform inventory quality control; and
o promote the usage, by our centers, of clinically appropriate products
that enhance our profit margins.
This is accomplished at competitive prices as a result of our direct
purchases from manufacturers.
Marketing of our distribution services is conducted on a national basis
through a dedicated sales force, catalogues and exhibits at industry and medical
meetings and conventions. We direct specialized catalogues to segments of the
healthcare industry, such as orthopedic surgeons and physical and occupational
therapists. We own certain patents and trademarks relating to our O&P products
and services. Among them is the Comfort-FlexTM Socket, which is a patented
design that presently is only available at our patient-care centers. A socket is
the connecting point between a prosthetic device and the body of the patient.
The Comfort-FlexTM Socket is a highly contoured flexible socket which has
revolutionized both above-knee and below-knee prosthetic devices. It features
anatomically designed channels to accommodate various muscle, bone, tendon,
vascular and nerve areas. This unique approach to socket design is generally
accepted as superior to previous socket systems. We also hold exclusive rights
to the Charleston Bending BraceTM, a custom-designed and fitted brace used to
correct spinal curvatures in young children.
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Satellite Center Development
In addition to acquired patient-care centers, we have historically
developed new satellite patient-care centers in existing markets with
underserved demand for O&P services. These satellite centers require less
capital to develop than complete O&P patient-care centers because the satellite
centers usually consist of only a waiting room and patient fitting rooms, but
without a fabrication laboratory for creating O&P devices. An O&P practitioner
will spend one or two days each week in a satellite center treating those
patients who find it inconvenient to visit the O&P practitioner's primary
patient-care center.
These satellite centers also tend to receive new patient referrals from
hospitals and physicians located near the newly developed satellite center,
increase new patient growth and satellite center revenue. While a partial
revenue shift occurs from the O&P practitioner's main patient-care center to the
satellite center because the O&P practitioner is now seeing some of the same
patients out of a new satellite center, the additional patient volume in the
satellite center increases the O&P practitioner's overall revenue. If demand for
O&P services at a satellite center increases beyond the ability of the O&P
practitioner to service it one or two days a week, we will staff the satellite
office on a full-time basis.
Sources of Payment
The principal reimbursement sources for our O&P services are:
o private payor/third-party insurer sources, which consist of
individuals, private insurance companies, HMOs, PPOs, hospitals,
vocational rehabilitation, workers' compensation and similar sources;
o Medicare, a federally funded health-insurance program providing health
insurance coverage for persons aged 65 or older and certain disabled
persons, which provides reimbursement for O&P products and services
based on prices set forth in fee schedules for 10 regional service
areas;
o Medicaid, a health insurance program jointly funded by federal and
state governments providing health insurance coverage for certain
persons in financial need, regardless of age, which may supplement
Medicare benefits for financially needy persons aged 65 or older; and
o the Veterans Administration, with which we have entered into contracts
to provide O&P services and products.
We estimate that Medicare, Medicaid and the U.S. Veterans Administration
accounted for approximately 43.9%, 40.5% and 38.4% of our net sales in 2002,
2001 and 2000, respectively. These payors have set maximum reimbursement levels
for O&P services and products. The healthcare policies and programs of these
agencies have been subject to changes in payment methodologies during the past
several years. There can be no assurance that future changes will not reduce
reimbursements for O&P services and products from these sources.
We provide O&P services and products to eligible veterans pursuant to
several contracts with the U.S. Veterans Administration. The U.S. Veterans
Administration establishes its reimbursement rates for itemized services and
products on a competitive bidding basis. The contracts, awarded on a
non-exclusive basis, establish the amount of reimbursement to the eligible
veteran if the veteran should choose to use our services
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and products. We have been awarded U.S. Veterans Administration contracts in the
past and expect that we will obtain additional contracts when our present
agreements expire.
In addition to referrals from physicians, we enter into contracts with
third-party payors that allow us to perform O&P services for a referred patient
and be paid under the contract with the third-party payor. These contracts
typically have a stated term of one year and automatically renew annually. These
contracts generally may be terminated without cause by either party on 60 to 90
days' notice or on 30 days' notice if we have not complied with certain
licensing, certification, program standards, Medicare or Medicaid requirements
or other regulatory requirements. Reimbursement for services is typically based
on a fee schedule negotiated with the third-party payor that reflects various
factors, including geographic area and number of persons covered.
Suppliers
We purchase prefabricated O&P devices, components and materials that our
technicians use to fabricate O&P products from approximately 1,454 suppliers
across the country. These devices, components and materials are used in
approximately 800 products that we offer in our patient-care centers throughout
the country. Currently, only three of our suppliers account for more than 5% of
our total patient-care purchases.
Sales and Marketing
The individual practitioners in the local patient-care centers historically
have conducted our sales and marketing efforts. Due primarily to the fragmented
nature of the O&P industry, the success of a particular patient-care center has
been largely a function of its local reputation for quality of care,
responsiveness and length of service in the local communities. Individual
practitioners have relied almost exclusively on referrals from local physicians
or physical therapists and typically have not used advanced marketing
techniques.
We are developing a centralized marketing department that will be led by
our recently elected Vice President of Marketing. We believe that having a
centralized marketing department will remove the bulk of the sales and marketing
responsibilities from the individual practitioner, enabling the practitioner to
focus his or her efforts on patient-care. We expect that our marketing
organization will include the following major areas of focus:
o Marketing and public relations. We intend to increase the visibility
of the "Hanger" name by building relationships with major referral
sources through activities such as co-sponsorship of sporting events
and co-branding of products. We also intend to explore creating
alliances with certain vendors to market products and services on a
nationwide basis.
o Business Development. We intend to have dedicated personnel in each of
our regions of operation who will be responsible for arranging
seminars, clinics and forums to increase the individual communities'
awareness of the "Hanger" name. These personnel will also be
responsible for training the O&P practitioners in the individual
patient-care centers in that community on certain limited marketing
techniques.
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o Contracting. We intend to have sales and marketing personnel who will
be dedicated to increasing the number of nationwide and local
contracts that we have with referral sources. These personnel will
evaluate our current contracts and determine whether we should explore
the renegotiation of any of their terms.
We believe that this new marketing initiative will enable us to attract new
referral sources and thereby increase both our same-store and new patient-care
center net sales.
Acquisitions
During 2001, we did not acquire any O&P companies, as we were focusing our
attention on our integration and restructuring efforts following our 1999
acquisition of NovaCare O&P and the implementation of our performance
improvement plan. In 2002, we resumed our acquisition program and acquired two
O&P companies that had a total of seven patient-care centers located in
Maryland, Ohio, and Pennsylvania. The aggregate purchase price paid by us for
the acquisitions, excluding potential earn-out provisions, was $6.1 million.
Competition
The O&P services industry is highly fragmented, consisting mainly of local
O&P patient-care centers. The business of providing O&P patient-care services is
highly competitive in the markets in which we operate. We compete with
independent O&P businesses for referrals from physicians, therapists, employers,
HMOs, PPOs, hospitals, rehabilitation centers, out-patient clinics and insurance
companies on both a local and regional basis. We believe that we compete with
other patient-care service providers on the basis of quality and timeliness of
patient care and location of patient-care centers, and, to a lesser degree,
charges for services.
We also compete for the retention and recruitment of qualified O&P
practitioners. In certain markets, the demand for O&P practitioners exceeds the
supply of qualified personnel. If the availability of these practitioners begins
to decline in our markets it may be more difficult for us to attract qualified
practitioners to staff our patient-care centers or to expand our operations.
Special Note On Forward-Looking Statements
Some of the statements contained in this report discuss our plans and
strategies for our business or make other forward-looking statements, as this
term is defined in the Private Securities Litigation Reform Act. The words
"anticipates," "believes," "estimates," "expects," "plans," "intends" and
similar expressions are intended to identify these forward-looking statements,
but are not the exclusive means of identifying them. These forward-looking
statements reflect the current views of our management; however, various risks,
uncertainties and contingencies could cause our actual results, performance or
achievements to differ materially from those expressed in, or implied by, these
statements, including the following:
o our indebtedness and the impact of increases in interest rates on such
indebtedness;
o the demand for our orthotic and prosthetic services and products;
o our ability to integrate effectively the operations of businesses that
we plan to acquire in the future;
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o our ability to maintain the benefits of our performance improvement
plans;
o our ability to attract and retain qualified orthotic and prosthetic
practitioners;
o changes in federal Medicare reimbursement levels and other
governmental policies affecting orthotic and prosthetic operations;
o changes in prevailing interest rates and the availability of favorable
terms of equity and debt financing to fund the anticipated growth of
our business;
o changes in, or failure to comply with, federal, state and/or local
governmental regulations; and
o liability relating to orthotic and prosthetic services and products
and other claims asserted against us.
For a discussion of important risks of an investment in our securities,
including factors that could cause actual results to differ materially from
results referred to in the forward-looking statements, see "Risk Factors" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" below. We do not have any obligation to update publicly any
forward-looking statements, whether as a result of new information, future
events or otherwise.
Risk Factors
We have a recent history of net losses and may incur net losses in the future.
Following the NovaCare O&P acquisition, we incurred net losses of $8.9
million and $14.0 million for the years ended December 31, 2001 and 2000,
respectively. For the year ended December 31, 2002, however, we generated net
income of $23.6 million. We cannot assure that we will not incur net losses in
the future.
Changes in government reimbursement levels could adversely affect our net sales,
cash flows and profitability.
We derived 43.9%, 40.5% and 38.4% of our net sales for the years ended
December 31, 2002, 2001 and 2000, respectively, from reimbursements for O&P
services and products from programs administered by Medicare, Medicaid and the
U.S. Veterans Administration. Each of these programs sets maximum reimbursement
levels for O&P services and products. If these agencies reduce reimbursement
levels for O&P services and products in the future, our net sales could
substantially decline. In addition, the percentage of our net sales derived from
these sources may increase as the portion of the U.S. population over age 65
continues to grow, making us more vulnerable to maximum reimbursement level
reductions by these organizations. Reduced government reimbursement levels could
result in reduced private payor reimbursement levels because of indexing of
Medicare fee schedules by certain third party payors. Furthermore, the
healthcare industry is experiencing a trend towards cost containment as
government and other third-party payors seek to impose lower reimbursement rates
and negotiate reduced contract rates with service providers. This trend could
adversely affect our net sales. Medicare provides for reimbursement for O&P
products and services based on prices set forth in fee schedules for ten
regional service areas. Additionally, if the U.S. Congress were to legislate
modifications to the Medicare fee schedules to include upper limits based on
national median prices, our net sales from Medicare and other payors could be
adversely and materially affected. We
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cannot predict whether any such modifications to the fee schedules will be
enacted or what the final form of any modifications might be. See "Sources of
Payment" and "Government Regulation."
If we cannot collect our accounts receivable and manage our inventory, our
business, results of operations, financial condition and ability to satisfy our
obligations under our indebtedness could be adversely affected.
As of December 31, 2002 and 2001, our accounts receivable over 120 days
represented approximately 25% and 30% of total accounts receivable outstanding
in each period, respectively. If we cannot collect our accounts receivable, our
business, results of operations, financial condition and ability to satisfy our
obligations under our indebtedness could be adversely affected. In addition, our
principal means of control with respect to accounting for inventory and costs of
goods sold is a physical inventory conducted on an annual basis. This accepted
method of accounting controls and procedures may result in an understatement or
overstatement, as the case may be, of inventory between our annual physical
inventories. For example, in conjunction with the physical inventory performed
on September 30, 2000, we recorded a $9.6 million inventory write down.
Conversely, in conjunction with our physical inventory performed on September
30, 2002 and 2001, we recorded a $0.2 million and $4.2 million increase in
inventory, respectively. Because our gross profit percentage is based on our
inventory levels, adjustments to inventory during interim periods following our
physical inventory could adversely affect our results of operations and
financial condition.
If we are unable to effectively implement our new billing system, OPS, it could
affect our ability to properly generate bills for our services and our ability
to collect our accounts receivable.
During 2002, we incurred substantial costs in the development and testing of our
new billing system, OPS. We will implement OPS across all of our practices
during 2003. There are no guarantees that OPS will work as designed or as
intended. If we are unable to effectively implement OPS, it could have a
material adverse effect on our ability to properly generate bills for our
services and our ability to collect our accounts receivable.
If we are unable to maintain good relations with our suppliers, our existing
purchasing discounts may be jeopardized, which could adversely affect our net
sales.
We currently enjoy significant purchasing discounts with most of our suppliers,
and our ability to sustain our gross margins has been, and will continue to be,
dependent, in part, on our ability to continue to obtain favorable discount
terms from our suppliers. These terms may be subject to changes in suppliers'
strategies, from time to time, which could adversely affect our gross margins
over time. The profitability of our business depends, in part, upon our ability
to maintain good relations with these suppliers.
We depend on the continued employment of our orthotists and prosthetists who
work at our patient-care centers and their relationships with referral sources
and patients. Our ability to provide O&P services at our patient-care centers
would be impaired and our net sales reduced if we were unable to maintain these
employment and referral relationships.
Our net sales would be reduced if a significant number of our practitioners
leave us. In addition, any failure of these practitioners to maintain the
quality of care provided or to otherwise adhere to certain general operating
procedures at our facilities or any damage to the reputation of a significant
number of our
12
practitioners could damage our reputation, subject us to liability and
significantly reduce our net sales. A substantial amount of our business is
derived from patient referrals by orthopedic surgeons and other healthcare
providers. If the quality of our services and products declines in the opinion
of these sources, the number of their patient referrals may decrease, which
would adversely affect our net sales.
If the non-competition agreements we have with our key executive officers and
key practitioners were found by a court to be unenforceable, we could experience
increased competition resulting in a decrease in our net sales.
We generally enter into employment agreements with our executive officers and a
significant number of our practitioners which contain non-compete and other
provisions. The laws of each state differ concerning the enforceability of
non-competition agreements. State courts will examine all of the facts and
circumstances at the time a party seeks to enforce a non-compete covenant. We
cannot predict with certainty whether or not a court will enforce a non-compete
covenant in any given situation based on the facts and circumstances at that
time. If one of our key executive officers and/or a significant number of our
practitioners were to leave us and the courts refused to enforce the non-compete
covenant, we might be subject to increased competition, which could materially
and adversely affect our business, financial condition and results of
operations.
We face periodic reviews, audits and investigations under our contracts with
federal and state government agencies, and these audits could have adverse
findings that may negatively impact our business.
We contract with various federal and state governmental agencies to provide O&P
services. Pursuant to these contracts, we are subject to various governmental
reviews, audits and investigations to verify our compliance with the contracts
and applicable laws and regulations. Any adverse review, audit or investigation
could result in:
o refunding of amounts we have been paid pursuant to our government
contracts;
o imposition of fines, penalties and other sanctions on us;
o loss of our right to participate in various federal programs; or
o damage to our reputation in various markets.
We may be unable to successfully integrate and operate other O&P businesses that
we acquire in the future.
Part of our business strategy involves the acquisition and integration of small
and medium-sized O&P businesses. We may not be able to successfully consummate
and/or integrate future acquisitions. We continuously review acquisition
prospects that would complement our existing operations, increase our size and
expand into geographic scope of operations or otherwise offer growth
opportunities. The financing for these acquisitions could significantly dilute
our investors or result in an increase in our indebtedness. While we have no
current significant agreements or negotiations with respect to any such
acquisitions, we may acquire or make investments in businesses or products in
the future. Acquisitions may entail numerous integration risks and impose costs
on us, including:
o difficulties in assimilating acquired operations or products,
including the loss of key employees from acquired businesses;
o diversion of management's attention from our core business concerns;
o adverse effects on existing business relationships with suppliers and
customers;
13
o risks of entering markets in which we have no or limited experience;
o dilutive issuances of equity securities;
o incurrence of substantial debt;
o assumption of contingent liabilities; and
o incurrence of significant immediate write-offs.
Our failure to successfully complete the integration of future acquisitions
could have a material adverse effect on our results of operations, business and
financial condition.
Government Regulation
We are subject to a variety of governmental regulations. We make every
effort to comply with all applicable regulations through compliance programs,
manuals and personnel training. Despite these efforts, we cannot guarantee that
we will be in absolute compliance with all regulations at all times. Failure to
comply with applicable governmental regulations may result in significant
penalties, including exclusion from the Medicare and Medicaid programs, which
could have a material adverse effect on our business.
Medical Device Regulation. We distribute products that are subject to
regulation as medical devices by the U.S. Food and Drug Administration under the
Federal Food, Drug and Cosmetic Act and accompanying regulations. We believe
that the products we distribute, including O&P devices, accessories and
components, are exempt from the FDA's regulations for pre-market clearance of
approval requirements and from requirements relating to quality system
regulation (except for certain recordkeeping and complaint handling
requirements). We are required to adhere to regulations regarding adverse event
reporting, and are subject to inspection by the FDA for compliance with all
applicable requirements. Labeling and promotional materials also are subject to
scrutiny by the FDA and, in certain circumstances, by the Federal Trade
Commission. Although we have never been challenged by the FDA for noncompliance
with FDA requirements, we cannot assure that we would be found to be or to have
been in compliance at all times. Noncompliance could result in a variety of
civil and/or criminal enforcement actions, which could have a material adverse
effect on our business and results or operations.
Fraud and Abuse. Violations of fraud and abuse laws are punishable by
criminal and/or civil sanctions, including, in some instances, imprisonment and
exclusion from participation in federal health care programs, including
Medicare, Medicaid, U.S. Veterans Administration health programs and the
Department of Defense's TRICARE program, formerly known as CHAMPUS. These laws,
which include but are not limited to, antikickback laws, false claims laws,
physician self-referral laws, and federal criminal healthcare fraud laws, are
discussed in further detail below. We believe our billing practices, operations,
and compensation and financial arrangements with referral sources and others
materially comply with applicable federal and state requirements. However, we
cannot assure that such requirements will not be interpreted by a governmental
authority in a manner inconsistent with our interpretation and application. The
failure to comply, even if inadvertent, with any of these requirements could
require us to alter our operations and/or refund payments to the government.
Such refunds could be significant and could also lead to the imposition of
significant penalties. Even if we successfully defend against any action against
us for violation of these laws or regulations, we would likely be forced to
incur significant legal expenses and divert our management's attention from the
operation of our business. Any of these actions, individually or in the
aggregate, could have a material adverse effect on our business and financial
results.
14
Antikickback Laws. Our operations are subject to federal and state
antikickback laws. The federal Antikickback Statute (Section 1128B(b) of the
Social Security Act) prohibits persons or entities from knowingly and willfully
soliciting, offering, receiving, or paying any remuneration in return for, or to
induce, the referral of persons eligible for benefits under a federal health
care program (including Medicare, Medicaid, the VA health programs and TRICARE),
or the ordering, purchasing, leasing, or arranging for, or the recommendation of
purchasing, leasing or ordering of, items or services that may be paid for, in
whole or in part, by a federal healthcare program. Some courts have held that
the statute may be violated when even one purpose (as opposed to a primary or
sole purpose) of a payment is to induce referrals or other business.
Recognizing that the law is broad and may technically prohibit beneficial
arrangements, the Office of Inspector General of the Department of Health and
Human Services developed regulations addressing a small number of business
arrangements that will not be subject to scrutiny under the law. These "safe
harbors" describe activities that may technically violate the act, but which are
not considered to be illegal provided that they meet all the requirements of the
applicable Safe Harbor. For example, the Safe Harbors cover activities such as
offering discounts to healthcare providers and contracting with physicians or
other individuals or entities that have the potential to refer business to us
that would ultimately be billed to a federal health care program. Failure to
qualify for Safe Harbor protection does not mean that an arrangement is illegal.
Rather, the arrangement must be analyzed under the antikickback statue to
determine whether there is an intent to pay or receive remuneration in return
for referrals. Conduct and business arrangements that do not fully satisfy one
of the Safe Harbors may result in increased scrutiny by government enforcement
authorities. In addition, some states also have antikickback laws that vary in
scope and may apply regardless of whether a federal health care program is
involved.
Our operations and business arrangements include, for example, discount
programs for individuals or entities that purchase our products and services and
financial relationships with potential and actual purchasers and referral
sources, such as lease arrangements with hospitals and certain participation
agreements. Therefore, our operations and business arrangements are required to
comply with the antikickback laws. Although our business arrangements and
operations may not always satisfy all the criteria of a Safe Harbor, we believe
that our operations are in material compliance with federal and state
antikickback statutes.
HIPAA Violations. The Health Insurance Portability and Accountability Act
("HIPAA") provides for criminal penalties for, among other offenses, healthcare
fraud, theft or embezzlement in connection with healthcare, false statements
related to healthcare matters, and obstruction of criminal investigation of
healthcare offenses. Unlike the federal antikickback laws, these offenses are
not limited to federal health care programs.
In addition, HIPAA authorizes the imposition of civil monetary penalties
where a person offers or pays remuneration to any individual eligible for
benefits under a federal health care program that such person knows or should
know is likely to influence the individual to order or receive covered items or
services from a particular provider, practitioner or supplier. Excluded from the
definition of "remuneration" are incentives given to individuals to promote the
delivery of preventive care (excluding cash or cash equivalents), incentives of
nominal value and certain differentials in or waivers of coinsurance and
deductible amounts.
These laws may apply to certain of our operations. As noted above, we have
established various types of discount programs or compensation or other
financial arrangements with individuals and entities who
15
purchase our products and services and/or refer patients to our O&P patient-care
centers. We also bill third party payors and other entities for items and
services provided at our O&P patient-care centers. While we endeavor to ensure
that our discount programs, compensation and other financial arrangements, and
billing practices comply with applicable laws, such programs, arrangements and
billing practices could be subject to scrutiny and challenge under HIPAA.
False Claims Laws. We are also subject to federal and state laws
prohibiting individuals or entities from knowingly presenting, or causing to be
presented, claims for payment to third-party payors (including Medicare and
Medicaid) that are false or fraudulent, are for items or services not provided
as claimed, or otherwise contain misleading information. Each of our O&P
patient-care centers is responsible for preparation and submission of
reimbursement claims to third-party payors for items and services furnished to
patients. In addition, our personnel may, in some instances, provide advice on
billing and reimbursement to purchasers of our products. While we endeavor to
assure that our billing practices comply with applicable laws, if claims
submitted to payors are deemed to be false, fraudulent, or for items or services
not provided as claimed, we could face liability for presenting or causing to be
presented such claims.
Physician Self-Referral Laws. We are also subject to federal and state
physician self-referral laws. With certain exceptions, the federal
Medicare/Medicaid physician self-referral law (the "Stark II" law) (Section 1877
of the Social Security Act) prohibits a physician from referring Medicare and
Medicaid beneficiaries to an entity for "designated health services" - including
prosthetics, orthotics and prosthetic devices and supplies - if the physician or
the physician's immediate family member has a financial relationship with the
entity. A financial relationship includes both ownership or investment interests
and compensation arrangements. A violation occurs when any person presents or
causes to be presented to the Medicare or Medicaid program a claim for payment
in violation of Stark II.
With respect to ownership/investment interests, there is an exception under
Stark II for referrals made to a publicly traded entity in which the physician
has an investment interest if the entity's shares are traded on certain
exchanges, including the New York Stock Exchange, and had shareholders' equity
exceeding $75.0 million for its most recent fiscal year, or an average during
the three previous fiscal years. We meet these tests and, therefore, believe
that referrals from physicians that have ownership interests in our business
should not trigger liability under Stark II.
With respect to compensation arrangements, there are exceptions under Stark
II that permit physicians to maintain certain business arrangements, such as
personal service contracts and equipment or space leases, with healthcare
entities to which they refer. We believe that our compensation arrangements
comply with Stark II, either because the physician's relationship fits within a
regulatory exception or does not generate prohibited referrals. Because we have
financial arrangements with physicians and possibly their immediate family
members, and because we may not be aware of all those financial arrangements, we
must rely on physicians and their immediate family members to avoid making
referrals to us in violation of Stark II or similar state laws. If, however, we
receive a prohibited referral without knowing that the referral was prohibited,
our submission of a bill for services rendered pursuant to a referral could
subject us to sanctions under Stark II and applicable state laws.
Certification and Licensure. Most states do not require separate licensure
for O&P practitioners. However, several states currently require O&P
practitioners to be certified by an organization such as the American Board for
Certification.
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The American Board for Certification conducts a certification program for
practitioners and an accreditation program for patient-care centers. The minimum
requirements for a certified practitioner are a college degree, completion of an
accredited academic program, one to four years of residency at a patient-care
center under the supervision of a certified practitioner and successful
completion of certain examinations. Minimum requirements for an accredited
patient-care center include the presence of a certified practitioner and
specific plant and equipment requirements. While we endeavor to comply with all
state licensure requirements, we cannot assure that we will be in compliance at
all times with these requirements. Failure to comply with state licensure
requirements could result in civil penalties, termination of our Medicare
agreements, and repayment of amounts received from Medicare for services and
supplies furnished by an unlicensed individual or entity.
Confidentiality and Privacy Laws. The Administrative Simplification
Provisions of HIPAA, and their implementing regulations, set forth privacy
standards and implementation specifications concerning the use and disclosure of
individually identifiable health information (referred to as "protected health
information") by health plans, healthcare clearinghouses and healthcare
providers that transmit health information electronically in connection with
certain standard transactions ("Covered Entities"). HIPAA further requires
Covered Entities to protect the confidentiality of health information by meeting
certain security standards and implementation specifications. In addition, under
HIPAA, Covered Entities that electronically transmit certain administrative and
financial transactions must utilize standardized formats and data elements ("the
transactions/code sets standards"). HIPAA imposes civil monetary penalties for
non-compliance, and, with respect to knowing violations of the privacy
standards, or violations of such standards committed under false pretenses or
with the intent to sell, transfer or use individually identifiable health
information for commercial advantage, criminal penalties. We must comply with
the privacy standards by no later than April 16, 2003, with the
transactions/code sets standards by no later than April 16, 2003, and with the
security standards by April 21, 2005. We believe that we are subject to the
Administrative Simplification Provisions of HIPAA and are taking steps to meet
applicable standards and implementation specifications. We expect the new
requirements to have a significant effect on the manner in which we handle
health data and communicate with payers. Our new billing system, OPS, which is
scheduled to be put into operation in 2003, is designed to meet these
requirements.
In addition, state confidentiality and privacy laws may impose civil and/or
criminal penalties for certain unauthorized or other uses or disclosures of
individually identifiable health information. We are also subject to these laws.
While we endeavor to assure that our operations comply with applicable laws
governing the confidentiality and privacy of health information, we could face
liability in the event of a use or disclosure of health information in violation
of one or more of these laws.
17
Personnel and Training
None of our employees are subject to a collective-bargaining agreement. We
believe that we have satisfactory relationships with our employees and strive to
maintain these relationships by offering competitive benefit packages, training
programs and opportunities for advancement. The following table summarizes our
employees as of December 31, 2002:
Certified O&P
Practitioners Technicians Administrative Distribution Other
------------- ----------- -------------- ------------ -----
Hanger Prosthetics & Orthotics, Inc. 872 570 1,095 -- 346
Southern Prosthetic Supply, Inc. -- -- 32 43 29
Other -- -- -- -- 96
We have established an affiliation with the University of Connecticut
pursuant to which we own and operate a school at the Newington, Connecticut
campus that offers a certificate in orthotics and/or prosthetics after the
completion of a nine-month course. We believe there are only seven schools of
this kind in the United States. The program director is a Hanger employee, and
our practitioners teach most of the courses. After completion of the nine-month
course, graduates receive a certificate and go on to complete a residency in
their area of specialty. After their residency is complete, graduates can choose
to complete a course of study in the other area of specialty. Most graduates
will then sit for a certification exam to either become a certified prosthetist
or certified orthotist. We offer exam preparation courses for graduates who
agree to become our practitioners to help them prepare for those exams.
We also provide a series of ongoing training programs to improve the
professional knowledge of our practitioners. For example, we have an annual
Education Fair which is attended by over 740 of our O&P practitioners and
consists of lectures and seminars covering topics such as the latest technology
and process improvements, basic accounting and business courses and other
courses which allow the practitioners to fulfill their ongoing continuing
education requirements.
Insurance
We currently maintain insurance of the type and in the amount customary in
the O&P rehabilitation industry, including coverage for malpractice liability,
product liability, workers' compensation and property damage. Our general
liability insurance coverage is $0.5 million per incident, with a $25 million
umbrella insurance policy. Based on our experience and prevailing industry
practices, we believe our coverage is adequate as to risks and amount. We have
not incurred a material amount of expenses in the past as a result of uninsured
O&P claims.
Our Website
Our website is http://www.hanger.com. We make available free of charge, on
or through our website, our Annual reports on Form 10-K, Quarterly Reports on
Form 10-Q and Current Reports on Form 8-K, as soon as reasonably practicable
after electronically filing such reports with the Securities and Exchange
Commission. Information contained on our website is not part of this report.
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ITEM 2. PROPERTIES.
As of December 31, 2002, we operated 583 patient-care centers and
facilities in 44 states and the District of Columbia. Of these, 26 centers are
owned by us. There are an additional two centers owned but not in use in New
York and Pennsylvania. The remaining centers are occupied under leases expiring
between the years of 2003 and 2014. We believe our leased or owned centers are
adequate for carrying on our current O&P operations at our existing locations,
as well as our anticipated future needs at those locations. We believe we will
be able to renew such leases as they expire or find comparable or additional
space on commercially suitable terms.
The following table sets forth the number of our patient-care centers
located in each state:
Patient-Care Patient-Care Patient-Care
State Center State Cente State Centers
- ----- ------------ ----- ------------ ----- ------------
Alabama 11 Louisiana 11 North Carolina 14
Arizona 19 Maine 4 North Dakota 1
Arkansas 5 Maryland 8 Ohio 33
California 65 Massachusetts 10 Oklahoma 11
Colorado 10 Michigan 6 Oregon 15
Connecticut 13 Minnesota 8 Pennsylvania 32
Delaware 1 Mississippi 12 South Carolina 12
District of Columbia 1 Missouri 14 South Dakota 2
Florida 38 Montana 6 Tennessee 15
Georgia 24 Nebraska 9 Texas 20
Illinois 29 Nevada 5 Virginia 7
Indiana 13 New Hampshire 2 West Virginia 9
Iowa 10 New Jersey 13 Washington 7
Kansas 9 New Mexico 5 Wisconsin 5
Kentucky 9 New York 28 Wyoming 2
We also own one distribution facility in Texas, and lease two distribution
facilities in California and Georgia. We lease our corporate headquarters in
Bethesda, Maryland. Substantially all of our properties are pledged to
collateralize bank indebtedness. See Note H to our Consolidated Financial
Statements.
ITEM 3. LEGAL PROCEEDINGS.
On November 28, 2000, a class action complaint (Norman Ottmann v. Hanger
Orthopedic Group, Inc., Ivan R. Sabel and Richard A. Stein; Civil Action No.
00CV3508) was filed against us in the United States District Court for the
District of Maryland on behalf of all purchasers of our common stock from
November 8, 1999 through and including January 6, 2000. The complaint also names
as defendants Ivan R. Sabel our Chairman of the Board, and Chief Executive
Officer (and then President), and Richard A. Stein, our former Chief Financial
Officer, Secretary and Treasurer.
The complaint alleges that during the above period of time, the defendants
violated Section 10(b) and 20(a) of the Securities Exchange Act of 1934 by,
among other things, knowingly or recklessly making material misrepresentations
concerning our financial results for the quarter ended September 30, 1999, and
19
the progress of our efforts to integrate the recently-acquired operations of
NovaCare O&P. The complaint further alleges that by making those material
misrepresentations, the defendants artificially inflated the price of our common
stock. The plaintiff seeks to recover damages on behalf of all of the class
members.
The class action lawsuit has been dismissed by the District Court for
failure to comply with statutory requirements. On November 5, 2002, plaintiffs
filed a Notice of Appeal with the United States Court of Appeals for the Fourth
Circuit. Such appeal is still pending.
We believe that the allegations have no merit and are vigorously defending
the lawsuit. Additionally, we believe that it is remote that any claims would
result from this action and therefore, no related liabilities have been
recorded.
We are party to various legal actions that are ordinary and incidental to
our business. While the outcome of legal actions cannot be predicted with
certainty, our management believes the outcome of these proceedings will not
have a material adverse effect on our financial condition or results of
operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matter was submitted during the fourth quarter of the fiscal year
covered by this report to a vote of stockholders.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT.
The following table sets forth information regarding our current executive
officers and certain of our subsidiaries:
Name Age Office with the Company
- ---- --- -----------------------
Ivan R. Sabel, CPO 57 Chairman of the Board, Chief Executive Officer and
Director
Thomas F. Kirk 57 President, Chief Operating Officer and Director
Richmond L. Taylor 54 Executive Vice President; President and Chief
Officer Operating of Hanger Prosthetics & Orthotics, Inc.
and HPO, Inc.
George E. McHenry 50 Executive Vice President and Chief Financial
Officer
Ron N. May 56 President and Chief Operating Officer of
Southern Prosthetic Supply, Inc. (Distribution)
Glenn M. Lohrmann 48 Vice President, Secretary and Controller
Jason P. Owen 29 Treasurer
Edward L. Mitzel 43 Vice President and Chief Information Officer
20
Michael F. Murphy 42 Vice President - Marketing and Business Development
Brian A. Wheeler 42 Vice President - Human Resources
Ivan R. Sabel, CPO has been our Chairman of the Board of Directors and
Chief Executive Officer since August 1995 and was our President from November
1987 to January 2, 2002. Mr. Sabel also served as the Chief Operating Officer
from November 1987 until August 1995. Prior to that time, Mr. Sabel had been
Vice President-Corporate Development from September 1986 to November 1987. Mr.
Sabel was the founder, owner and President of Capital Orthopedics, Inc. from
1968 until that company was acquired by us in 1986. Mr. Sabel is a Certified
Prosthetist and Orthotist ("CPO"), a clinical instructor in orthopedics at the
Georgetown University Medical School in Washington, D.C., a member of the Board
of Directors of the American Orthotic and Prosthetic Association ("AOPA"), a
former Chairman of the National Commission for Health Certifying Agencies, a
former member of the Strategic Planning Committee, a current member of the U.S.
Veterans Administration Affairs Committee of AOPA and a former President of the
American Board for Certification in Orthotics and Prosthetics. Mr. Sabel also
serves on the Board of Directors of Mid-Atlantic Medical Services, Inc., a
company engaged in the healthcare management services business, and a member of
the Medical Advisory Board of DJ Orthopedics, Inc., a manufacturer of knee
braces. Mr. Sabel has been a director since 1986.
Thomas F. Kirk has been the President and Chief Operating Officer of Hanger
since January 2, 2002. From September 1998 to January 1, 2002, Mr. Kirk was a
principal with AlixPartners, LLC (formerly Jay Alix & Associates), a management
consulting company retained by Hanger in December, 2000 to facilitate its
reengineering process. From May 1997 to August 1998, Mr. Kirk served as Vice
President, Planning, Development and Quality for FPL Group, a full service
energy provider located in Florida. From April 1996 to April 1997, he served as
Vice President and Chief Financial Officer for Quaker Chemical Corporation in
Pennsylvania. From December 1987 to March 1996, he served as Senior Vice
President and Chief Financial Officer for Rhone-Poulenc, S.A. in Princeton, New
Jersey and Paris, France. From March 1977 to November 1988, he was employed by
St. Joe Minerals Corp., a division of Fluor Corporation. Prior to this he held
positions in sales, commercial development, and engineering with Koppers Co.,
Inc. Mr. Kirk holds a Ph.D. degree in strategic planning/marketing, and an
M.B.A. degree in finance, from the University of Pittsburgh. He also holds a
Bachelor of Science degree in mechanical engineering from Carnegie Mellon
University. He is a registered professional engineer and a member of the
Financial Executives Institute.
George E. McHenry has been an Executive Vice President and our Chief
Financial Officer since October 15, 2001. From 1987 until he joined us in
October 2001, Mr. McHenry served as Executive Vice President, Chief Financial
Officer and Secretary of U.S. Vision, Inc., an optical company with 600
locations in 47 states. Prior to joining U.S. Vision, Inc., he was employed
principally as a Senior Manager by the firms of Touche Ross & Co. (now Deloitte
& Touche) and Main Hurdman (now KPMG LLP) from 1974 to 1987. Mr. McHenry is a
Certified Public Accountant and received a Bachelor of Science degree in
accounting from St. Joseph's University.
Richmond L. Taylor is an Executive Vice President, and the President and
Chief Operating Officer of each of Hanger Prosthetics & Orthotics, Inc. and HPO,
Inc. (formerly NovaCare O&P), our two wholly-owned subsidiaries which operate
all of our patient-care centers. Previously, Mr. Taylor served as the Chief
21
Operating Officer of NovaCare O&P from June 1996 until July 1, 1999, and held
the positions of Region Vice-President and Region President of NovaCare O&P for
the West Region from 1989 to June 1996. Prior to joining NovaCare O&P, Mr.
Taylor spent 20 years in the healthcare industry in a variety of management
positions including Regional Manager at American Hospital Supply Corporation,
Vice President of Operations at Medtech, Vice President of Sales at Foster
Medical Corporation and Vice President of Sales at Integrated Medical Systems.
Ron N. May has been the President and Chief Operating Officer of Southern
Prosthetic Supply, Inc., our wholly-owned subsidiary that distributes orthotic
and prosthetic products, since December 1998. From January 1984 to December
1998, Mr. May was Executive Vice President of the distribution division of J.E.
Hanger, Inc. of Georgia until that company was acquired by us in November 1996.
Mr. May also currently serves as a Board Member of the O&P Athletic Fund.
Glenn M. Lohrmann has been our Vice President, Secretary and Controller
since July 2001, and is the Vice President, Secretary and Treasurer of each of
Hanger Prosthetics & Orthotics, Inc., OPNET, Inc., Southern Prosthetic Supply,
Inc. and HPO, Inc. (formerly NovaCare O&P). From August 1985 to July 2001, Mr.
Lohrmann served in senior financial positions with a large medical faculty
practice, various teaching hospitals, an HMO, and the corporate office of Inova
Health System. Mr. Lohrmann also worked for Ernst & Young from January 1978 to
August 1985, including service at their National Health Care Office. Mr.
Lohrmann is a Certified Public Accountant and holds a B.S. degree in Accounting
and a M.B.A. degree from the University of Maryland.
Jason P. Owen has been our Treasurer since August 2001. Previously, Mr.
Owen served as our Vice President of Strategic Planning from 2000 to 2001. Mr.
Owen also served as our Director of Business Development from 1998 to 1999,
during which time he was jointly responsible for our small to medium-sized
acquisitions. Prior to joining us, Mr. Owen spent five years in the banking
industry with GE Capital and SunTrust Bank, during which time he held positions
responsible for portfolio management, origination, capital markets and treasury
management services. Mr. Owen holds an M.B.A. degree in finance from Georgia
State University. He also holds a Bachelor of Business Administration degree in
finance from Georgia Southern University.
Edward L. Mitzel has been a Vice President and our Chief Information
Officer since April 2002. Prior to joining Hanger, he was Director of
Information Technology at Provident Mutual Financial Services and has held
senior information technology positions with an international
construction/marketing company and a long-term care development/management
company. Mr. Mitzel holds a B.S. degree in Business Administration and a Masters
degree in Economics from the University of Baltimore and a M.A.S. degree in
Information Technology from Johns Hopkins University.
Michael F. Murphy has been our Vice President - Marketing and Business
Development since December 2002. Prior to joining Hanger, he held senior
healthplan operations leadership positions with CIGNA Healthcare and was Chief
Marketing Officer for two leading ancillary managed care companies. Mr. Murphy
holds a B.A. degree in History from Holy Cross College.
Brian A. Wheeler has been our Vice President - Human Resources since
November, 2002. Prior to joining Hanger, he was the Vice President of Human
Resources for Rhodia Inc., a wholly-owned U.S.
22
subsidiary of the French Specialty Chemicals Company. Mr. Wheeler holds a B.A.
degree in Political Science from the University of Florida.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS.
Our Common Stock has been listed and traded on the New York Stock Exchange
since December 15, 1998, under the symbol "HGR." The following table sets forth
the high and low intra-day sale prices for the Common Stock for the periods
indicated as reported on the New York Stock Exchange:
Year Ended December 31, 2001 High Low
------ ------
First Quarter $ 2.25 $ 0.98
Second Quarter 2.70 1.06
Third Quarter 4.25 2.40
Fourth Quarter 6.80 3.30
Year Ended December 31, 2002 High Low
------ ------
First Quarter $10.35 $ 6.02
Second Quarter 15.19 11.05
Third Quarter 17.70 10.50
Fourth Quarter 16.74 12.49
At March 17, 2003, there were approximately 414 holders of record of our
Common Stock.
Dividend Policy
We have never paid cash dividends on our Common Stock and intend to
continue this policy for the foreseeable future. We plan to retain earnings for
use in our business. The terms of our agreements with our financing sources and
certain other agreements prohibit the payment of dividends on our Common Stock
and Preferred Stock and such agreements will continue to prohibit the payment of
dividends in the future. Any future determination to pay cash dividends will be
at the discretion of our Board of Directors and will be dependent on our results
of operations, financial condition, contractual and legal restrictions and any
other factors deemed to be relevant.
23
Equity Compensation Plan
The following table sets forth information as of December 31, 2002
regarding our equity compensation plans:
Number of
Number of securities
securities to be remaining
issued upon available for
exercise of Weighted average future issuance
outstanding exercise price of (excluding
options, warrants, outstanding options, securities
Plan Category and rights warrants, and rights reflected in
--------------------------------------------------------------
( a ) ( b ) ( c )
Equity Compensation Plans
approved by security holders 3,911,569 7.71 1,114,002
Equity Compensation Plans not
approved by security holders 505,000 6.37 N/A
--------------------- -------------------
Total 4,416,569 1,114,002
===================== ===================
Unregistered Sales of Securities.
During the years ended December 31, 2001 and 2000, we issued no securities
without registration under the Securities Act of 1933 ("Securities Act").
On February 15, 2002, we sold $200.0 million principal amount of 10 3/8%
Senior Notes due 2009 ("Senior Notes") to four institutional investors in
connection with an offering of the Senior Notes to qualified institutional
buyers in reliance on Rule 144A under the Securities Act and to other persons
outside the U.S. in reliance on Regulation S under the Securities Act. Issuance
of the Senior Notes to the four initial purchasers was exempt from registration
under Section 4(2) of the Securities Act. The four initial purchasers were
Lehman Brothers Inc., J. P. Morgan Securities Inc., Salomon Smith Barney Inc.
and BNP Paribas Securities Corp. The Senior Notes were sold for cash to the
initial purchasers at 97% of the principal amount thereof. The approximately
$194.0 million net proceeds from the sale of the Senior Notes, along with
approximately $36.9 million borrowed under our new credit facility, were used to
pay related fees and expenses and to retire the approximately $228.4 million
outstanding indebtedness under our previously existing credit facility as of
February 15, 2002.
In connection with the aforementioned sale of the Senior Notes, we entered
into a Registration Rights Agreement that required us to file with the SEC an
Exchange Offering Registration Statement with respect to the Senior Notes within
ninety days of closing the sale. On May 13, 2002, we commenced an offer to
exchange the privately-placed, unregistered Senior Notes with new Senior Notes
that had been registered under the Securities Act of 1933, as amended, on our
Registration Statement on Form S-4 filed with the Securities and Exchange
Commission. The exchange offer expired on June 11, 2002. All of the previously
issued unregistered Senior Notes were exchanged for registered Senior Notes. The
new notes are substantially identical to the previously issued unregistered
notes except that the new notes are free of the transfer restrictions that
applied to the unregistered notes.
24
ITEM 6. SELECTED CONSOLIDATED FINANCIAL INFORMATION.
The selected consolidated financial data presented below is derived from
the audited Consolidated Financial Statements and Notes thereto.
SELECTED FINANCIAL DATA
(In thousands, except per share data)
Year Ended December 31,
------------------------------------------------------------------
Statement of Operations Data: 2002 2001 2000 1999 1998
------------------------------------------------------------------
Net sales $ 525,534 $ 508,053 $ 486,031 $ 346,826 $ 187,870
------------------------------------------------------------------
Gross profit 284,162 267,185 234,663 177,750 94,967
Selling, general and administrative 189,768 182,972 177,392 113,995 63,827
Depreciation and amortization 9,892 11,613 10,303 6,100 3,294
Amortization of excess cost over net assets acquired (1) - 13,073 13,025 7,958 2,488
Unusual charges (2) 1,860 24,438 2,364 6,340 -
------------------------------------------------------------------
Income from operations 82,642 35,089 31,579 43,357 25,358
Interest expense, net 38,314 43,065 47,072 22,177 1,902
------------------------------------------------------------------
Income (loss) before taxes, extraordinary item 44,328 (7,976) (15,493) 21,180 23,456
Provision (benefit) for income taxes 17,947 907 (1,497) 10,194 9,616
------------------------------------------------------------------
Income (loss) before extraordinary item 26,381 (8,883) (13,996) 10,986 13,840
Extraordinary loss on early extinguishment of debt 2,811 - - - -
------------------------------------------------------------------
Net income (loss) $ 23,570 $ (8,883) $ (13,996) $ 10,986 $ 13,840
==================================================================
Net income (loss) applicable to common stock $ 18,368 $ (13,741) $ (18,534) $ 8,831 $ 13,818
==================================================================
Basic Per Common Share Data
Income (loss) before extraordinary item applicable
to common stock $ 1.08 $ (0.73) $ (0.98) $ 0.47 $ 0.82
Extraordinary loss on early extinguishment of debt (0.14) - - - -
------------------------------------------------------------------
Net income (loss) applicable to common stock $ 0.94 $ (0.73) $ (0.98) $ 0.47 $ 0.82
==================================================================
Shares used to compute basic per common
share amounts 19,535 18,920 18,910 18,855 16,813
==================================================================
Diluted Per Common Share Data (3)
Income (loss) before extraordinary item applicable
to common stock $ 0.99 $ (0.73) $ (0.98) $ 0.44 $ 0.75
Extraordinary loss on early extinguishment of debt (0.13) - - - -
------------------------------------------------------------------
Net income (loss) applicable to common stock $ 0.86 $ (0.73) $ (0.98) $ 0.44 $ 0.75
==================================================================
Shares used to compute diluted per common
share amounts 21,457 18,920 18,910 20,005 18,516
==================================================================
(1) We discontinued amortization related to goodwill and other indefinite-lived
intangible assets commencing January 1, 2002 pursuant to Statement of
Financial Accounting Standards No. 142
(2) The 1999 and 2000 results include integration and restructuring costs of
$6.3 million and $2.4 million, respectively, incurred in connection with
the purchase of NovaCare O&P. The 2001 results include impairment,
restructuring, and improvement costs of $24.4 million, comprised of: (i) a
non-cash charge of approximately $4.8 million related to stock compensation
to AlixPartners, LLC (formerly Jay Alix & Associates; "JA&A") for services
rendered; (ii) restructuring charges of $3.7 million recorded in the second
quarter of 2001 principally related to severance and lease termination
expenses; (iii) an asset impairment loss of approximately $8.1 million
incurred in
25
connection with the October 9, 2001 sale of substantially all of the
manufacturing assets of Seattle Orthopedic Group, Inc.; and (iv)
approximately $7.8 million of other charges primarily comprised of fees
paid to JA&A in connection with development of our performance improvement
plan. The 2002 results include payments made to a prior workman's
compensation carrier related to claims for the 1995 through 1998 policy
years and a non-cash charge related to the write-off of abandoned
leaseholds of $1.3 million and $0.6 million, respectively.
(3) Excludes the effect of the conversion of the 7% Redeemable Convertible
Preferred Stock into Common Stock as it is considered anti-dilutive. For
2000 and 2001, excludes the effect of all dilutive options and warrants as
a result of our net loss for the years ended December 31, 2000 and 2001.
Balance Sheet Data: December 31,
----------------------------------------------------
2002 2001 2000 1999 1998
----------------------------------------------------
Cash and cash equivalents $ 6,566 $ 10,043 $ 20,669 $ 5,735 $ 9,683
Working capital 126,668 109,216 133,690 118,428 49,678
Total assets 712,226 699,907 761,818 750,081 205,948
Long-term debt 378,101 367,315 422,838 426,211 11,154
Redeemable convertible
preferred stock 75,941 70,739 65,881 61,343 -
Shareholders' equity 167,667 145,674 154,380 172,914 162,553
Other Financial Data:
Year Ended December 31,
--------------------------------------------------------
2002 2001 2000 1999 1998
--------------------------------------------------------
Capital expenditures $ 9,112 $ 6,697 $ 9,845 $ 12,598 $ 2,859
Gross margin 54.1% 52.6% 48.3% 51.3% 50.5%
Net cash provided by
(used in):
Operating activities $ 47,534 $ 51,166 $ 3,607 $ (224) $ 18,531
Investing activities (18,012) 1,105 4,624 (444,995) (33,650)
Financing activities (32,999) (62,897) 6,703 441,271 18,245
26
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
Overview
The following is a discussion of our results of operations and financial
position for the periods described below. This discussion should be read in
conjunction with the Consolidated Financial Statements included in this report.
Our discussion of our results of operations and financial condition includes
various forward-looking statements about our markets, the demand for our
products and services and our future results. These statements are based on
certain assumptions that we consider reasonable. Our actual results may differ
materially from those indicated forward looking statements.
We are the largest operator and developer of orthotic and prosthetic ("O&P")
patient-care centers in the United States. Orthotics is the design, fabrication,
fitting and device maintenance of custom-made braces and other devices (such as
spinal, knee and sports-medicine braces) that provide external support to treat
musculoskeletal disorders. Musculoskeletal disorders are ailments of the back,
extremities or joints caused by traumatic injuries, chronic conditions,
diseases, congenital disorders or injuries resulting from sports or other
activities. Prosthetics is the design, fabrication and fitting of custom-made
artificial limbs for patients who have lost limbs as a result of traumatic
injuries, vascular diseases, diabetes, cancer or congenital disorders. We have
two segments, the O&P patient-care services segment, which generated
approximately 94.4% of our sales in 2002, and the distribution of O&P components
segment, which accounted for 5.6% of our sales. Our operations are located in 44
states and the District of Columbia, with a substantial presence in California,
Florida, Georgia, Illinois, New York, Ohio, Pennsylvania and Texas.
We generate sales primarily from patient-care services related to the
fabrication, fitting and maintenance of O&P devices. During 2002, same-center
sales increased by 4.6% over 2001. Same-center sales growth represents the
aggregate increase or decrease of our patient-care centers' sales in the current
year compared to the preceding year. Patient-care centers that have been owned
by the Company for at least one full year are included in the computation. The
sales related to patient-care centers that have been sold are not included in
the calculation for the current and preceding years. Our sales growth in 2001
was also principally driven by 6.8% same-center sales growth. Prior to calendar
2001, our growth in sales resulted primarily from an aggressive program of
acquiring and developing O&P patient-care centers and secondarily from
same-center sales. We acquired six additional patient-care centers in October,
2002 and one additional patient-care center in December, 2002. We operated 583
and 597 patient-care centers at December 31, 2002 and 2001, respectively and
three distribution facilities at both December 31, 2002 and 2001. The decrease
in patient-care centers was primarily due to the planned closure or merger of
existing facilities.
We calculate cost of goods sold in accordance with the gross profit method. We
base the estimates used in applying the gross profit method on the actual
results of the most recently completed fiscal year and other factors affecting
cost of goods sold. Estimated cost of goods sold is adjusted when the annual
physical inventory is taken and compiled, generally in the fourth quarter, and a
new accrual rate is established.
Our revenues and results of operations are affected by seasonal considerations.
The adverse weather conditions often experienced in certain geographical areas
of the United States during the first quarter of each year, together with a
greater degree of patients' sole responsibility for their insurance deductible
payment obligations during the beginning of each calendar year, have contributed
to lower net sales in the first quarter.
27
We believe that the expansion of our business through a combination of continued
same-center sales growth, which has averaged 5.8% over the last three years, the
addition of new facilities and a program of selective acquisitions is critical
to the continued improvement in our profitability.
Results of Operations
The following table sets forth for the periods indicated certain items of our
statements of operations as a percentage of our net sales:
For the Year
ended December 31,
------------------------
2002 2001 2000
------------------------
Net sales 100.0% 100.0% 100.0%
Cost of goods sold 45.9 47.4 51.7
Gross profit 54.1 52.6 48.3
Selling, general and administrative 36.1 36.0 36.5
Depreciation and amortization 1.9 2.3 2.1
Amortization of excess cost over net assets acquired - 2.6 2.7
Unusual charges 0.4 4.8 0.5
Income from operations 15.7 6.9 6.5
Interest expense, net 7.3 8.5 9.7
Income (loss) before taxes 8.4 (1.6) (3.2)
Provision (benefit) for income taxes 3.4 0.1 (0.3)
Extraordinary item (net of tax) 0.5 - -
Net income (loss) 4.5 (1.7) (2.9)
Net income (loss) applicable to common stock 3.5 (2.7) (3.8)
Year ended December 31, 2002 compared with the year ended December 31, 2001
Net Sales. Net sales for the year ended December 31, 2002 were $525.5 million,
an increase of $17.4 million, or 3.4%, versus net sales of $508.1 million for
the year ended December 31, 2001. The sales growth was primarily the result of a
4.6% increase in same-center sales in our O&P patient-care practices and a $0.2
million, or 0.7%, increase in outside sales of the distribution segment offset
by a $4.9 million, or 0.9%, reduction in sales due to the sale of Seattle
Orthopedic Group, Inc. ("SOGI"), our manufacturing segment, in October 2001.
Gross Profit. Gross profit for the year ended December 31, 2002 was $284.2
million, an increase of $17.0 million, or 6.4%, compared to gross profit of
$267.2 million for the year ended December 31, 2001. Gross profit as a
percentage of net sales increased to 54.1% in 2002 versus 52.6% in 2001.
Specifically, for the patient-care segment, the gross profit, as a percentage of
sales increased to 54.2% in 2002 versus 53.4% in 2001; similarly, the gross
profit, as a percentage of sales, for the distribution segment increased to
18.8% in 2002 versus 14.0% in 2001. The improvement in gross profit, in both
dollars and as a percentage of sales, in both segments was due to a reduction in
labor, improved efficiency of operations, and lower material costs, due to a
concentration of purchasing which resulted in larger discounts, as well as to
the increase in net sales. During 2002, labor costs decreased $2.7 million over
the prior year. Material costs increased $3.2 million in
28
terms of absolute dollars, however, as a percentage of sales, material costs
decreased to 27.1% compared to 27.4% in the prior year.
Selling, General and Administrative. Selling, general and administrative
expenses for the year ended December 31, 2002 increased by $6.8 million, or
3.7%, compared to the year ended December 31, 2001. Selling, general and
administrative expenses as a percentage of net sales remained relatively stable
at 36.1% in 2002 compared to 36.0% in 2001. The increase in selling, general and
administrative expenses was primarily due to a $5.8 million increase in our
practitioners' performance-based bonus program resulting from increased
collections and decreased labor and material costs.
Depreciation and Amortization. Depreciation and amortization for the year ended
December 31, 2002 amounted to $9.9 million, a 59.9% decrease in such costs
versus the $24.7 million for the year ended December 31, 2001. The decrease was
due primarily to the discontinuation of amortization related to excess cost over
net assets acquired commencing January 1, 2002 pursuant to SFAS No. 142, which
had been $13.1 million during 2001, and secondarily, the sale of SOGI in 2001
which was $0.9 million.
Unusual Charges. Unusual charges for the year ended December 31, 2002, amounted
to $1.9 million compared to $24.4 million in 2001. The unusual charges consisted
of the following one-time costs: (i) payments of approximately $1.3 million made
to a prior workman's compensation carrier related to claims for the 1995 through
1998 policy years and (ii) a non-cash charge of approximately $0.6 million
related to the write-off of abandoned leaseholds. See "Unusual Charges" below
for additional information regarding unusual charges incurred in 2001 and 2002.
Income from Operations. Principally as a result of the above, income from
operations for the year ended December 31, 2002 was $82.6 million, an increase
of $47.6 million, or 135.5%, from the year ended December 31, 2001. Income from
operations as a percentage of net sales increased by 8.8 percentage points to
15.7% for the year ended December 31, 2002 from 6.9% for the year ended December
31, 2001.
Interest Expense, Net. Net interest expense for the year ended December 31, 2002
was $38.3 million, a decrease of $4.8 million from the $43.1 million incurred in
2001. The decrease in interest expense was primarily attributable to a decrease
in average borrowings and a reduction in interest rates.
Income Taxes. The provision for income taxes for the year ended December 31,
2002 was $17.9 million compared to $0.9 million for the year ended December 31,
2001. The change in the income tax provision was due to our profitability.
Income before Extraordinary Item. As a result of the above, we recorded income
before extraordinary item of $26.4 million for the year ended December 31, 2002,
compared to a loss before extraordinary item of $8.9 million in the prior year,
an improvement of $35.3 million.
Extraordinary Item. The extraordinary item of $2.8 million ($4.6 million
pre-tax) for the year ended December 31, 2002, represented the write-off of debt
issuance costs as a result of extinguishing $228.4 million of bank debt in
connection with the issuance of 10 3/8% Senior Notes with a principal amount of
$200.0 million due 2009 and the establishment of a $75.0 million senior secured
revolving line of credit.
Net Income. As a result of the above, we recorded net income of $23.6 million
for the year ended December 31, 2002, compared to net loss of $8.9 million in
the prior year, an improvement of $32.5 million.
29
Year ended December 31, 2001 compared with the year ended December 31, 2000
Net Sales. Net sales for the year ended December 31, 2001 were $508.1 million,
an increase of $22.1 million or 4.5%, over the prior year's net sales of $486.0
million. The increase in net sales was primarily due to a 6.8% increase in
same-center sales in our O&P practices offset by a reduction in net sales due to
the sale of SOGI in October 2001.
Gross Profit. Gross profit for the year ended December 31, 2001 improved by
$32.5 million to $267.2 million, or 52.6% of net sales, compared to $234.7
million, or 48.3% of net sales, in the prior year. The gross margin was
favorably impacted by the increase in net sales along with a reduction in the
costs of materials and labor resulting from the impact of various performance
improvement initiatives implemented during 2001.
Selling, General and Administrative. Selling, general and administrative
expenses for the year ended December 31, 2001 were $183.0 million, an increase
of $5.6 million, or 3.2%, compared to $177.4 million for the year ended December
31, 2000. The increase in selling, general and administrative expenses in
dollars was primarily the result of an increase of $14.0 million in
performance-based bonus program costs and an increase in legal fees of $1.2
million offset by (i) a decrease of $6.8 million in labor expense, (ii) a
decrease of $1.7 million in bad debt expense, and (iii) a reduction in travel
expenses of $1.1 million. Selling, general and administrative expenses as a
percentage of net sales decreased to 36.0% for the year ended December 31, 2001,
as compared to 36.5% for the year ended December 31, 2000. The decrease in
selling, general and administrative expenses as a percentage of sales was
primarily the result of the aforementioned increase in net sales.
Depreciation and Amortization. Depreciation and amortization for the year ended
December 31, 2001 amounted to $11.6 million, a 12.7% increase in such costs over
the prior year ended December 31, 2000. The increase is attributable to our
purchase of fixed assets. Amortization of excess cost over net assets acquired
for the year ended December 31, 2001 increased by 0.4% to $13.1 million,
compared to the year ended December 31, 2000. We discontinued amortization of
excess cost over net assets acquired commencing January 1, 2002 pursuant to
Statement of Financial Accounting Standards No. 142.
Unusual Charges. Unusual charges for the year ended December 31, 2001 amounted
to $24.4 million, which consisted of the following one-time costs: (i) a
non-cash charge of $4.8 million related to stock compensation to JA&A for
services rendered; (ii) restructuring charges of $3.7 million recorded in the
second quarter of 2001 principally related to severance and lease termination
expenses; (iii) an $8.1 million loss on the disposal of substantially all the
manufacturing assets of SOGI; and (iv) $7.8 million in other charges primarily
related to fees paid to JA&A in connection with development of our performance
improvement plan. During the year ended December 31, 2000, we recognized $1.7
million of integration costs in connection with the acquisition of NovaCare O&P
and $0.7 million of restructuring costs. Additional information relating to
these costs is set forth below under "Unusual Charges".
Income from Operations. Principally as a result of the above, income from
operations for the year ended December 31, 2001 was $35.1 million, an increase
of $3.5 million, or 11.1%, from the year ended December 31, 2000. Income from
operations as a percentage of net sales increased to 6.9% for the year ended
December 31, 2001 from 6.5% for the year ended December 31, 2000.
30
Interest Expense, Net. Net interest expense for the year ended December 31, 2001
was $43.1 million, a decrease of $4.0 million from $47.1 million incurred for
the year ended December 31, 2000. Interest expense as a percentage of net sales
decreased to 8.5% for the year ended December 31, 2001 from 9.7% for the year
ended December 31, 2000. The decrease in interest expense as a percentage of net
sales was primarily attributable to the net sales increase, a decrease of $26.9
million in average borrowings and a reduction in LIBOR.
Income Taxes. The provision for income taxes for the year ended December 31,
2001 was $0.9 million compared to a benefit from income taxes of $1.5 million
for the year ended December 31, 2000. We recorded a provision for income taxes
in 2001 due to the impact of nondeductible amortization on low levels of pre-tax
loss.
Net Loss. As a result of the above, we recorded a net loss of $8.9 million for
the year ended December 31, 2001, compared to a net loss of $14.0 million in the
prior year, an improvement of $5.1 million. We recorded a net loss applicable to
common stock of $13.7 million, or $0.73 per diluted common share, for the year
ended December 31, 2001, compared to net loss applicable to common stock of
$18.5 million, or $0.98 per diluted common share, for the year ended December
31, 2000.
Unusual Charges
Restructuring and Integration Costs
- -----------------------------------
In connection with the acquisition of NovaCare O&P on July 1, 1999, we
implemented a restructuring plan that contemplated lease termination and
severance costs associated with the closure of certain patient-care centers and
corporate functions made redundant after the NovaCare O&P acquisition. As of
December 31, 2000, the planned reduction in work force had been completed and we
closed all patient-care centers that were identified for closure in 1999. During
the year ended December 31, 2001, management reversed $0.8 million of the lease
termination restructuring reserve as a result of favorable lease buyouts and
subleasing activity. The remaining lease payments on these closed patient-care
centers are expected to be paid through 2003.
In December 2000, our management and the Board of Directors determined that
additional performance improvement initiatives needed to be adopted. We retained
JA&A to do an assessment of the opportunities available for improved financial
and operating performance. The first phase of the plan called for the
termination of 234 employees, for which we recorded $0.7 million in severance
costs during 2000.
In January 2001, we developed, with the assistance of JA&A, a comprehensive
performance improvement program consisting of 14 performance improvement
initiatives aimed at improving cash collections, reducing working capital
requirements and improving operating performance. In connection with these
initiatives, we recorded $4.5 million in restructuring and asset impairment
costs. These initiatives called for the closure of 37 additional patient-care
centers and the termination of 135 additional employees. During 2001, the lease
restructuring component of the plan was amended as seven additional properties,
which were originally contemplated but not finalized, were added to the list of
restructured facilities. As of December 31, 2002, all of the contemplated
employee terminations and property closures have taken place. All payments have
been made under the severance initiative and all payments under the lease
initiative are expected to be paid by December 31, 2004.
31
Performance Improvement Costs
- -----------------------------
In 2001, we recorded $12.6 million in cash and non-cash charges associated with
performance improvement initiatives. These charges were comprised of $7.8
million in fees and costs, primarily related to payments of $6.3 million made to
JA&A for consulting and success fees, and a $4.8 million non-cash charge related
to stock compensation paid JA&A for their services.
Impairment Loss on Assets Held for Sale
- ---------------------------------------
In connection with the analysis of our continuing business, we determined that
the manufacture of orthotic and prosthetic components and devices was not one of
our core businesses as it represented only 0.9% of our net sales for the year
ended December 31, 2001 and 1.7% for the year ended December 31, 2000. In July
2001, we agreed to the general terms of a sale of substantially all of the
manufacturing assets of SOGI to United States Manufacturing Company, LLC for
$20.0 million. The sale resulted in our recording, in the second quarter of
2001, an asset impairment loss of $8.1 million, as the net book value of the
assets was $26.2 million, while net proceeds from the sale of the assets were
$18.1 million.
Performance Improvement Plan
In January 2001, we developed, with the assistance of our consultant, JA&A, a
performance improvement plan which contained many initiatives that were designed
to effect cost savings through improved utilization and efficiency of support
services, enhanced purchasing and inventory management, improved collection
methods and consolidation of distribution services. In addition, we sought to
enhance net sales through improved marketing and branding initiatives and more
efficient billing procedures.
During 2002, these initiatives have become part of our normal operations and the
savings associated with their implementation are reflected in our financial
performance. These and other new initiatives related to accounts receivable,
material and labor efficiencies, and information systems continue to be
evaluated and implemented to improve our operations and financial position.
32
Financial Condition, Liquidity and Capital Resources
Our working capital at December 31, 2002 was approximately $126.7 million
compared to $109.2 million at December 31, 2001. The $17.5 million increase in
working capital was attributable principally to the refinancing of our bank debt
in February 2002, which reduced the current portion of our then existing
long-term debt. Our cash and cash equivalents amounted to $6.6 million at
December 31, 2002 and $10.0 million at December 31, 2001. The ratio of current
assets to current liabilities was 2.9 to 1 at December 31, 2002, compared to 2.3
to 1 at December 31, 2001. Availability under our revolving line of credit
increased to $60.0 million at December 31, 2002 compared to $25.2 million at
December 31, 2001, due both to the effect of the February refinancing and
principal repayments out of cash flow from operations.
Net cash provided by operating activities for the year ended December 31, 2002
was $47.5 million, compared to $51.2 million provided by operating activities
for the year ended December 31, 2001. The decrease was primarily due to an
increase in working capital due principally to an $8.4 million income tax
receivable that we expect to receive in the second quarter of 2003.
Net cash used in investing activities was $18.0 million for the year ended
December 31, 2002, versus net cash provided by investing activities of $1.1
million in the prior year. The change in net cash used was primarily due to
proceeds received from the sale of certain assets, including SOGI, which
provided a $16.1 million benefit in 2001.
Net cash used in financing activities was $33.0 million for the year ended
December 31, 2002. The cash was used principally to make payments against our
revolving line of credit and scheduled payments of seller notes. On February 15,
2002, we received $200.0 million in proceeds from the sale of the 10 3/8% Senior
Notes due 2009 ("Senior Notes") in a private placement exempt from registration
under the Securities Act of 1933, as amended. The Senior Notes were issued under
an indenture, dated as of February 15, 2002, with Wilmington Trust Company, as
trustee. We also closed, concurrent with the sale of Senior Notes, a new $75.0
million senior secured revolving line of credit ("New Revolving Credit
Facility"). The proceeds from the sale of Senior Notes and the New Revolving
Credit Facility were offset by (i) principal payments of $153.6 million to
retire our Tranche A & B Term Facilities, (ii) a net paydown of $38.3 million of
our prior revolving line of credit, and (iii) payment of $8.1 million in
financing costs related to the issuance of the Senior Notes and the
establishment of the New Revolving Credit Facility. In addition to the
aforementioned proceeds, we received $3.9 million in proceeds from the exercise
of stock options, offset by: (i) payment of approximately $2.4 million to JA&A
to repurchase 601,218 shares underlying an outstanding option to purchase shares
of our Common Stock, as discussed below, (ii) scheduled principal payments of
$11.3 million on our long-term debt, (iii) an additional net pay down of $21.5
million of our New Revolving Credit Facility and (iv) an additional payment of
$1.7 million in financing costs related to the issuance of the Senior Notes and
the establishment of the New Revolving Credit Facility.
The Senior Notes mature on February 15, 2009 and do not require any prepayments
of principal prior to maturity. Interest on the Senior Notes accrues from
February 15, 2002, and is payable semi-annually on February 15 and August 15 of
each year, commencing August 15, 2002. Payment of principal and interest on the
Senior Notes is guaranteed on a senior unsecured basis by all of our current and
future domestic subsidiaries. On and after February 15, 2006, we may redeem all
or part of the Senior Notes at 105.188% of principal amount during the 12 month
period commencing on February 15, 2006, at 102.594% of principal amount if
redeemed during the 12-month period commencing on February 15, 2007, and at 100%
of principal
33
amount if redeemed on or after February 15, 2008. Before February 15, 2005, we
may redeem up to 35% of the aggregate principal amount of the Senior Notes at a
redemption price of 110.375% of the principal amount thereof, plus interest,
with the cash proceeds of certain equity offerings, provided that at least 65%
of the aggregate principal amount of Senior Notes remains outstanding after the
redemption. Upon the occurrence of certain specified change of control events,
unless we have exercised our option to redeem all the Senior Notes and Senior
Subordinated Notes as described above, each holder of a Senior Note will have
the right to require us to repurchase all or a portion of such holder's Senior
Notes at a purchase price in cash equal to 101% of the principal amount, plus
accrued and unpaid interest, if any, to the date of repurchase. The terms of the
Senior Notes, Senior Subordinated Notes, and the New Revolving Credit Facility
limit our ability to, among other things, incur additional indebtedness, create
liens, pay dividends on or redeem capital stock, make certain investments, make
restricted payments, make certain dispositions of assets, engage in transactions
with affiliates, engage in certain business activities and engage in mergers,
consolidations and certain sales of assets.
On May 13, 2002, we commenced an offer to exchange the privately-placed,
unregistered Senior Notes with new Senior Notes that had been registered under
the Securities Act of 1933, as amended, on our Registration Statement on Form
S-4 filed with the Securities and Exchange Commission. The exchange offer
expired on June 11, 2002. All of the previously issued unregistered Senior Notes
were exchanged for registered Senior Notes. The new notes are substantially
identical to the previously issued unregistered notes except that the new notes
are free of the transfer restrictions that applied to the unregistered notes.
The New Revolving Credit Facility, which was provided by a syndicate of banks
and other financial institutions led by BNP Paribas, is a senior secured
revolving credit facility providing for loans of up to $75.0 million and will
terminate on February 15, 2007. Borrowings under the New Revolving Credit
Facility will bear interest, at our option, at an annual rate equal to LIBOR
plus a variable margin rate or the Base Rate (as defined in the New Revolving
Credit Facility) plus a variable margin rate. In each case, the variable margin
rate is subject to adjustments based on financial performance. At December 31,
2002, the interest rates have been adjusted to LIBOR plus 3.00% or the Base Rate
plus 2.00%. Our obligations under the New Revolving Credit Facility are
guaranteed by our subsidiaries and are secured by a first priority perfected
security interest in our subsidiaries' shares, all of our assets and all of the
assets of our subsidiaries. We can prepay borrowings under the New Revolving
Credit Facility at any time without premium or penalty. The New Revolving Credit
Facility requires compliance with various financial covenants, including a
minimum consolidated interest coverage ratio, minimum consolidated EBITDA, a
maximum total leverage ratio, a maximum senior secured leverage ratio and a
minimum fixed charge coverage ratio, as well as other covenants. EBITDA is
defined as net income (loss) before interest, taxes, depreciation and
amortization, and unusual charges consisting of impairment loss on assets held
for sale, and integration, impairment, restructuring, and performance
improvement costs. As of December 31, 2002, we were in compliance with these
covenants. EBITDA is not a measure of performance under GAAP. We assess, on a
quarterly basis, our compliance with these covenants and monitor any matters
critical to continue our compliance. The New Revolving Credit Facility contains
customary events of default and is subject to various mandatory prepayments and
commitment reductions.
During the fourth quarter of 2001, we approved for payment two invoices from
JA&A for success fees. In accordance with our contract with JA&A, the invoices
were satisfied by the payment of $1.1 million in cash and the issuance of a
nonqualified option to purchase approximately 1.2 million shares of our common
stock
34
at an exercise price of $1.40 per share. The option was valued using a
Black-Scholes option-pricing model, and an expense of $4.8 million was recorded.
On July 23, 2002, we agreed to repurchase 601,218 of the shares underlying such
previously granted option for a payment of $3.98 per share, or a total of $2.4
million, which was paid during the third quarter of 2002 and recorded as a
reduction in additional paid-in capital. On July 23, 2002, our common stock
opened for trading at $12.00 per share. In accordance with our agreement with
JA&A, we filed a Registration Statement on Form S-3 with the Securities and
Exchange Commission to register the remaining 601,218 shares underlying the
outstanding option in order to permit JA&A to sell the shares of our stock that
it may acquire upon exercise of the option. JA&A also agreed to permanently
amend its contract with us so that the payment of future success fees, if any,
would be made only in cash. We concluded our relationship with JA&A in 2002
without the payment of any additional success fees.
We believe that, based on current levels of operations and anticipated growth,
cash generated from operations, together with other available sources of
liquidity, including borrowings available under the New Revolving Credit
Facility, will be sufficient for the foreseeable future to fund anticipated
capital expenditures and make required payments of principal and interest on our
debt, including payments due on the Senior Notes and obligations under the New
Revolving Credit Facility. In addition, we continually evaluate potential
acquisitions and expect to fund such acquisitions from our available sources of
liquidity, as discussed above.
Contractual Obligations and Commercial Commitments
The following table sets forth our contractual obligations and commercial
commitments as of December 31, 2002:
Payments Due by Period (000s)
-----------------------------------------------------------------------
Total 2003 2004 2005 2006 2007 Thereafter
-----------------------------------------------------------------------
Long-term debt 374,884 5,181 1,823 920 601 15,605 350,754
Interest on long-term debt 218,714 35,467 35,197 35,070 35,008 34,126 43,846
Redeemable preferred stock 128,726 - - - - - 128,726
Operating leases 72,945 21,663 17,161 12,859 8,612 5,357 7,293
Unconditional purchase
commitments (1) 35,436 8,500 9,500 8,718 8,718 - -
Other long-term obligations 3,533 1,940 806 343 167 107 170
-----------------------------------------------------------------------
Total contractual cash
obligations $834,238 $72,751 $64,487 $57,910 $53,106 $55,195 $ 530,789
=======================================================================
(1) We entered into a Supply Agreement with USMC, under which we agreed to purchase certain products
and components for use solely by our patient-care centers during a five-year period following
the date of the agreement.
35
Selected Operating Data
The following table sets forth selected operating data as of the end of the
years indicated:
2002 2001 2000 1999 1998
----------------------------------------
Patient-care centers 583 597 620 617 256
Certified practitioners 872 867 888 962 321
Number of states (including D.C.) 45 45 45 42 31
Same-center net sales growth (1) 4.6% 6.8% 6.0% 4.1% 11.1%
(1) Represents the aggregate increase or decrease of our patient-care centers'
sales in the current year compared to the preceding year.
Market Risk
We are exposed to the market risk that is associated with changes in interest
rates. To manage that risk, in March 2002, we entered into interest rate swaps
to modify our exposure to interest rate movements and reduce borrowing costs. We
entered into $100.0 million fixed-to-floating interest rate swaps, consisting of
floating rate instruments benchmarked to LIBOR. We are exposed to potential
losses in the event of nonperformance by the counterparties to the swap
agreements.
Critical Accounting Estimates
Our analysis and discussion of our financial condition and results of operations
are based upon our Consolidated Financial Statements that have been prepared in
accordance with generally accepted accounting principles in the United States
("U.S. GAAP"). The preparation of financial statements in conformity with U.S.
GAAP requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. U.S. GAAP provides the
framework from which to make these estimates, assumptions and disclosures. We
have chosen accounting policies within U.S. GAAP that management believes are
appropriate to accurately and fairly report our operating results and financial
position in a consistent manner. Management regularly assesses these policies in
light of current and forecasted economic conditions. Our accounting policies are
stated in Note B to the Consolidated Financial Statements as presented elsewhere
in this Annual Report on Form 10-K. We believe the following accounting policies
are critical to understanding the results of operations and affect the more
significant judgments and estimates used in the preparation of the consolidated
financial statements.
o Revenue Recognition: Revenues on the sale of orthotic and prosthetic
devices and associated services to patients are recorded when the device is
accepted by the patient. Revenues on the sale of orthotic and prosthetic
devices to customers by our distribution segment are recorded upon the
shipment of products, in accordance with the terms of the invoice. Revenue
is recorded at its net realizable value taking into consideration all
governmental and contractual adjustments and discounts. Deferred revenue
represents both deposits made prior to the final fitting and acceptance by
the patient and unearned service contract revenue. Subsequent to billing
for our devices and services, disallowed sales may result if there are
problems with pre-authorization or with other insurance coverage issues
with third party payors. If these problems occur, they are recognized as
reductions in sales. Other revenue may be uncollectible, even if properly
pre-authorized and billed. In the cases when valid
36
revenue cannot be collected, a bad debt expense is recognized. In addition
to the actual bad debt expense encountered during collection activities, we
estimate the amount of potential bad debt expense that may occur in the
future as we collect our receivables. This estimate is based upon our
historical experience as well as a detailed review of our receivable
balances.
o Inventories: Inventories, which consist principally of purchased parts and
work in process, are stated at the lower of cost or market using the
first-in, first-out (FIFO) method. We calculate cost of goods sold in
accordance with the gross profit method. We base the estimates used in
applying the gross profit method on the actual results of the most recently
completed fiscal year and other factors affecting cost of goods sold during
the current reporting periods. Estimated cost of goods sold during the
period is adjusted when the annual physical inventory is taken. In 2000 and
2001, unfavorable and favorable (respectively) adjustments were made in the
fourth quarter as a result of completing the physical inventory. In 2002,
virtually no adjustment was required in the fourth quarter as we were more
accurately estimating our cost of goods sold throughout the year.
Management adjusts our reserve for inventory obsolescence whenever the
facts and circumstances indicate that the carrying cost of certain
inventory items is in excess of its market price.
o Intangible Assets: Excess cost over net assets acquired ("Goodwill")
represents the excess of purchase price over the value assigned to net
identifiable assets of purchased businesses. The assembled workforce
intangibles meet the criteria of "Indefinite-lived" intangibles which, in
accordance with the provisions of SFAS No. 141, have been reclassified as
Goodwill and are no longer being amortized as of January 1, 2002. We assess
Goodwill for impairment when events or circumstances indicate that the
carrying value may not be recoverable, or, at a minimum, annually as
required by SFAS No. 142. Any impairment would be recognized by a charge to
operating results and a reduction in the carrying value of the intangible
asset. We completed the annual impairment test as of October 1, 2002, which
did not result in the impairment of Goodwill. This assessment included
assumptions regarding estimated future cash flows, discount rates and other
factors.
Non-compete agreements are recorded based on agreements entered into by us
and are amortized over their terms ranging from 5 to 7 years using the
straight-line method. Other definite-lived intangible assets are recorded
at cost and are amortized over their estimated useful lives of up to 16
years using the straight-line method. Whenever the facts and circumstances
indicate that the carrying amounts of these intangibles may not be
recoverable, management reviews and assesses the future cash flows expected
to be generated from the related intangible for possible impairment. Any
impairment would be recognized as a charge to operating results and a
reduction in the carrying value of the intangible asset.
o Deferred Tax Assets(Liabilities): We account for certain income and expense
items differently for financial accounting purposes than for income tax
purposes. Deferred income taxes are provided in recognition of these
temporary differences. We recognize, in accordance with SFAS No. 109
deferred tax assets if it is more likely than not the assets will be
realized in future years.
37
New Accounting Standards
In August 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets ("SFAS No. 144"). SFAS No. 144
supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets to
be Disposed of, and changes the criteria that have to be met to classify an
asset as held-for-sale, and redefines the reporting of discontinued operations.
We adopted SFAS No. 144 for the fiscal year beginning January 1, 2002. There was
no material effect upon adoption of this statement.
In April 2002, the FASB issued Statement of Financial Accounting Standards No.
145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections ("SFAS No. 145"). Under SFAS No.
145, gains and losses from the early extinguishment of debt will no longer be
extraordinary items, unless they satisfied the criteria in Accounting Principles
Board Opinion No. 30 ("APB 30") where extraordinary items are stated to be
distinguishable by their unusual nature and by the infrequency of their
occurrence. Any gain or loss on extinguishment of debt that was classified as an
extraordinary item in prior periods presented that does not meet the criteria in
APB 30 for classification as an extraordinary item shall be reclassified. In
addition, under SFAS No. 145, certain lease modifications that have economic
effects similar to sale-leaseback transactions be accounted for in the same
manner as sale-leaseback transactions. SFAS No. 145 is effective for fiscal
years beginning after May 15, 2002. SFAS No. 145 was adopted by us on January 1,
2003 and will result in a reclassification of existing extraordinary losses on
the early extinguishment of debt from an extraordinary item to a non-operating
item.
In July 2002, the FASB issued Statement of Financial Accounting Standards No.
146, Accounting for Costs Associated with Exit or Disposal Activities ("SFAS No.
146"). Under SFAS No. 146, costs associated with exit or disposal activities
would be recognized when they are incurred rather than at the date of a
commitment to an exit or disposal plan. Such costs would include lease
termination costs and certain employee severance costs that are associated with
a restructuring, discontinued operation, plant closing, or other exit or
disposal activity. SFAS No. 146 is to be applied prospectively to exit or
disposal activities initiated after December 31, 2002. We do not expect SFAS No.
146 to have a material effect on our financial statements.
In December 2002, the FASB issued Statement of Financial Accounting Standards
No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, an
amendment of SFAS Statement No. 123 ("SFAS No. 148"). SFAS No. 148 amends SFAS
No. 123, Accounting for Stock-Based Compensation, to provide alternative methods
of transition for a voluntary change to the fair value based method of
accounting for stock-based compensation. We continue to use the
intrinsic-value-based method of accounting for stock-based employee compensation
as prescribed by APB Opinion No. 25. See Note B to the Consolidated Financial
Statements for the disclosures required by this standard at December 31, 2002.
In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to
require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. We adopted the disclosure
provisions of SFAS No. 148 as of December 31, 2002. The adoption had no material
impact on our financial statements.
In November 2002, the FASB issued FASB Interpretation No. 45, Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others ("FIN 45"). FIN 45 requires that, upon
issuance of a guarantee, a guarantor must recognize a liability for the fair
38
value of an obligation assumed under a guarantee. FIN 45 also requires
additional disclosures by a guarantor in its interim and annual financial
statements about the obligations associated with guarantees issued. The
recognition provisions of FIN 45 are effective for any guarantees that are
issued or modified after December 31, 2002. The disclosure requirements will be
effective for our quarter ended March 31, 2003. Management believes the adoption
of this statement will not have a material effect on our financial statements.
Other
Inflation has not had a significant effect on our operations, as increased costs
to us generally have been offset by increased prices of products sold.
39
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
We have existing obligations relating to our Senior Notes, 11 1/4% Senior
Subordinated Notes due 2009, subordinated seller notes, and Redeemable Preferred
Stock. We do not have cash flow exposure to changing interest rates on these
obligations because the interest and dividend rates of these securities are
fixed. However, as discussed below, we entered into two fixed-to-floating
interest rate swaps, in connection with the sale of our Senior Notes, whereby
the aggregate notional amount of the swaps equaled one-half, or $100 million, of
the principal amount of the Senior Notes.
We have a $75 million revolving line of credit, with an outstanding balance of
$15 million at December 31, 2002, as discussed in Note H to our Consolidated
Financial Statements. The rates at which interest accrues under the entire
outstanding balance are variable.
In addition, in the normal course of business, we are exposed to fluctuations in
interest rates. We address this risk by using interest rate swaps from time to
time. At December 31, 2001 there were no interest rate swaps outstanding. In
March 2002, we entered into two fixed-to-floating interest rate swaps with an
aggregate notional amount of $100 million in connection with the sale of our
Senior Notes, as discussed in Note H. Variable rate debt and fixed-to-floating
interest rate swaps subject us to cash flow exposure resulting from changing
interest rates, as illustrated in the table below.
Presented below is an analysis of our financial instruments as of December 31,
2002 that are sensitive to changes in interest rates. The table demonstrates the
change in cash flow related to the Senior Notes, as affected by the related
fixed-to-floating interest rate swaps, and the outstanding balance under the New
Revolving Credit Facility, calculated for an instantaneous parallel shift in
interest rates, plus or minus 50 basis points ("BPS"), 100 BPS, and 150 BPS.
Annual Interest Expense Given an No Change Annual Interest Expense Given an
Interest Rate Decrease of X Basis in Interest Interest Rate Increase of X Basis
Cash Flow Risk Points Rates Points
- ------------------------------ ----------------------------------- ----------- ----------------------------------
(in thousands) (150 BPS) (100 BPS) (50 BPS) Fair Value 50 BPS 100 BPS 150 BPS
----------- ----------- ----------- ----------- ------ --------- ----------
Senior Notes (as affected by
related interest-rate swaps) $15,548 $ 16,048 $ 16,548 $ 17,048 $ 17,548 $ 18,048 $ 18,548
Revolving Credit Facility $ 440 $ 515 $ 590 $ 665 $ 740 $ 815 $ 890
-------------------------------------------------------------------------------------
$15,988 $ 16,563 $ 17,138 $ 17,713 $ 18,288 $ 18,863 $ 19,438
=====================================================================================
40
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The consolidated financial statements and schedules required hereunder and
contained herein are listed under Item 15(a) below.
Quarterly Financial Data
Quarter Ended
--------------------------------------------
2001 March 31 June 30 Sept. 30 Dec. 31
-------- -------- -------- --------
Net Sales $120,573 $129,187 $129,605 $128,688
Gross Profit 57,599 65,753 67,999 75,834
Net Income (Loss) (1) 132 (4,741) (17) (4,257)
Diluted per Common Share Data Net Loss (2) $ (0.06) $ (0.31) $ (0.07) $ (0.29)
Quarter Ended
--------------------------------------------
2002 March 31 June 30 Sept. 30 Dec. 31
-------- -------- -------- --------
Net Sales $123,510 $133,056 $133,980 $134,988
Gross Profit 63,973 71,758 74,009 74,422
Net Income before extraordinary item 4,333 7,671 7,830 6,547
Extraordinary item (2,811) - - -
Net Income (1) 1,522 7,671 7,830 6,547
Diluted per Common Share Data Income before Extraordinary Item 0.14 0.29 0.30 0.24
Extraordinary Item, net of tax benefit (0.13) - - -
Diluted per Common Share Data Net Income (2) $ 0.01 $ 0.29 $ 0.30 $ 0.24
(1) During the fourth quarter of 2001, we recorded a credit of approximately
$4.2 million related to the book to physical adjustment of inventory.
Management considers this charge to be a change in estimate in accordance
with the provisions of Accounting Principles Board Opinion No. 20.
(2) Excludes the effect of the conversion of the 7% Redeemable Convertible
Preferred Stock into 4.6 million shares of Common Stock as it is considered
anti-dilutive. For 2001, excludes the effect of all dilutive options and
warrants as a result of our net loss for the years ended December 31, 2001.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
41
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Pursuant to General Instruction G(3) of Form 10-K, the information called
for by this item regarding directors is hereby incorporated by reference from
our definitive proxy statement or amendment hereto to be filed pursuant to
Regulation 14A not later than 120 days after the end of the fiscal year covered
by this report. Information regarding our executive officers is set forth under
Item 4A of this Form 10-K.
ITEM 11. EXECUTIVE COMPENSATION.
Pursuant to General Instruction G(3) of Form 10-K, the information called
for by this item is hereby incorporated by reference from our definitive proxy
statement or amendment hereto to be filed pursuant to Regulation 14A not later
than 120 days after the end of the fiscal year covered by this report.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
Pursuant to General Instruction G(3) of Form 10-K, the information called
for by this item is hereby incorporated by reference from our definitive proxy
statement or amendment hereto to be filed pursuant to Regulation 14A not later
than 120 days after the end of the fiscal year covered by this report.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Pursuant to General Instruction G(3) of Form 10-K, the information called
for by this item is hereby incorporated by reference from our definitive proxy
statement or amendment hereto to be filed pursuant to Regulation 14A not later
than 120 days after the end of the fiscal year covered by this report.
ITEM 14. CONTROLS & PROCEDURES
Based upon an evaluation within the 90 days prior to the filing date of
this report, the Company's Chief Executive Officer and Chief Financial Officer
have concluded that the Company's disclosure controls and procedures are
effective. There have been no significant changes in the Company's internal
controls or in other factors that could significantly affect the Company's
internal controls subsequent to the date of the evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
42
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K.
(a) Financial Statements and Financial Statement Schedule:
(1) Financial Statements:
Hanger Orthopedic Group, Inc.
- ----------------------------
Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 2002 and 2001
Consolidated Statements of Operations for the Three Years Ended December 31,
2002
Consolidated Statements of Changes in Shareholders' Equity for the Three Years
Ended December 31, 2002
Consolidated Statements of Cash Flows for the Three Years Ended December 31,
2002
Notes to Consolidated Financial Statements
(2) Financial Statements Schedule:
Report of Independent Accountants
Schedule II - Valuation and qualifying accounts
All other schedules are omitted either because they are not applicable or
required, or because the required information is included in the financial
statements or notes thereto:
(b) Reports on Form 8-K:
No Current Report on Form 8-K was filed during the quarter ended December 31,
2002.
43
(c) Exhibits: The following exhibits are filed herewith or incorporated
herein by reference:
Exhibit No. Document
- ----------- --------
3(a) Certificate of Incorporation, as amended, of the Registrant.
(Incorporated herein by reference to Exhibit 3.1 to the
Registrant's Annual Report on Form 10-K for the fiscal year
ended September 30, 1988.)
3(b) Certificate of Amendment of the Registrant's Certificate of
Incorporation (which, among other things, changed the
Registrant's corporate name from Sequel Corporation to Hanger
Orthopedic Group, Inc.), as filed on August 11, 1989 with the
Office of the Secretary of State of Delaware. (Incorporated
herein by reference to Exhibit 3(b) to the Registrant's
Current Report on Form 10-K dated February 13, 1990.)
3(c) Certificate of Agreement of Merger of Sequel Corporation and
Delaware Sequel Corporation. (Incorporated herein by reference
to Exhibit 3.1(a) to the Registrant's Annual Report on Form
10-K for the fiscal year ended September 30, 1988.)
3(d) Certificate of Ownership and Merger of Hanger Acquisition
Corporation and J. E. Hanger, Inc. as filed with the Office of
the Secretary of the State of Delaware on April 11, 1989.
(Incorporated herein by reference to Exhibit 2(f) to the
Registrant's Current Report on Form 8-K dated May 15, 1989.)
3(e) Certificate of Designation, Preferences and Rights of
Preferred Stock of the Registrant as filed on February 12,
1990 with the Office of the Secretary of State of Delaware.
(Incorporated herein by reference to Exhibit 3(a) to the
Registrant's Current Report on Form 8-K dated February 13,
1990.)
3(f) Certificate of Amendment to Certificate of Incorporation of
the Registrant, as filed with the Secretary of State of
Delaware on September 16, 1999. (Incorporated herein by
reference to Exhibit 3 to the Registrant's Quarterly Report on
Form 10-Q for the quarter ended September 30, 1999.)
3(g) Certificate of Designation, Rights and Preferences of 7%
Redeemable Preferred Stock as filed with the Office of the
Secretary of State of Delaware on June 28, 1999. (Incorporated
herein by reference to Exhibit 2(b) to the Registrant's
Current Report of Form 8-K dated July 1, 1999.)
3(h) Certificate of Elimination of Class A, B, C, D, E and F
Preferred Stock of the Registrant as filed with the Office of
the Secretary of State of Delaware on June 18, 1999.
(Incorporated herein by reference to Exhibit 2(c) to the
Registrant's Current Report on Form 8-K dated July 1, 1999.)
3(i) By-Laws of the Registrant, as amended. (Incorporated herein by
reference to Exhibit 3 to the Registrant's Current Report on
Form 8-K dated May 15, 1989.)
44
10(a) Registration Agreement, dated May 15, 1989, between Sequel
Corporation, First Pennsylvania Bank, N.A., Gerald E. Bisbee,
Jr., Ivan R. Sabel, Richard A. Stein, Ronald J. Manganiello,
Joseph M. Cestaro and Chemical Venture Capital Associates.
(Incorporated herein by reference to Exhibit 10(l) to the
Registrant's Current Report on Form 8-K dated May 15, 1989.)
10(b) First Amendment dated as of February 12, 1990, to the
Registration Agreement, dated as of May 15, 1989, by and among
Hanger Orthopedic Group, Inc., First Pennsylvania Bank, N.A.,
Ivan R. Sabel, Richard A. Stein, Ronald J. Manganiello, Joseph
M. Cestaro and Chemical Venture Capital Associates.
(Incorporated herein by reference to Exhibit 10(m) to the
Registrant's Current Report on Form 8-K dated February 13,
1990.)
10(c) Fifth Amendment, dated as of November 8, 1990, to the Stock
and Note Purchase Agreement, dated as of February 28, 1989 and
as amended on May 9, 1989, May 15, 1989, February 12, 1990,
and June 19, 1990 by and among J. E. Hanger, Inc., as
successor to Hanger Acquisition Corporation, Ronald J.
Manganiello, Joseph M. Cestaro, Chemical Venture Capital
Associates and Chemical Equity Associates. (Incorporated
herein by reference to Exhibit 10(f) to the Registrant's
Current Report on Form 8-K filed on November 21, 1990.)
10(d) Form of Stock Option Agreements, dated as of August 13, 1990,
between Hanger Orthopedic Group, Inc. and Thomas P. Cooper,
James G. Hellmuth, Walter F. Abendschein, Jr., Norman Berger,
Bruce B. Grynbaum and Joseph S. Torg. (Incorporated herein by
reference to Exhibit 10(rrr) to the Registrant's Registration
Statement on Form S-2, File No. 33-37594.) *
10(e) Warrants to purchase Common Stock of Hanger Orthopedic Group,
Inc. issued November 1, 1996. (Incorporated herein by
reference to Exhibit 10(c) to the Registrant's Current Report
on Form 8-K filed on November 12, 1996.)
10(f) 1991 Stock Option Plan of the Registrant, as amended through
September 16, 1999. (Incorporated herein by reference to
Exhibit 4(a) to the Registrant's Proxy Statement, dated July
28, 1999, relating to the Registrant's Annual Meeting of
Stockholders held on September 8, 1999.)*
10(g) 1993 Non-Employee Directors Stock Option Plan of the
Registrant. (Incorporated herein by reference to Exhibit 4(b)
to the Registrant's Registration Statement on Form S-8 (File
No. 33-63191).)*
10(h) Employment and Non-Compete Agreement, dated as of November 1,
1996, and Amendment No. 1 thereto, dated January 1, 1997,
between the Registrant and H.E. Thranhardt. (Incorporated
herein by reference to Exhibit 10(p) to the Registrant's
Annual Report on Form 10-K for the year ended December 31,
1997.)*
45
10(i) Employment and Non-Compete Agreement, dated as of November 1,
1996, between the Registrant and John McNeill. (Incorporated
herein by reference to Exhibit 10(q) to the Registrant's
Annual Report on Form 10-K for the year ended December 31,
1997.)*
10(j) Asset Purchase Agreement, dated as of March 26, 1997, by and
between Hanger Prosthetics & Orthotics, Inc., Acor
Orthopaedic, Inc., and Jeff Alaimo, Greg Alaimo and Mead
Alaimo. (Incorporated by reference to Exhibit 2 to the Current
Report on Form 8-K filed by the Registrant on April 15, 1997.)
10(k) Asset purchase Agreement, dated as of May 8, 1997, by and
between Hanger Prosthetics & Orthotics, Inc., Fort Walton
Orthopedic, Inc., Mobile Limb and Brace, Inc. and Frank
Deckert, Ronald Deckert, Thomas Deckert, Robert Deckert and
Charles Lee. (Incorporated by reference to Exhibit 2 to the
Current Report on Form 8-K filed by the Registrant on June 5,
1997.)
10(l) Asset Purchase Agreement, dated as of November 3, 1997, by and
between Hanger Prosthetics & Orthotics, Inc., Morgan
Prosthetic-Orthotics, Inc. and Dan Morgan. (Incorporated
herein by reference to Exhibit 10(v) to the Registrant's
Annual Report on Form 10-K for the year ended December 31,
1997.)
10(m) Asset Purchase Agreement, dated as of December 23, 1997, by
and between Hanger Prosthetics & Orthotics, Inc., Harshberger
Prosthetic & Orthotic Center, Inc., Harshberger Prosthetic &
Orthotic Center of Mobile, Inc., Harshberger Prosthetic &
Orthotic Center of Florence, Inc., FAB-CAM, Inc. and Jerald J.
Harshberger. (Incorporated herein by reference to Exhibit
10(w) to the Registrant's Annual Report on Form 10-K for the
year ended December 31, 1997.)
10(n) Stock Purchase Agreement, dated as of April 2, 1999, by and
among NovaCare, Inc., NC Resources, Inc., the Registrant and
HPO Acquisition Corporation, Amendment No. 1 thereto, dated as
of May 19, 1999, and Amendment No. 2 thereto, dated as of June
30, 1999. (Incorporated herein by reference to Exhibit 2(a) to
the Registrant's Current Report on Form 8-K dated July 15,
1999.)
10(o) Indenture, dated as of June 16, 1999, among the Registrant,
its subsidiaries and U.S. Bank Trust National Association, as
Trustee. (Incorporated herein by reference to Exhibit 10(a) to
the Registrant's Current Report on Form 8-K dated July 1,
1999.)
10(p) Form of First Supplemental Indenture, dated as of August 12,
1999, to Indenture, dated as of June 16, 1999, among the
Registrant, its subsidiaries and U.S. Bank Trust National
Association, as Trustee. (Filed with original Registration
Statement on Form S-4 on August 12, 1999.)
10(q) Credit Agreement, dated as of June 16, 1999, among the
Registrant, various bank lenders, and The Chase Manhattan
Bank, as administrative agent, collateral agent and issuing
bank, Chase Securities Inc., as lead arranger and book
manager, Bankers Trust Company, as syndication agent, and
Paribas, as documentation agent. (Incorporated
46
herein by reference to Exhibit 10(a) to the Registrant's
Current Report on Form 8-K dated July 1, 1999.)
10(r) Senior Subordinated Note Purchase Agreement, dated as of June
9, 1999, relating to 11.25% Senior Subordinated Notes due
2009, among the Registrant, Deutsche Banc Securities Inc.,
Chase Securities Inc. and Paribas Corporation. (Incorporated
herein by reference to Exhibit 10(b) to the Registrant's
Current Report on Form 8-K dated July 1, 1999.)
10(s) Registration Rights Agreement, dated as of June 16, 1999, by
and among the Registrant, Deutsche Banc Securities, Inc.,
Chase Securities Inc. and Paribas Corporation, relating to the
11.25% Senior Subordinated Notes due 2009. (Incorporated
herein by reference to Exhibit 10(d) to the Registrant's
Current Report on Form 8-K dated July 1, 1999.)
10(t) Securities Purchase Agreement, dated as of June 16, 1999,
Relating to 7% Redeemable Preferred Stock, among the
Registrant, Chase Equity Associates, L.P. and Paribas North
America, Inc. (Incorporated herein by reference to Exhibit
10(e) to the Registrant's Current Report on Form 8-K dated
July 1, 1999.)
10(u) Investor Rights Agreement, dated July 1, 1999, among the
Registrant, Chase Equity Associates, L.P. and Paribas North
America, Inc. (Incorporated herein by reference to Exhibit
10(f) to the Registrant's Current Report on Form 8-K dated
July 1, 1999.)
10(v) Purchase Agreement, dated as of February 8, 2002, among Hanger
Orthopedic Group, Inc., the guarantors signatory thereto,
Lehman Brothers Inc., J.P. Morgan Securities Inc., Salomon
Smith Barney Inc. and BNP Paribas Securities Corp.
(Incorporated herein by reference to Exhibit 1 to the
Registrant's Current Report on Form 8-K dated February 15,
2002.)
10(w) Indenture, dated as of February 15, 2002, among Hanger
Orthopedic Group, Inc., the Subsidiary Guarantors and
Wilmington Trust Company as trustee, relating to the 10 3/8%
Senior Notes due 2009. (Incorporated herein by reference to
Exhibit 4(a) to the Registrant's Current Report on Form 8-K
dated February 15, 2002.)
10(x) Registration Rights Agreement, dated as of February 15, 2002,
among Hanger Orthopedic Group, Inc., the guarantors signatory
thereto, Lehman Brothers Inc., J.P. Morgan Securities Inc.,
Salomon Smith Barney Inc. and BNP Paribas Securities Corp.
(Incorporated herein by reference to Exhibit 4(b) to the
Registrant's Current Report on Form 8-K dated February 15,
2002.)
10(y) Credit Agreement, dated as of February 15, 2002, among Hanger
Orthopedic Group, Inc., BNP Paribas Securities Corp. as
administrative agent, and various other lenders. (Incorporated
herein by reference to Exhibit 10 to the Registrant's Current
Report on Form 8-K dated February 15, 2002.)
47
10(z) Employment Agreement, dated as of April 29, 1999, between the
Registrant and Ivan R. Sabel. (Incorporated herein by
reference to Exhibit 10(r) to the Registrant's Registration
Statement on Form S-4 (File No. 333-85045).)*
10(aa) Employment Agreement, dated as of July 1, 1999, between the
Registrant and Rick Taylor. (Incorporated herein by reference
to Exhibit 10(u) to the Registrant's Registration Statement on
Form S-4 (File No. 333-85045).)*
10(bb) Employment Agreement, dated as of November 1, 1996, between
the Registrant and Ron May. (Incorporated herein by reference
to Exhibit 10(w) to the Registrant's Registration Statement on
Form S-4 (File No. 333-85045).)*
10(cc) Employment Agreement, dated as of August 29, 2001, between the
Registrant and George McHenry. (Incorporated herein by
reference to Exhibit 10 (cc) to the Registrant's Annual Report
on Form 10-K for the year ended December 31, 2001.)*
10(dd) Employment Agreement, dated as of January 2, 2002, between the
Registrant and Thomas Kirk. (Incorporated herein by reference
to Exhibit 10 (dd) to the Registrant's Annual Report on Form
10-K for the year ended December 31, 2001.)*
10(ee) 2002 Stock Option Plan of the Registrant. (Incorporated herein
by reference to Exhibit A to the Registrant's Proxy Statement,
dated April 30, 2002, relating to the Registrant's Annual
Meeting of Stockholders held on May 30, 2002.
(File No. 001-10670).)*
21 List of Subsidiaries of the Registrant. (Filed herewith.)
23 Consent of PricewaterhouseCoopers LLP. (Filed herewith.)
99.1 Certificate of Chief Executive Officer. (Filed herewith.)
99.2 Certificate of Chief Financial Officer. (Filed herewith.)
- ------------------------
* Management contract or compensatory plan
48
I, Ivan R. Sabel, certify that:
1. I have reviewed this annual report on Form 10-K of Hanger Orthopedic
Group, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) Designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
c) Presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 25, 2003 /s/ Ivan R. Sabel
------------------------------------
Ivan R. Sabel, CPO
Chairman and Chief Executive Officer
49
I, George E. McHenry, certify that:
1. I have reviewed this annual report on Form 10-K of Hanger Orthopedic
Group, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) Designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
c) Presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 25, 2003 /s/ George E. McHenry
------------------------------------
George E. McHenry
Chief Financial Officer
50
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.
HANGER ORTHOPEDIC GROUP, INC.
Dated: March 25, 2003 By: /s/ Ivan R. Sabel
------------------------------------
Ivan R. Sabel, CPO
Chairman and Chief Executive Officer
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons, on behalf of the
Registrant and in the capacities and on the dates indicated.
Dated: March 25, 2003 /s/ Ivan R. Sabel
--------------------------------------
Ivan R. Sabel, CPO
Chairman and Chief Executive Officer and
Director (Principal Executive Officer)
Dated: March 25, 2003 /s/ George E. McHenry
--------------------------------------
George E. McHenry
Chief Financial Officer
(Principal Financial Officer)
Dated: March 25, 2003 /s/ Glenn M. Lohrmann
--------------------------------------
Glenn M. Lohrmann
Controller
(Chief Accounting Officer)
51
Dated:
--------------------------------------
Mitchell J. Blutt, M.D.
Director
Dated: March 25, 2003 /s/ Edmond E. Charrette
--------------------------------------
Edmond E. Charrette, M.D.
Director
Dated: March 25, 2003 /s/ Thomas P. Cooper
--------------------------------------
Thomas P. Cooper, M.D.
Director
Dated: March 27, 2003 /s/ Thomas F. Kirk
--------------------------------------
Thomas F. Kirk
Director
Dated: March 25, 2003 /s/ Eric Green
--------------------------------------
Eric Green
Director
Dated:
--------------------------------------
C. Raymond Larkin, Jr.
Director
Dated: March 27, 2003 /s/ Risa J. Lavizzo-Mourey, M.D.
--------------------------------------
Risa J. Lavizzo-Mourey, M.D.
Director
Dated: March 25, 2003 /s/ H.E. Thranhardt
--------------------------------------
H.E. Thranhardt, CPO
Director
52
INDEX TO FINANCIAL STATEMENTS
Hanger Orthopedic Group, Inc.
- -----------------------------
Report of Independent Accountants F-1
Consolidated Balance Sheets as of December 31, 2002
and 2001 F-2
Consolidated Statements of Operations for the Three
Years Ended December 31, 2002 F-4
Consolidated Statements of Changes in Shareholders'
Equity for the Three Years Ended December 31, 2002 F-5
Consolidated Statements of Cash Flows for the Three
Years Ended December 31, 2002 F-6
Notes to Consolidated Financial Statements F-7
Financial Statement Schedule
- ----------------------------
Schedule II - Valuation and Qualifying Accounts S-1
1
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and
Shareholders of Hanger Orthopedic Group, Inc.:
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15(a)(1) on page 43 present fairly, in all material
respects, the financial position of Hanger Orthopedic Group, Inc. and its
subsidiaries at December 31, 2002 and 2001, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2002, in conformity with accounting principles generally accepted in the
United States of America. In addition, in our opinion, the financial statement
schedule listed in the index appearing under Item 15(a)(2) on page 43 presents
fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements. These financial
statements and financial statement schedule are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements and financial statement schedule based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note B to the consolidated financial statements, the Company
adopted the Financial Accounting Standards Board Statement No. 142, (Goodwill
and Other Intangible Assets), effective January 1, 2002.
/s/ PRICEWATERHOUSECOOPERS LLP
PRICEWATERHOUSECOOPERS LLP
McLean, Virginia
February 27, 2003
F-1
HANGER ORTHOPEDIC GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share and per share amounts)
December 31,
---------------------------
2002 2001
---------- ---------
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 6,566 $ 10,043
Accounts receivable, less allowances for doubtful accounts
of $8,649 and $17,625 in 2002 and 2001, respectively 107,604 104,040
Inventories 56,454 55,946
Prepaid expenses, other assets, and income taxes receivable 15,432 4,901
Deferred income taxes 6,586 20,957
---------- ---------
Total current assets 192,642 195,887
---------- ---------
PROPERTY, PLANT AND EQUIPMENT
Land 3,743 4,078
Buildings 6,715 8,629
Machinery and equipment 17,110 15,670
Computer and software 17,990 13,005
Furniture and fixtures 10,353 9,967
Leasehold improvements 18,671 18,027
---------- ---------
74,582 69,376
Less accumulated depreciation and amortization 39,036 31,598
---------- ---------
35,546 37,778
---------- ---------
INTANGIBLE ASSETS
Excess cost over net assets acquired 453,988 445,686
Patents and other intangible assets, $10,232 and $10,124
less accumulated amortization of $4,404 and $3,430
in 2002 and 2001, respectively 5,828 6,694
---------- ---------
459,816 452,380
---------- ---------
OTHER ASSETS
Debt issuance costs, net 13,741 10,846
Other assets 10,481 3,016
---------- ---------
Total other assets 24,222 13,862
---------- ---------
TOTAL ASSETS $712,226 $ 699,907
========== =========
The accompanying notes are an integral part of the consolidated financial statements.
F-2
HANGER ORTHOPEDIC GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share and per share amounts)
December 31,
---------------------------
2002 2001
---------- ---------
LIABILITIES, REDEEMABLE PREFERRED STOCK
AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Current portion of long-term debt $ 5,181 $ 30,512
Accounts payable 14,876 16,901
Accrued expenses 5,460 8,196
Accrued interest payable 7,507 2,017
Accrued compensation related cost 32,950 29,045
---------- ---------
Total current liabilities 65,974 86,671
LONG-TERM LIABILITES
Long-term debt, less current portion 378,101 367,315
Deferred income taxes 22,965 26,495
Other liabilities 1,578 3,013
---------- ---------
Total liabilities 468,618 483,494
---------- ---------
PREFERRED STOCK
7% Redeemable Convertible Preferred stock, liquidation preference
$1,000 per share 75,941 70,739
---------- ---------
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY
Common stock, $.01 par value; 60,000,000 shares authorized,
20,277,180 shares and 19,057,876 shares issued and
outstanding in 2002 and 2001, respectively 203 191
Additional paid-in capital 150,287 146,674
Retained earnings (accumulated deficit) 17,833 (535)
---------- ---------
168,323 146,330
Treasury stock, cost (133,495 shares) (656) (656)
---------- ---------
167,667 145,674
---------- ---------
TOTAL LIABILITIES, REDEEMABLE PREFERRED STOCK
AND SHAREHOLDERS' EQUITY $ 712,226 $ 699,907
========== =========
The accompanying notes are an integral part of the consolidated financial statements.
F-3
HANGER ORTHOPEDIC GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31,
(Dollars in thousands, except share and per share amounts)
2002 2001 2000
----------- ----------- -----------
Net sales $ 525,534 $ 508,053 $ 486,031
Cost of goods sold (exclusive of depreciation and amortization) 241,372 240,868 251,368
----------- ----------- -----------
Gross profit 284,162 267,185 234,663
Selling, general and administrative 189,768 182,972 177,392
Depreciation and amortization 9,892 11,613 10,303
Amortization of excess cost over net assets acquired - 13,073 13,025
Unusual charges 1,860 24,438 2,364
----------- ----------- -----------
Income from operations 82,642 35,089 31,579
Interest expense, net 38,314 43,065 47,072
----------- ----------- -----------
Income (loss) before taxes 44,328 (7,976) (15,493)
Provision (benefit) for income taxes 17,947 907 (1,497)
----------- ----------- -----------
Income (loss) before extraordinary item 26,381 (8,883) (13,996)
Extraordinary loss on early extinguishment of debt,
net of tax benefit 2,811 - -
----------- ----------- -----------
Net income (loss) $ 23,570 $ (8,883) $ (13,996)
=========== =========== ===========
Income (loss) before extraordinary item applicable to common stock $ 21,179 $ ( 13,741) $ (18,534)
=========== =========== ===========
Net income (loss) applicable to common stock $ 18,368 $ (13,741) $ (18,534)
=========== =========== ===========
Basic Per Common Share Data
Income (loss) before extraordinary item applicable to common stock $ 1.08 $ (0.73) $ (0.98)
Extraordinary item, net of tax benefit (0.14) - -
----------- ----------- -----------
Net income (loss) applicable to common stock $ 0.94 $ (0.73) $ (0.98)
=========== =========== ===========
Shares used to compute basic per common share amounts 19,535,272 18,920,094 18,910,002
=========== =========== ===========
Diluted Per Common Share Data
Income (loss) before extraordinary item applicable to common stock $ 0.99 $ (0.73) $ (0.98)
Extraordinary item, net of tax benefit (0.13) - -
----------- ----------- -----------
Net income (loss) applicable to common stock $ 0.86 $ (0.73) $ (0.98)
=========== =========== ===========
Shares used to compute diluted per common share amounts 21,456,994 18,920,094 18,910,002
=========== =========== ===========
The accompanying notes are an integral part of the consolidated financial statements.
F-4
HANGER ORTHOPEDIC GROUP, INC
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
For the Three Years Ended December 31, 2002
(In thousands)
Retained
Additional Earnings
Common Common Paid in (Accumulated Treasury
Shares Stock Capital Deficit) Stock Total
-------- ------- --------- ---------- --------- ----------
Balance, December 31, 1999 18,910 $ 190 $ 146,498 $ 26,882 $ (656) $ 172,914
Preferred dividends declared - - - (4,464) - (4,464)
Accretion of Preferred Stock - - - (74) - (74)
Net loss - - - (13,996) - (13,996)
-------- ------- --------- ---------- --------- ----------
Balance, December 31, 2000 18,910 190 146,498 8,348 (656) 154,380
Preferred dividends declared - - (4,784) - - (4,784)
Accretion of Preferred Stock - - (74) - - (74)
Net loss - - - (8,883) - (8,883)
Issuance of Common Stock in
connection with the exercise
of stock options 77 - 250 - - 250
Issuance of stock options in
connection with Performance
Improvement Plan - - 4,785 - - 4,785
Issuance of Common Stock in
connection with the exercise
of warrants 71 1 (1) - - -
-------- ------- --------- ---------- --------- ----------
Balance, December 31, 2001 19,058 191 146,674 (535) (656) 145,674
Preferred dividends declared - - - (5,128) - (5,128)
Accretion of Preferred Stock - - - (74) - (74)
Net income - - - 23,570 - 23,570
Issuance of Common Stock in
connection with the exercise
of stock options 1,219 12 3,905 - - 3,917
Tax beneft associated with
exercise of stock options - - 2,101 - - 2,101
Repurchase of outstanding
stock options - - (2,393) - - (2,393)
-------- ------- --------- ---------- --------- ----------
Balance, December 31, 2002 20,277 $ 203 $ 150,287 $ 17,833 $ (656) $ 167,667
======== ======= ========= ========== ========= ==========
The accompanying notes are an integral part of the consolidated financial statements.
F-5
HANGER ORTHOPEDIC GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31,
(Dollars in thousands)
2002 2001 2000
-------- -------- --------
Cash flows from operating activities:
Net income (loss) $ 23,570 $ (8,883) $(13,996)
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
Extraordinary loss on early extinguishment of debt 2,811 - -
Loss on disposal of assets 1,036 7,997 -
Provision for bad debts 19,738 21,961 23,740
Depreciation and amortization 9,892 11,613 10,303
Amortization of excess cost over net assets acquired - 13,073 13,025
Amortization of debt issuance costs 2,307 2,747 2,436
Deferred income taxes 14,846 (328) (3,200)
Restructuring costs - 3,688 654
Stock-based compensation in connection with performance improvement plan - 4,785 -
Changes in assets and liabilities, net of effects of acquired companies:
Accounts receivable (22,632) (15,851) (31,089)
Inventories (306) 2,043 (1,113)
Prepaid expenses, other assets, and income taxes receivable (8,712) 6,543 259
Other assets 933 417 273
Accounts payable (1,960) 1,483 1,361
Accrued expenses, interest and income taxes 3,542 (12,278) 4,724
Accrued compensation related costs 3,905 11,798 (1,287)
Other liabilities (1,436) 358 (2,483)
-------- -------- --------
Net cash provided by operating activities 47,534 51,166 3,607
-------- -------- --------
Cash flows from investing activities:
Purchase of property, plant and equipment (9,112) (6,697) (9,845)
Acquisitions, net of cash acquired (10,407) (8,277) (9,958)
Cash received pursuant to purchase price adjustment - - 24,700
Proceeds from sale of certain assets, net of cash 1,507 16,079 -
Purchase of other intangible assets - - (273)
-------- -------- --------
Net cash provided by (used in) investing activities (18,012) 1,105 4,624
-------- -------- --------
Cash flows from financing activities:
Borrowings under revolving credit agreement 46,975 6,000 54,300
Repayments under revolving credit agreement (106,775) (15,900) (24,600)
Proceeds from sale of Senior Notes 200,000 - -
Repayment and termination of bank loans (153,587) (38,163) (8,250)
Scheduled repayment of long-term debt (11,306) (13,912) (13,521)
Increase in financing costs (9,830) (1,172) (1,226)
Proceeds from issuance of Common Stock 3,917 250 -
Repurchase of outstanding stock options (2,393) - -
-------- -------- --------
Net cash provided by (used in) financing activities (32,999) (62,897) 6,703
-------- -------- --------
Increase (decrease) in cash and cash equivalents (3,477) (10,626) 14,934
Cash and cash equivalents at beginning of year 10,043 20,669 5,735
-------- -------- --------
Cash and cash equivalents at end of year $ 6,566 $ 10,043 $ 20,669
======== ======== ========
The accompanying notes are an integral part of the consolidated financial statements.
F-6
HANGER ORTHOPEDIC GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A - THE COMPANY
Hanger Orthopedic Group, Inc. is the nation's largest owner and operator of
orthotic & prosthetic ("O&P") patient-care centers. In addition to providing O&P
patient-care services through its operating subsidiaries, the Company also
distributes components and finished patient-care products to the O&P industry
primarily in the United States. Hanger's subsidiary, Hanger Prosthetics &
Orthotics, Inc. formerly known as J.E. Hanger, Inc., was founded in 1861 by a
Civil War amputee and is the oldest company in the O&P industry in the United
States. Orthotics is the design, fabrication, fitting and supervised use of
custom-made braces and other devices that provide external support to treat
musculoskeletal disorders. Prosthetics is the design, fabrication and fitting of
custom-made artificial limbs.
NOTE B - SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries. All intercompany transactions and balances have
been eliminated.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities, disclosure of contingent
assets and liabilities at the date of the financial statements, and the reported
amounts of revenues and expenses during the reporting period. Actual results
could differ from those estimates.
Cash and Cash Equivalents
The Company considers all highly liquid investments with original maturities of
three months or less at the date of purchase to be cash equivalents. At various
times throughout the year, the Company maintains cash balances in excess of
Federal Deposit Insurance Corporation limits.
Credit Risk
The Company primarily provides customized O & P devices throughout the United
States and is reimbursed by the patients' third-party insurers or governmentally
funded health insurance programs. The Company performs ongoing credit
evaluations of its distribution customers. Accounts receivable are not
collateralized. The ability of the Company's debtors to meet their obligations
is dependent upon the financial stability of the insurers of the Company's
customers and future legislation and regulatory actions. Additionally, the
Company maintains reserves for potential losses from these receivables that
historically have been within management's expectations.
F-7
NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Inventories
Inventories, which consist principally of purchased parts and work in process,
are stated at the lower of cost or market using the first-in, first-out (FIFO)
method. The Company calculates cost of goods sold in accordance with the gross
profit method. The Company bases the estimates used in applying the gross profit
method on the actual results of the most recently completed fiscal year and
other factors affecting cost of goods sold during the current reporting periods.
Estimated cost of goods sold during the period is adjusted when the annual
physical inventory is taken. In the fourth quarter of 2002, 2001 and 2000, the
Company recorded book-to-physical adjustments as income (expense) of $0.2
million, $4.2 million, and $(9.6) million, respectively. The Company treated
these adjustments as changes in accounting estimates in accordance with the
provisions of Accounting Principles Board Opinion No. 20.
Property, Plant and Equipment
Property, plant and equipment are recorded at cost. The cost and related
accumulated depreciation of assets sold, retired or otherwise disposed of are
removed from the respective accounts, and any resulting gains or losses are
included in the statement of operations. Depreciation is computed for financial
reporting purposes using the straight-line method over the estimated useful
lives of the related assets as follows: machinery and equipment, furniture and
fixtures, and computers and software - 5 years; leasehold improvements - shorter
of the asset life or term of lease; and buildings - 10-20 years. In accordance
with SOP 98-1, Accounting for the Costs of Computer Software Developed or
Obtained for Intenal Use, the Company capitalizes certain internal and external
costs incurred in connection with the development of internal software. At
December 31, 2002, computers and software includes capitalized computer software
currently under development of $3.1 million. Depreciation expense was
approximately $8.9 million, $10.4 million and $9.0 million for the years ended
December 31, 2002, 2001 and 2000, respectively.
Intangible Assets
Effective July 1, 2001, the Company adopted certain provisions of Statement of
Financial Accounting Standards ("SFAS") 141, Business Combinations, and
effective January 1, 2002, the Company adopted the full provisions of SFAS 141
and SFAS 142, Goodwill and Other Intangible Assets.
SFAS 141 requires business combinations initiated after June 30, 2001 to be
accounted for using the purchase method of accounting, and broadens the criteria
for recording intangible assets apart from goodwill. The Company evaluated its
goodwill and intangibles acquired prior to June 30, 2001 using the criteria of
SFAS 141, which resulted in other intangibles with an unamortized balance of
$4.8 million (comprised entirely of assembled workforce intangibles) being
combined into goodwill at January 1, 2002.
SFAS 142 requires that purchased goodwill and certain indefinite-lived
intangibles no longer be amortized, but instead be tested for impairment at
least annually. The Company evaluated its intangible assets, other than
goodwill, and determined that all such assets have determinable lives.
F-8
NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Intangible Assets (continued)
SFAS 142 prescribes a two-phase process for impairment testing of goodwill. The
first phase, required to be completed by June 30, 2002, screened for impairment;
while the second phase (if necessary), required to be completed by December 31,
2002, measured the impairment. The Company has completed the transitional
impairment test, which did not result in the impairment of recorded goodwill. In
completing the analysis, the Company determined that it had two reporting units,
which were the same as its reportable segments: (i) patient-care centers and
(ii) distribution. The Company has completed the annual impairment test as of
October 1, 2002, which did not result in the impairment of recorded goodwill. As
of December 31, 2002, the patient-care center segment had goodwill of $454.0
million, an increase of $8.3 million over January 1, 2002. The distribution
segment has no goodwill.
The activity related to goodwill for the year ended December 31, 2002 is as
follows (in thousands):
Balance at December 31, 2001 $ 440,874
Assembled workforce reclass,
net of deferred taxes 2,911
Additions due to acquisitions 5,037
Additions due to earn-outs 5,166
--------------
Balance at December 31, 2002 $ 453,988
==============
In accordance with SFAS 142, the effect of this accounting change is reflected
prospectively. Supplemental comparative disclosure as if the change had been
retroactively applied to the prior year period is as follows (in thousands,
except per share amounts):
2002 2001 2000
---- ---- ----
Net income (loss):
Reported net income (loss) $ 23,570 $ (8,883) $ (13,996)
Goodwill amortization, net of tax benefit (1) - 11,029 11,208
------------------------------------
Adjusted net income (loss) $ 23,570 $ 2,146 $ (2,788)
====================================
Per share info:
---------------
Basic:
Reported income (loss) $ 0.94 $ (0.73) $ (0.98)
Goodwill amortization, net of tax benefit (1) $ - $ 0.59 $ 0.59
------------------------------------
Adjusted basic income (loss) $ 0.94 $ (0.14) $ (0.39)
====================================
Diluted:
Reported income (loss) $ 0.86 $ (0.73) $ (0.98)
Goodwill amortization, net of tax benefit (1) $ - $ 0.59 $ 0.59
------------------------------------
Adjusted diluted income (loss) $ 0.86 $ (0.14) $ (0.39)
====================================
(1) For the years ended December 31, 2001 and 2000, consists of $13.1
million and $13.0 million, respectively, of amortization offset by the
related tax benefit of $2.1 million and $1.8 million, respectively.
Amortization includes amortization related to assembled workforce,
which was combined with goodwill at January 1, 2002.
F-9
NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Intangible Assets (continued)
Amortization expense related to definite-lived intangible assets for the years
ended December 31, 2002, 2001, and 2000 was $1.0 million, $1.2 million, and $1.3
million, respectively. Non-compete agreements are recorded based on agreements
entered into by the Company and are amortized over their estimated useful lives
ranging from 5 to 7 years using the straight-line method. Other definite-lived
intangible assets are recorded at cost and are amortized over their estimated
useful lives of up to 16 years using the straight-line method. Estimated
aggregate amortization expense for such assets for each of the five years ending
December 31, 2007 and thereafter is as follows (in thousands):
2003 $ 882
2004 $ 818
2005 $ 779
2006 $ 761
2007 $ 735
Thereafter $1,853
Debt Issuance Costs
Debt issuance costs incurred in connection with the Company's long-term debt are
being amortized through the maturity of the related debt instrument.
Amortization of these costs are included in interest expense in the consolidated
statement of operations.
Long-Lived Asset Impairment
In accordance with SFAS 144, the company evaluates the carrying value of
long-lived assets to be held and used whenever events or changes in circumstance
indicate that the carrying amount may not be recoverable. The carrying value of
a long-lived asset is considered impaired when the projected undiscounted future
cash flows are less than its carrying value. The Company measures impairment
based on the amount by which the carrying value exceeds the fair market value.
Fair market value is determined primarily using the projected future cash flows
discounted at a rate commensurate with the risk involved. Losses on long-lived
assets to be disposed of are determined in a similar manner, except that fair
market values are reduced for the cost to dispose.
Derivatives
The Company uses derivative financial instruments for the purpose of hedging
interest rate exposures that exist as part of ongoing business operations. The
Company's derivative financial instruments are designated as and qualify as fair
value hedges. The Company's policy requires that the Company formally document
all relationships between hedging instruments and hedged items, as well as the
Company's risk management objective and strategy for undertaking various hedging
transactions. As a policy, the Company does not engage in speculative or
leveraged transactions, nor does the Company hold or issue financial instruments
for trading purposes.
F-10
NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Derivatives (continued)
As discussed in Note H, in March 2002, the Company entered into two
fixed-to-floating interest rate swaps with an aggregate notional amount of
$100.0 million in connection with the sale of the Senior Notes and in order to
mitigate its interest rate risk. The Company has designated its interest rate
swaps as fair value hedges and they qualify for the short-cut method of
accounting under the provisions of SFAS 133, Accounting for Derivative
Instruments and Hedging Activities. The Company has adjusted the carrying amount
of the Senior Notes and the swaps by $8.4 million to reflect the fair value of
the swaps as of December 31, 2002. The fair value of interest rate swaps is
included in other assets.
Fair Value of Financial Instruments
The carrying value of the Company's short-term financial instruments, such as
receivables and payables, approximate their fair values, based on the short-term
maturities of these instruments. The carrying value of the Company's long-term
debt, excluding its Senior Subordinated Notes, approximates fair value based on
using rates currently available to the Company for debt with similar terms and
remaining maturities. The fair value of the Senior Notes, as of December 31,
2002, was $208.0 million, as compared to the carrying value of $200.0 million at
that date. The fair value of the Senior Subordinated Notes, as of December 31,
2002, was $153.8 million, as compared to the carrying value of $150.0 million at
that date. The fair values of the Senior Notes and Senior Subordinated Notes
were based on quoted market prices at December 31, 2002.
Revenue Recognition
Revenues on the sale of orthotic and prosthetic devices to patients are recorded
when the device is accepted by the patient. Revenues on the sale of orthotic and
prosthetic devices to customers by our distribution segment are recorded upon
the shipment of products, in accordance with the terms of the invoice. Deferred
revenue represents deposits made prior to the final fitting and acceptance by
the patient and unearned service contract revenue. Revenue is recorded at its
net realizable value taking into consideration all governmental and contractual
adjustments and discounts.
Income Taxes
Income taxes are determined in accordance with Statement of Financial Accounting
Standards ("SFAS") 109, Accounting for Income Taxes, which requires recognition
of deferred income tax liabilities and assets for the expected future tax
consequences of events that have been included in the financial statements or
tax returns. Under this method, deferred income tax liabilities and assets are
determined based on the difference between financial statement and tax bases of
assets and liabilities using enacted tax rates in effect for the year in which
the differences are expected to reverse. SFAS 109 also provides for the
recognition of deferred tax assets if it is more likely than not that the assets
will be realized in future years.
F-11
NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Stock-Based Compensation
At December 31, 2002, the Company has multiple stock-based employee compensation
plans and has non-qualified options outstanding to employees, which are
described more fully in Note O. Stock based compensation is accounted for by
using the intrinsic value based method in accordance with Accounting Principles
Board Opinion (APB) 25, Accounting for Stock Issued to Employees, and related
Interpretations. No stock-based employee compensation expense is reflected in
net income (loss) as all options granted under these plans and the non-qualified
options granted to employees had an exercise price equal to the market value of
the underlying common stock on the date of grant. The following table
illustrates the effect on net income (loss) and earnings (loss) per share if the
Company had applied the fair value recognition provisions of SFAS 123,
Accounting for Stock-Based Compensation, to stock-based employee compensation:
2002 2001 2000
---- ---- ----
(in thousands, except per share amounts)
Net income (loss), as reported $ 23,570 $ (8,883) $ (13,996)
Deduct: Total stock-based employee compensation
expense determined under fair value method for all
awards, net of related tax effects (4,398) (4,262) (5,562)
----------------------------------------
Pro forma net income (loss) $ 19,172 $(13,145) $ (19,558)
========================================
Earnings per share:
Basic - as reported $ 0.94 $ (0.73) $ (0.98)
Basic - pro forma $ 0.72 $ (0.95) $ (1.27)
Diluted - as reported $ 0.86 $ (0.73) $ (0.98)
Diluted - pro forma $ 0.65 $ (0.95) $ (1.27)
The fair value for these options was estimated at the date of grant using a
Black-Scholes option pricing model with the following weighted average
assumptions for 2002, 2001 and 2000:
2002 2001 2000
------- ------- -------
Expected term 5 5 5
Volatility factor 71% 72% 58%
Risk free interest rate 5.8% 5.9% 6.7%
Dividend yield 0% 0% 0%
Fair value $ 6.80 $ 1.21 $ 2.64
Segment Information
SFAS 131, Disclosures about Segments of an Enterprise and Related Information,
applies a "management" approach to disclosure of segment information. The
management approach designates the internal organization that is used by
management for making operating decisions and assessing performance as the basis
of the Company's reportable segments. SFAS 131 also requires disclosure about
products and services, geographic
F-12
NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Segment Information (continued)
areas and major customers. The description of the Company's reportable segments
and the disclosure of segment information pursuant to SFAS 131 are presented in
Note P.
Reclassifications
Certain amounts in the prior years' financial statements have been reclassified
to conform to the current year presentation.
New Accounting Standards
In August 2001, the FASB issued SFAS 144, Accounting for the Impairment or
Disposal of Long-Lived Assets. SFAS 144 supercedes SFAS 121, Accounting for the
Impairment of Long-Lived Assets to be Disposed of , and changes the criteria
that have to be met to classify an asset as held-for-sale, and redefines the
reporting of discontinued operations. The Company adopted SFAS 144 for the
fiscal year beginning January 1, 2002. There was no material effect upon
adoption of this statement.
In April 2002, the Financial Accounting Standard Board ("FASB") issued Statement
of Financial Accounting Standards 145, Rescission of FASB Statements 4, 44, and
64, Amendment of FASB Statement 13, and Technical Corrections ("SFAS 145").
Under SFAS 145, gains and losses from the early extinguishment of debt would no
longer be extraordinary items, unless they satisfied the criteria in Accounting
Principles Board Opinion 30 ("APB 30") where extraordinary items are stated to
be distinguishable by their unusual nature and by the infrequency of their
occurrence. Any gain or loss on extinguishment of debt that was classified as an
extraordinary item in prior periods presented that does not meet the criteria in
APB 30 for classification as an extraordinary item shall be reclassified. In
addition, under SFAS 145, certain lease modifications that have economic effects
similar to sale-leaseback transactions be accounted for in the same manner as
sale-leaseback transactions. SFAS 145 is effective for fiscal years beginning
after May 15, 2002. SFAS 145 will be adopted by the Company on January 1, 2003
and will result in a reclassification of existing extraordinary losses on the
early extinguishment of debt from an extraordinary item to a non-operating item.
In July 2002, the FASB issued Statement of Financial Accounting Standards 146,
Accounting for Costs Associated with Exit or Disposal Activities ("SFAS 146").
Under SFAS 146, costs associated with exit or disposal activities would be
recognized when they are incurred rather than at the date of a commitment to an
exit or disposal plan. Such costs would include lease termination costs and
certain employee severance costs that are associated with a restructuring,
discontinued operation, plant closing, or other exit or disposal activity. SFAS
146 is to be applied prospectively to exit or disposal activities initiated
after December 31, 2002. The Company does not expect SFAS 146 to have a material
effect on its financial statements.
In December 2002, the FASB issued Statement of Financial Accounting Standards
148, Accounting for Stock-Based Compensation - Transition and Disclosure, an
amendment of SFAS Statement 123 ("SFAS 148"). SFAS 148 amends SFAS 123,
Accounting for Stock-Based Compensation, to provide alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based compensation. The Company continues to use the
intrinsic-value-based method of accounting for stock-based employee
F-13
NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
New Accounting Standards (continued)
compensation as prescribed by APB Opinion 25. In addition, SFAS 148 amends the
disclosure requirements of SFAS 123 to require prominent disclosures in both
annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The company adopted the disclosure provisions of SFAS 148 as of
December 31, 2002. The adoption had no material impact on the Company's
financial statements.
In November 2002, the FASB issued FASB Interpretation No. 45, Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others ("FIN 45"). FIN 45 requires that upon
issuance of a guarantee, a guarantor must recognize a liability for the fair
value of an obligation assumed under a guarantee. FIN 45 also requires
additional disclosures by a guarantor in its interim and annual financial
statements about the obligations associated with guarantees issued. The
recognition provisions of FIN 45 are effective for any guarantees that are
issued or modified after December 31, 2002. The disclosure requirements will be
effective for the Company's quarter ended March 31, 2003. Management believes
the adoption of this statement will not have a material effect on the Company's
financial statements.
NOTE C - SUPPLEMENTAL CASH FLOW FINANCIAL INFORMATION
The following are the supplemental disclosure requirements for the statements of
cash flows:
2002 2001 2000
---- ---- ----
(in thousands)
Cash paid during the period for:
Interest $ 40,620 $ 47,382 $ 42,645
Income taxes $ 10,514 $ 1,822 $ 2,666
Non-cash financing and investing activities:
Preferred stock dividends declared and accretion $ 5,202 $ 4,858 $ 4,538
Issuance of notes in connection with acquisitions $ 1,750 $ - $ 2,874
NOTE D - ACQUISITIONS
Following the acquisition of NovaCare O&P in 1999, the Company and NovaCare
disagreed regarding the determination of the amount of NovaCare O&P adjusted
working capital. On February 25, 2000, the Company and NovaCare submitted the
matter to the independent arbitrator in accordance with the dispute resolution
arbitration mechanism provided under the Stock Purchase Agreement. On May 22,
2000, an independent arbitrator issued its report concluding that the Company
was entitled to the working capital deficiency of approximately $25.1 million,
representing the required decrease in the purchase price previously paid by the
Company for NovaCare O&P. On May 25, 2000, the escrow agent released $15.0
million of escrowed funds to the Company. Pursuant to the Stock Purchase
Agreement, the Company was entitled to receive the approximately $10.1 million
balance of the working capital deficiency on or before June 21, 2000.
On June 5, 2000, NovaCare (the name of which was changed to NAHC, Inc.) filed a
complaint contesting the arbitrator's decision. On June 30, 2000, the Company
entered into a Settlement Agreement with NovaCare
F-14
NOTE D - ACQUISITIONS (CONTINUED)
providing for dismissal of the litigation and execution of a mutual release
relating to currently unknown matters arising from the acquisition. In addition,
the Settlement Agreement provided that of the $10.1 million owed by NovaCare to
the Company, $6.0 million would be paid immediately by NovaCare and NovaCare
would execute a collateralized promissory note in the principal amount of $3.7
million, plus 7% annual interest, payable monthly over the following six months.
All payments required by the settlement were paid when due.
During 2000, the Company acquired five orthotic and prosthetic companies. The
aggregate purchase price, excluding potential earn-out provisions, was $4.5
million, comprised of $2.4 million in cash and $2.1 million in promissory notes.
The notes are payable over two to five years with interest rates ranging from 6%
to 8%. The cash portion of the purchase price for these acquisitions was
borrowed under the Company's revolving credit facility.
During 2001, the Company did not acquire any companies. During 2002, the Company
acquired two orthotic and prosthetic companies. The aggregate purchase price,
excluding potential earn-out provisions, was $6.1 million, comprised of $4.1
million in cash, $1.8 million in promissory notes and $0.2 million in
transaction costs. The notes are payable over one to five years with interest
rates of 6.5%.
All of the above acquisitions have been accounted for as business combinations
in accordance with the purchase method. The results of operations for these
acquisitions are included in the Company's results of operations from their date
of acquisition. Pro forma results would not be materially different.
In connection with acquisitions, the Company occasionally agrees to make
payments if future earnings targets are reached. In connection with these
agreements and the Company's acquisitions prior to 2001, the Company paid $6.0
million, $8.3 million and $8.4 million in 2002, 2001, and 2000, respectively.
The Company has accounted for these amounts as additional purchase price,
resulting in an increase in goodwill. The Company estimates that it may pay an
additional $1.5 million related to earn-out provisions in future periods.
F-15
NOTE E - UNUSUAL CHARGES
Summary
Unusual charges for the years ended December 31, 2002, 2001, and 2000 consist of
the following costs, which are explained below:
2002 2001 2000
---- ---- ----
(in thousands)
Integration costs $ - $ - $ 1,710
Leasehold abandonments 528 - -
Restructuring and asset impairment costs - 3,688 654
Performance improvement costs - 7,892 -
Stock-based compensation in connection
with performance improvement plan - 4,785 -
Impairment loss on assets held for sale - 8,073 -
Workman's compensation claims 1,332 - -
-------- ---------- --------
Unusual charges $ 1,860 $ 24,438 $ 2,364
======== ========== ========
Workman's Compensation and Leasehold Abandonments
Unusual charges for the year ended December 31, 2002, amounted to $1.9 million,
which consisted of the following costs: (i) payments of approximately $1.3
million made to a prior workman's compensation carrier related to claims for the
1995 through 1998 policy years which the Company treated as a change in
accounting estimate in accordance with the provisions of Accounting Principles
Board Opinion No. 20, and (ii) a non-cash charge of approximately $0.6 million
related to the write-off of abandoned leaseholds.
Integration Costs
During the year ended December 31, 2000, primarily in relation to the
acquisition of NovaCare O&P, the Company recorded integration costs of
approximately $1.7 million, including costs of changing patient-care center
names, payroll and related benefits, conversion, stay-bonuses and related
benefits for transitional employees and certain other costs related to the
acquisition. These costs were expensed as incurred and recorded against
operations.
F-16
NOTE E - UNUSUAL CHARGES (CONTINUED)
Restructuring and Asset Impairment Costs
Components of the restructuring reserves, spending during the periods, and
remaining reserve balances are as follows:
Lease
Employee Termination Total
Severance and other Exit Restructuring
Costs Costs Reserve
- ---------------------------------------------------------------------------------------------------------------
(in thousands)
1999 & 2000 Restructuring Reserve
Balance at December 31, 1999 $ 1,600 $ 2,992 $ 4,592
Provision 1,035 - 1,035
Spending (1,942) (913) (2,855)
Amendment to Plan - (672) (672)
--------- ----------- ---------
Balance at December 31, 2000 693 1,407 2,100
Spending (693) (307) (1,000)
Amendment - favorable buyout and sublease activity - (771) (771)
--------- ----------- ---------
Balance at December 31, 2001 - 329 329
Spending (82) (82)
--------- ----------- ---------
Balance at December 31, 2002 - 247 247
--------- ----------- ---------
2001 Restructuring Reserve
Balance at December 31, 2000 - - -
Provision (1) 1,208 3,251 4,459
Spending (1,158) (1,365) (2,523)
Favorable buyout and sublease activity - (739) (739)
Amendment to plan for seven additional properties - 739 739
--------- ----------- ---------
Balance at December 31, 2001 50 1,886 1,936
Spending (50) (1,047) (1,097)
--------- ----------- ---------
Balance at December 31, 2002 - 839 839
--------- ----------- ---------
1999, 2000, and 2001 Restructuring Reserves
--------- ----------- ---------
Balance at December 31, 2002 $ - $ 1,086 $ 1,086
========= =========== =========
(1) Includes $0.5 million of asset impairment for impaired leasehold
improvements at branches to be vacated.
F-17
NOTE E - UNUSUAL CHARGES (CONTINUED)
Restructuring and Asset Impairment Costs (continued)
During 1999, the Company recorded $7.0 million in restructuring related costs
($1.3 million recorded as a change to the statement of operations and $5.7
million recorded as an increase to goodwill in accordance with purchase
accounting requirements) associated with the acquisition of the NovaCare O&P
operations. The restructuring costs primarily included severance pay benefits
and lease termination costs. The cost of providing severance pay and benefits
for the reduction of approximately 225 employees was estimated at approximately
$3.4 million. Lease termination costs, for patient-care centers closed, were
estimated at $3.5 million and are expected to be paid through 2003. As of
December 31, 2000, all of the employees had been terminated and 44 of the 54
patient-care centers identified for closure were closed. Additionally,
management reversed approximately $0.7 million of the restructuring reserve
providing an approximate restructuring benefit of $0.4 million and a reduction
of goodwill of approximately $0.3 million.
During 2000, management implemented a plan to sever 234 employees in an effort
to reduce general and administrative expenses. The Company recorded
approximately $1.0 million in restructuring expense which was paid in January of
2001, thus completing the plan of restructuring. During 2001, management
reversed approximately $0.8 million originally included in the 2000
restructuring reserve as a result of favorable lease buyouts and sublease
activity.
During 2001, as a result of the initiatives associated with the Company's
performance improvement plan developed in conjunction with AlixPartners, LLC
(formerly Jay Alix & Associates, Inc.; "JA&A"), the Company recorded
approximately $4.5 million in restructuring and asset impairment costs. The plan
called for the closure of 37 facilities and the termination of approximately 135
additional employees.
Also during 2001, management reversed approximately $0.7 million originally
included in the 37 facilities associated with the 2001 restructuring reserve as
a result of favorable buy outs of leases and sublease activity. Management then
added seven additional patient-care centers which were originally contemplated
but not finalized to the lease restructuring component of the 2000 plan. An
amended restructuring reserve of $0.7 million was recorded for these properties.
As of December 31, 2002, all properties had been vacated and all of the
employees had been terminated. As of December 31, 2002, all payments under the
severance initiative have been made. All payments under the plan for lease and
severance costs are expected to be paid by December 31, 2004.
F-18
NOTE E - UNUSUAL CHARGES (CONTINUED)
Performance Improvement Costs
In December of 2000, management and the Board of Directors determined that major
performance improvement initiatives needed to be adopted. As such, on December
11, 2000, the Company retained the services of JA&A to assist in identifying
areas for cash generation and profit improvement. Subsequent to the completion
of this diagnostic phase, the Company modified and extended the retention
agreement on January 23, 2001 to assist in the implementation of the plan. Among
the targeted areas were spending reductions, improvements in the utilization and
effectiveness of support services, including claims processing, the refinement
of materials purchasing and inventory management and the consolidation of
distribution services. In addition, the Company planned to enhance revenues and
cash collections through improved marketing efforts and more efficient billing
procedures.
The terms of the engagement provided for payment of JA&A's normal hourly fees
plus a success fee if certain defined benefits were achieved. Management
elected, at the time the agreement was signed, to pay one-half of any earned
success fee in cash, with the remaining one-half of the success fee to be paid
through a grant of options to purchase the Company's common stock. All the
options were to be granted with an exercise price of $1.40 per share, which was
the average closing price of the Company's common stock for all trading days
during the period from December 23, 2000 through January 23, 2001. The number of
options was to be determined by multiplying the non-cash half of each success
fee invoice of JA&A by 1.5 and dividing the product by $1.40. The options were
to be granted within 30 days of each invoice, were to be exercisable beginning
with the sixth month following each award and were to expire five years from the
termination of JA&A's engagement.
JA&A's work was substantially complete on December 31, 2001. As of December 31,
2001, the total hourly cash fees and expenses paid to JA&A were $4.6 million.
During the fourth quarter of 2001, JA&A invoiced the Company for the success
fees upon the accomplishment of benefits defined in the engagement letter. The
Company paid half of the success fee in cash totaling $1.1 million and the
remaining half with an option for approximately 1.2 million shares, as
determined above, with an estimated fair value of $4.8 million. The fair value
of these options was estimated at the date of grant using a Black-Scholes option
pricing model. In addition to the amounts paid to JA&A, the Company incurred
$2.2 million in internal costs related to these performance initiatives. As
discussed in Note O, during 2002, the Company repurchased 0.6 million of the
shares underlying the option. No additional success fees were paid in 2002 and
no future service fees are applicable.
Impairment Loss on Assets Held for Sale
On October 9, 2001, the Company completed the sale of substantially all of the
manufacturing assets of Seattle Orthopedic Group, Inc., ("SOGI") to United
States Manufacturing Company ("USMC"). The purchase price was $20.0 million, of
which $3.0 million was placed in an escrow account for a period of up to three
years. During the escrow period, the escrowed funds will be released to the
Company in amounts and at times that will be determined on the basis of the
amount of purchases made by Hanger from USMC under the terms of a separate
supply agreement entered into among the parties (see Note K). The Company
incurred an impairment loss of $8.1 million on the disposal of SOGI's
manufacturing assets, which has been reflected in the Company's statement of
operations.
F-19
NOTE E - UNUSUAL CHARGES (CONTINUED)
Impairment Loss on Assets Held for Sale (continued)
For the year ended December 31, 2001, the results of operations of SOGI's
manufacturing activities, including intercompany transactions during that same
period were:
(in thousands)
Net sales $ 8,633
Cost of goods sold 5,891
----------------
Gross profit 2,742
Selling, general and administrative 2,989
Depreciation and amortization 918
Amortization of excess cost over net assets acquired 412
Unusual charges 91
----------------
Loss from operations $ (1,668)
================
Reconciliation of Loss from SOGI Transaction (in thousands)
Accounts receivable $ 1,060
Inventory 3,234
Net fixed assets 4,611
Net intangibles 18,584
Other 61
Liabilities assumed (1,399)
----------------
Net book value 26,151
Net proceeds from assets held for sale 18,078
----------------
Loss on sale of assets $ 8,073
================
NOTE F - NET INCOME (LOSS) PER COMMON SHARE
Basic per common share amounts are computed using the weighted average number of
common shares outstanding during the year. Diluted per common share amounts are
computed using the weighted average number of common shares outstanding during
the year and dilutive potential common shares. Dilutive potential common shares
consist of stock options, stock warrants and redeemable convertible preferred
stock and are calculated using the treasury stock method.
F-20
NOTE F - NET INCOME (LOSS) PER COMMON SHARE (CONTINUED)
Income/(Loss) per share is computed as follows:
2002 2001 2000
---- ---- ----
(in thousands, except share and per share)
Income (loss) before extraordinary item $ 26,381 $ (8,883) $ (13,996)
Less preferred stock dividends declared and accretion (5,202) (4,858) (4,538)
----------------------------------------------
Income (loss) before extraordinary item available to common
stockholders used to compute basic and
diluted per common share amounts $ 21,179 $ (13,741) $ (18,534)
==============================================
Net income (loss) $ 23,570 $ (8,883) $ (13,996)
Less preferred stock dividends declared and accretion (5,202) (4,858) (4,538)
----------------------------------------------
Net income (loss) available to common stockholders used
to compute basic and diluted per common share amounts $ 18,368 $ (13,741) $ (18,534)
==============================================
Shares of common stock outstanding used to compute basic
per common share amounts 19,535,272 18,920,094 18,910,002
Effect of dilutive options 1,702,492 - -
Effect of dilutive warrants 219,230 - -
----------------------------------------------
Shares used to compute dilutive per common share amounts (1) 21,456,994 18,920,094 18,910,002
==============================================
Basic income (loss) per share applicable to common stock $ 0.94 (0.73) $ (0.98)
Diluted income (loss) per share applicable to common stock $ 0.86 (0.73) $ (0.98)
(1) Excludes the effect of the conversion of the 7% Redeemable Convertible
Preferred Stock into $4.6 million shares of Common Stock as it is
considered anti-dilutive For 2001 and 2000, excludes the effect of all
dilutive options and warrants as a result of the Company's net loss for the
years ended December 31, 2001 and 2000.
Options, outstanding at December 31, 2002, to purchase 1,275,998 shares of
common stock are not included in the computation of diluted income per share for
the year ended December 31, 2002, as these options are anti-dilutive because the
exercise price of the options were greater than the average market price of the
Company's common stock during 2002.
Options to purchase 5,552,217 and 3,345,693 shares of common stock and warrants
to purchase 360,001 and 830,650 shares of common stock were outstanding at
December 31, 2001 and 2000, respectively, and are not included in the
computation of diluted income per share due to the Company's net loss for the
years ended December 31, 2001 and 2000.
F-21
NOTE G - INVENTORY
Inventories at December 31, 2002 and 2001 consist of the following:
2002 2001
---- ----
(in thousands)
Raw materials $ 26,905 $ 27,224
Work in-process 19,719 19,908
Finished goods 9,830 8,814
---------------------------
$ 56,454 $ 55,946
===========================
NOTE H - LONG-TERM DEBT
Long-term debt consists of the following at December 31, 2002 and 2001:
2002 2001
-------------------------
(in thousands)
Revolving Credit Facility $ 15,000 $ 74,800
10 3/8% Senior Notes due 2009 (1) 208,398 -
A Term Loan Commitment - 63,995
B Term Loan Commitment - 89,592
11 1/4% Senior Subordinated Notes due 2009 150,000 150,000
Subordinated seller notes, non-collateralized, net of unamortized discount
of $0.1 million at December 31, 2002 and 2001 with principal and interest
payable in either monthly, quarterly or annual installments at effective interest
rates ranging from 6% to 12.287%, maturing through December 2011. 9,884 19,440
-------------------------
383,282 397,827
Less current portion (5,181) (30,512)
-------------------------
$ 378,101 $ 367,315
=========================
(1) Includes an $8.4 million fair value adjustment related to the interest rate swap.
The Revolving Credit Facility, Tranche A Term Loan Commitment, and Tranche B
Term Commitment outstanding as of December 31, 2001 were subsequently prepaid in
full and the agreements were terminated on February 15, 2002. Prior to its
termination, as stated in the Amended Credit Facility, the Revolving Credit
Facility outstanding as of December 31, 2001 carried an interest rate of LIBOR
plus 3.50%, or ABR plus 2.50%, and would have matured on July 1, 2005. The
Tranche A Term Facility carried an interest rate of LIBOR plus 3.50%, or ABR
plus 2.50% and would have matured on July 1, 2005. As of December 31, 2001, the
Tranche A Term Facility had required quarterly principal payments of $4.6
million. The Tranche B Term Facility carried an interest rate of LIBOR plus
4.50%, or ABR plus 3.50% and would have matured on January 1, 2007. At December
31, 2001, the Tranche B Term Facility had required quarterly principal payments
of $0.2 million through July 1, 2005 and of $14.4 million through January 1,
2007.
F-22
NOTE H - LONG-TERM DEBT (CONTINUED)
On February 15, 2002, the Company sold $200.0 million principal amount of its 10
3/8% Senior Notes due 2009 (the "Senior Notes") and established a new $75.0
million senior secured revolving line of credit (the "New Revolving Credit
Facility"). The Senior Notes were issued under an indenture, dated as of
February 15, 2002, with Wilmington Trust Company, as trustee. The Company used
the $194.0 million net proceeds from the sale of the Senior Notes, along with
approximately $36.9 million from the New Revolving Credit Facility, to retire
approximately $228.4 million of indebtedness, plus related fees and expenses,
outstanding under the Company's previously existing revolving credit and term
loan facilities
The Senior Notes mature on February 15, 2009, are senior indebtedness and are
guaranteed on a senior unsecured basis by all of the Company's current and
future domestic subsidiaries. Interest is payable semi-annually on February 15
and August 15, commencing August 15, 2002. The Senior Notes do not require any
prepayments of principal prior to maturity. The New Revolving Credit Facility
matures on February 15, 2007 and carries an interest rate, at our option, of
LIBOR plus a variable margin rate or the Base Rate (as defined in the New
Revolving Credit Facility) plus a variable margin rate. In each case, the
variable margin rate is subject to adjustments based on financial performance.
At December 31, 2002 the interest rates have been adjusted to LIBOR plus 3.00%
or the Base Rate plus 2.00%. The obligations under the New Revolving Credit
Facility are guaranteed by the Company's subsidiaries and are secured by a first
priority perfected security interest in the Company's subsidiaries' shares, all
of the Company's assets and all of the assets of the Company's subsidiaries. The
Company can prepay borrowings under the New Revolving Credit Facility at any
time without premium or penalty.
Before February 15, 2005, the Company may redeem up to 35% of the aggregate
principal amount of the Senior Notes at a redemption price of 110.375% of the
principal amount thereof, plus interest, with the proceeds of certain equity
offerings, provided at least 65% of the aggregate principal amount of the Senior
Notes remains outstanding after redemption.
Beginning February 15, 2006 through the date of maturity, the Company may redeem
all or part of the Senior Notes, at a redemption price as a percentage of the
principal amount, plus accrued and unpaid interest, if any. For the twelve-month
periods commencing on February 15, 2006 and 2007, the percentage would be
105.188% and 102.594%, respectively. Commencing on February 15, 2008 through the
date of maturity, the percentage would be 100%.
The New Revolving Credit Facility requires compliance with various financial
covenants, including a minimum consolidated interest coverage ratio, minimum
consolidated EBITDA, a maximum total leverage ratio, a maximum senior secured
leverage ratio and a minimum fixed charge coverage ratio, as well as other
covenants. As of December 31, 2002, the Company was in compliance with these
covenants. The Company assesses, on a quarterly basis, its compliance with these
covenants and monitors any matters critical to continue its compliance. The New
Revolving Credit Facility contains customary events of default and is subject to
various mandatory prepayments and commitment reductions.
As a result of retiring the previously existing indebtedness, the Company wrote
off $4.6 million in unamortized debt issuance costs that had previously been
included in other assets. The extraordinary item for the year ended December 31,
2002 consists of such costs, offset by a tax benefit of $1.8 million.
F-23
NOTE H - LONG-TERM DEBT (CONTINUED)
In March 2002, the Company entered into two fixed-to-floating interest rate
swaps with an aggregate notional amount of $100.0 million in connection with the
sale of the Senior Notes and in order to mitigate its interest rate risk. Under
the interest rate swap agreements, the Company will receive amounts based on a
fixed interest rate of 10 3/8% per annum. In return, the Company will pay
amounts based on a variable interest rate based on the six-month LIBOR plus a
spread between 492 and 497 basis points. The Company will receive and pay these
amounts semiannually through the maturity date of February 15, 2009. The terms
of these agreements are identical to the Senior Notes.
The $150.0 million in Senior Subordinated Notes bears interest at 11.25%, and
matures on June 15, 2009. Interest is payable on June 15 and December 15.
Beginning June 15, 2004 through the date of maturity, the Company may redeem all
or part of the Senior Subordinated Notes, at a redemption price as a percentage
of the principal amount, plus accrued and unpaid interest, if any. For the
twelve-month periods commencing on June 15, 2004, 2005, 2006 and 2007, the
percentage would be 105.625%, 104.219%, 102.813% and 101.406%, respectively.
Commencing on June 15, 2008 through the date of maturity, the percentage would
be 100%.
Upon the occurrence of certain specified change of control events, unless the
Company has exercised its option to redeem all the Senior Notes and Senior
Subordinated Notes, as described above, each holder of a Senior Note will have
the right to require the Company to repurchase all or a portion of such holder's
Senior Notes at a purchase price in cash equal to 101% of the principal amount,
plus accrued and unpaid interest, if any, to the date of repurchase. The terms
of the Senior Notes, Senior Subordinated Notes, and the New Revolving Credit
Facility limit the Company's ability to, among other things, incur additional
indebtedness, create liens, pay dividends on or redeem capital stock, make
certain investments, make restricted payments, make certain dispositions of
assets, engage in transactions with affiliates, engage in certain business
activities and engage in mergers, consolidations and certain sales of assets.
Maturities of long-term debt at December 31, 2002 are as follows:
(in thousands)
2003 $ 5,181
2004 1,823
2005 920
2006 601
2007 15,605
Thereafter 350,754
-----------------
$ 374,884
=================
As of December 31, 2002, the Company had available borrowings of $60.0 million
under the New Revolving Credit Facility.
F-24
NOTE I- INCOME TAXES
The provisions (benefit) for income taxes for the years ended December 31, 2002,
2001 and 2000 consisted of the following:
2002 2001 2000
---- ---- ----
(in thousands)
Current:
Federal $ 1,845 $ 383 $ (194)
State 1,255 852 1,897
------------------------------------
Total 3,100 1,235 1,703
Deferred:
Federal and State (1) 14,847 (328) (3,200)
------------------------------------
Provision (benefit) for income taxes $ 17,947 $ 907 $ (1,497)
===================================
(1) For the year ended December 31, 2002, $2.1 million related to the exercise
of non-qualified stock option has been recorded as additional paid-in
capital and $1.9 million of deferred tax liabilities associated with the
unamortized portion of workforce intangibles has been reclassified against
goodwill.
A reconciliation of the federal statutory tax rate to the effective tax rate for
the years ended December 31, 2002, 2001 and 2000 is as follows:
2002 2001 2000
---- ---- ----
Federal statutory tax rate (benefit) 35.0% (35.0)% (35.0)%
Increase in taxes resulting from:
State income taxes (net of federal effect) 5.3 8.1 6.8
Amortization of the excess cost over net assets acquired - 32.3 16.0
Other, net 0.2 6.0 2.5
------- ------- ------
Provision (benefit) for income taxes 40.5% 11.4% (9.7)%
======= ======= ======
F-25
NOTE I- INCOME TAXES (CONTINUED)
Temporary differences and carryforwards which give rise to deferred tax assets
and liabilities as of December 31, 2002 and 2001 are as follows:
2002 2001
---- ----
(in thousands)
Deferred tax liabilities:
Book basis in excess of tax $ 958 $ 958
Property, plant and equipment 25,963 22,541
Debt issue costs 435 548
Acquisition costs 2,856 2,448
Other 448 -
-----------------------
30,660 26,495
-----------------------
Deferred tax assets:
Net operating loss 4,859 3,678
Accrued expenses 2,106 8,020
Reserve for bad debts 3,631 7,519
Other 1,708 52
Inventory capitalization and reserves 1,977 1,688
-----------------------
14,281 20,957
-----------------------
Net deferred tax liabilities $ (16,379) $ (5,538)
=======================
For Federal tax purposes at December 31, 2002, the Company has available
approximately $11.4 million of net operating loss carryforwards expiring from
2020 through 2022.
NOTE J - DEFERRED COMPENSATION
In conjunction with the acquisition of J.E. Hanger, Inc. of Georgia ("JEH") in
1996, the Company assumed the unfunded deferred compensation plan that had been
established for certain key JEH officers. The plan accrues benefits ratably over
the period of active employment from the time the contract is entered into to
the time the participant retires. Participation had been determined by JEH's
Board of Directors. The Company has purchased individual life insurance
contracts with respect to each employee covered by this plan. The Company is the
owner and beneficiary of the insurance contracts. The liability related to the
deferred compensation arrangements amounted to approximately $1.0 million and
$1.1 million at December 31, 2002 and 2001, respectively.
NOTE K - COMMITMENTS AND CONTINGENT LIABILITIES
Commitments
In October 2001, the Company entered into a Supply Agreement with USMC, under
which it agreed to purchase certain products and components for use solely by
the Company's patient-care centers during a five-year period following the date
of the agreement. The Company satisfied its obligation to purchase from USMC at
least $7.5 million of products and components during the first year following
the date of the agreement. Accordingly, on November 1, 2002, the escrow agent
released $1.0 million in escrowed funds to the Company for the satisfaction of
such first-year purchase obligations.
F-26
NOTE K - COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)
Commitments (continued)
In addition, the Company is obligated to purchase from USMC at least $8.5
million and $9.5 million of products and components during the second and third
years following the agreement, respectively, subject to certain adjustments.
However, in the event purchases during each of the fourth and fifth years are
less than approximately $8.7 million, the Company shall pay USMC an amount equal
to $0.1 million multiplied by the number of $1.0 million units by which actual
purchases during each of the fourth and fifth years are less than approximately
$8.7 million.
Contingencies
The Company is subject to legal proceedings and claims which arise in the
ordinary course of its business, including additional payments under business
purchase agreements. Many of these legal proceedings and claims existed in the
NovaCare O&P business prior to the Company's acquisition of NovaCare O&P. In the
opinion of management, the amount of ultimate liability, if any, with respect to
these actions will not have a materially adverse effect on the financial
position, liquidity or results of operations of the Company.
On November 28, 2000, a class action complaint (Norman Ottmann v. Hanger
Orthopedic Group, Inc., Ivan R. Sabel and Richard A. Stein; Civil Action No.
00CV3508) was filed against the Company in the United States District Court for
the District of Maryland on behalf of all purchasers of our common stock from
November 8, 1999 through and including January 6, 2000. The complaint also names
as defendants Ivan R. Sabel, the Company's Chairman of the Board and Chief
Executive Officer (and then President), and Richard A. Stein, the Company's
former Chief Financial Officer, Secretary and Treasurer (the "Class Action
Lawsuit").
The complaint alleges that during the above period of time, the defendants
violated Section 10(b) and 20(a) of the Securities Exchange Act of 1934 by,
among other things, knowingly or recklessly making material misrepresentations
concerning the Company's financial results for the quarter ended September 30,
1999, and the progress of the Company's efforts to integrate the
recently-acquired operations of NovaCare O&P. The complaint further alleges that
by making those material misrepresentations, the defendants artificially
inflated the price of the Company's common stock. The plaintiff seeks to recover
damages on behalf of all of the class members.
The Class Action Lawsuit has been dismissed by the District Court for failure to
comply with statutory requirements. On November 5, 2002, plaintiffs filed a
notice of appeal to the United States Court of Appeals for the Fourth Circuit.
The Company believes that the allegations have no merit and is vigorously
defending the Class Action Lawsuit. Additionally, the Company believes that it
is remote that any claims would result from this action and therefore, no
related liabilities have been recorded.
F-27
NOTE K - COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)
Guarantees and Indemnifications
In the ordinary course of its business, the Company may enter into service
agreements with service providers in which it agrees to indemnify or limit the
service provider against certain losses and liabilities arising from the service
provider's performance of the agreement. In connection with the disclosure
provisions of FASB Interpretation No. 45, Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others, the Company has reviewed its existing contracts containing
indemnification or clauses of guarantees. The Company does not believe that its
liability under such agreements will result in any material liability.
NOTE L - OPERATING LEASES
The Company leases office space under noncancellable operating leases. Future
minimum rental payments, by year and in the aggregate, under operating leases
with terms of one year or more consist of the following at December 31, 2002:
(in thousands)
2003 $ 21,663
2004 17,161
2005 12,859
2006 8,612
2007 5,357
Thereafter 7,293
----------------
$ 72,945
================
Rent expense was approximately $24.1 million, $23.9 million and $23.7 million
for the years ended December 31, 2002, 2001 and 2000 respectively.
NOTE M - PENSION AND PROFIT SHARING PLANS
The Company maintains a 401(k) Savings and Retirement plan to cover all of the
employees of the Company. The Company may make discretionary contributions.
Under this 401(k) plan, employees may defer such amounts of their compensation
up to the levels permitted by the Internal Revenue Service. During 2002, 2001,
and 2000, the Company recorded contributions of $1.6 million, $1.2 million, and
$1.4 million under this plan, respectively.
F-28
NOTE N - REDEEMABLE PREFERRED STOCK
The Company has 10.0 million authorized shares of preferred stock, par value
$0.01 per share, which may be issued in various classes with different
characteristics.
The Company issued $60.0 million of 7% Redeemable Preferred Stock on July 1,
1999 in connection with its acquisition of NovaCare O&P. The 60,000 outstanding
shares of 7% Redeemable Preferred Stock are convertible into shares of our
non-voting common stock at a price of $16.50 per share, subject to adjustment.
The Company is entitled to require that the 7% Redeemable Preferred Stock be
converted into non-voting common stock on and after July 2, 2002, if the average
closing price of the common stock for 20 consecutive trading days is equal to or
greater than 175% of the conversion price. The 7% Redeemable Preferred Stock
will be mandatorily redeemable on July 1, 2010 at a redemption price equal to
the liquidation preference plus all accrued and unpaid dividends. In the event
of a change in control of the Company, the Company must offer to redeem all of
the outstanding 7% Redeemable Preferred Stock at a redemption price equal to
101% of the sum of the per share liquidation preference thereof plus all accrued
and unpaid dividends through the date of payment. The 7% Redeemable Preferred
Stock accrues annual dividends, compounded quarterly, equal to 7%, is subject to
put rights and will not require redemption prior to maturity on July 1, 2010. As
of December 31, 2002, the shares of 7% Redeemable Preferred Stock have an
aggregate redemption balance of $76.5 million.
NOTE O - WARRANTS AND OPTIONS
Warrants
Prior to 2000, the Company issued warrants to purchase shares of its common
stock to the holders of certain notes. At December 31, 2000, warrants to
purchase 830,650 shares, at a weighted average exercise price of $5.55, were
outstanding. During 2001, the Company issued 70,575 shares of its common stock
in connection with a cashless exercise of warrants to purchase 225,914 shares.
On December 31, 2001, 244,735 warrants expired. As of December 31, 2002 and
2001, warrants to purchase 360,001 shares, at a weighted average exercise price
of $5.00, were outstanding and exercisable. As of December 31, 2002, these
warrants have a weighted average remaining contractual life of 3.84 years. On
February 27, 2003, the holder exercised their option and the Company issued a
net 193,327 shares to satisfy their option with a cashless exercise.
Options
Under the Company's 2002 Stock Option Plan, 1.5 million shares of common stock
were authorized for issuance. Options may be granted only at an exercise price
not less than the fair market value of the Common Stock on the date of grant and
may expire no later than ten years after grant. Vesting and expiration periods
were established by the Compensation Committee of the Board of Directors,
generally with vesting of four years following grant and generally with
expirations of ten years after grant.
Under the Company's 1993 Non-Employee Director Stock Option Plan ("Director
Plan"), 250,000 shares of Common Stock are authorized for issuance to directors
of the Company who are not employed by the Company or any affiliate of the
Company. Under this plan, an option to purchase 5,000 shares of Common Stock is
granted automatically on an annual basis to each eligible director on the third
business day following the date of each Annual Meeting of Stockholders of the
Company at which the eligible director is elected. The exercise price of
F-29
NOTE O - WARRANTS AND OPTIONS (CONTINUED)
Options (continued)
each option is equal to 100% of the fair market value of the Common Stock on the
date of grant. Each option vests at the rate of 25% each year for the first four
years after the date of grant of the option and each such option expires ten
years from the date of grant; provided, however, that in the event of
termination of a director's service other than by reason of total and permanent
disability or death, then the outstanding options of such holder expire three
months after such termination. Outstanding options remain exercisable for one
year after termination of service by reason of total and permanent disability or
death. The number of shares that remain available for grant at December 31, 2002
and 2001 were 20,000 and 32,500, respectively.
Under the Company's expired 1991 Stock Option Plan ("1991 Plan"), 8.0 million
shares of Common Stock were authorized for issuance. Under the 1991 Plan,
options were granted at an exercise price not less than the fair market value of
the Common Stock on the date of grant. Vesting and expiration periods were
established by the Compensation Committee of the Board of Directors, generally
with vesting from three to four years following grant and generally with
expirations of eight to ten years after grant. As of December 31, 2002, options
for 2,915,570 remained outstanding.
The following is a summary of option transactions and exercise prices:
Stock Option Plans Director Plan
---------------------- ---------------------
Weighted Weighted
Average Average
Shares Price Shares Price
------------ --------- ------------- --------
Outstanding at December 31, 1999 2,422,188 $12.57 160,750 $10.00
Granted 1,304,497 $ 4.63 35,000 $ 5.19
Terminated (568,492) $ 8.26 (8,250) $ 6.00
------------ -----------
Outstanding at December 31, 2000 3,158,193 $ 9.54 187,500 $ 9.40
Granted 2,515,733 $ 1.67 30,000 $ 1.65
Terminated (1,545,346) $ 7.66 - $ -
Exercised (77,299) $ 3.23 - $ -
------------ -----------
Outstanding at December 31, 2001 4,051,281 $ 7.12 217,500 $ 8.38
Granted 405,998 $14.94 30,000 $14.00
Terminated (523,378) $11.08 (12,500) $ 8.99
Exercised (612,333) $ 5.28 (5,000) $ 3.42
------------ -----------
Outstanding at December 31, 2002 3,321,568 $ 6.98 230,000 $ 8.50
============ ===========
The following is a summary of the options exercisable:
1991 Plan Director Plan 2002 Plan Non-qualified
--------- ------------- --------- -------------
At December 31, 2002 1,673,112 140,000 - 40,417
At December 31, 2001 1,727,873 136,250 - -
At December 31, 2000 1,188,951 105,000 - -
F-30
NOTE O - WARRANTS AND OPTIONS (CONTINUED)
Options (continued)
Under the agreement with JA&A discussed in Note E, in December 2001, the Company
issued to JA&A a non-qualified option to purchase 1.2 million shares of the its
common stock at an exercise price of $1.40 per share. The option was valued
using a Black-Scholes option-pricing model, and an expense of $4.8 million was
recorded with an increase in additional paid-in capital. The option was
exercisable beginning with the sixth month following each award and will expire
five years from the termination of JA&A's engagement. As of December 31, 2001,
the option was outstanding with no shares being exerciseable.
During 2002, the Company agreed to repurchase 601,218 of the shares underlying
such previously granted option for a payment of $3.98 per share, or a total of
$2,392,704, which was paid during the third quarter of 2002 and recorded as a
reduction in additional paid-in capital. On July 23, 2002, shares of the
Company's common stock opened for trading at $12.00 per share. In accordance
with our agreement with JA&A, the Company filed a Registration Statement on Form
S-3 with the Securities and Exchange Commission to register the remaining
601,218 shares underlying the outstanding option in order to permit JA&A to sell
the shares of the Company's stock that it may acquire upon exercise of the
option. Under the agreement with the Company on July 23, 2002, in accordance
with the sale of any shares that JA&A may acquire by exercise of the option,
JA&A has agreed to limit such sales to 40,000 shares in any calendar week.
Through December 31, 2002, all options were exercised and the Company has issued
601,218 shares of its common stock pursuant to the exercises.
Under an employment agreement, in October 2001, the Company issued to its Chief
Financial Officer a non-qualified option to purchase 75,000 shares of its common
stock at an exercise price of $5.50 per share. Similarly, under an employment
agreement, in January 2002, the Company issued to its President and Chief
Operating Officer a non-qualified option to purchase 350,000 shares of its
common stock at an exercise price of $6.02 per share. In addition, the Company
has issued to other employees non-qualified options to purchase an aggregate of
80,000 shares of its common stock at a weighted average exercise price of $8.73
per share. These options were granted at fair market value on the date of grant.
The following table summarizes information concerning outstanding and
exercisable options as of December 31, 2002:
Options Outstanding Options Exercisable
------------------------------------ --------------------------
Weighted Average
Number of ------------------------ Weighted
Range of Options Remaining Exercise Options Average
Exercise Prices or Awards Life (Years) Price or Awards Exercise Price
- -------------------------------------- ----------- ------------ -------- --------- --------------
$ 1.640 to $ 1.650 1,103,020 6.48 $ 1.64 277,479 $ 1.64
$ 2.810 to $ 6.000 948,727 5.09 $ 4.69 544,726 $ 4.67
$ 6.020 to $ 8.750 496,669 6.06 $ 6.16 146,669 $ 6.49
$ 9.200 to $ 13.800 312,154 5.83 $ 11.34 212,154 $11.52
$13.875 to $ 14.230 636,998 6.32 $ 14.17 288,876 $14.16
$14.750 to $ 22.500 559,000 6.53 $ 17.38 383,625 $17.83
----------------------------------------------------------------------------------------------
$ 1.640 to $ 22.500 4,056,568 6.04 $ 7.79 1,853,529 $ 9.35
=========== =========
F-31
NOTE P - SEGMENT AND RELATED INFORMATION
The Company has identified two reportable segments in which it operates based on
the products and services it provides. The Company evaluates segment performance
and allocates resources based on the segments' EBITDA. EBITDA is defined as net
income (loss) before extraordinary item, interest, taxes, depreciation and
amortization, and unusual charges consisting of impairment loss on assets held
for sale, and integration, impairment, restructuring, and performance
improvement costs. EBITDA, as used by management to evaluate segment
performance, is not a measure of performance under GAAP. Other EBITDA not
directly attributable to reportable segments is primarily related to corporate
general and administrative expenses.
The reportable segments are: (i) patient-care centers; (ii) distribution; and
(iii) manufacturing (discontinued October 9, 2001 upon sale of substantially all
of the manufacturing assets of Seattle Orthopedic Group, Inc.). On June 1, 2001,
in anticipation of the sale of the manufacturing segment, the Company
transferred the Sea-Fab operations from the manufacturing to the practice
management and patient-care centers segment. Accordingly, previously reported
amounts for 2000 have been recast to be consistent with the reporting in 2001
and 2002. The reportable segments are described further below:
Patient-Care Centers - This segment consists of the Company's owned and operated
O&P patient-care centers, fabrication centers of O&P components and OPNET. The
patient-care centers provide services to design and fit orthotic and prosthetic
devices to patients. These centers also instruct patients in the use, care and
maintenance of the devices. Fabrication centers are involved in the fabrication
of O&P components for both the O&P industry and the Company's own patient-care
practices. OPNET is a national managed care agent for O&P services and a patient
referral clearing house.
Distribution - This segment distributes purchased O&P products and components to
both the O&P industry and the Company's own patient-care practices.
Manufacturing - This previously reportable segment consisted of the manufacture
of components and finished patient-care products for both the O&P industry and
the Company's own patient-care practices.
The accounting policies of the segments are the same as those described in the
summary of "Significant Accounting Policies."
F-32
NOTE P - SEGMENT AND RELATED INFORMATION (CONTINUED)
Summarized financial information concerning the Company's reportable segments is
shown in the following table. Intersegment sales mainly include sales of O&P
components from the manufacturing and distribution segments to the patient-care
centers segment and were made at prices which approximate market values.
Patient Care
Centers Distribution Manufacturing Other Total
------------ ------------ ------------- ----- -----
(in thousands)
2002
- ----
Net sales
Customers $ 496,031 $ 29,503 $ - $ - $ 525,534
Intersegments - 53,182 - (53,182) -
EBITDA 104,280 9,877 - (19,763) 94,394
Total assets 576,078 25,775 - 110,373 712,226
Capital expenditures 7,766 86 - 1,260 9,112
2001
- ----
Net sales
Customers $ 473,877 $ 29,292 $ 4,884 $ - $ 508,053
Intersegments - 53,202 3,749 (56,951) -
EBITDA 98,029 5,899 (247) (19,468) 84,213
Total assets 512,379 25,838 - 161,690 699,907
Capital expenditures 4,669 271 383 1,374 6,697
2000
- ----
Net sales
Customers $ 448,852 $ 28,999 $ 8,180 $ - $ 486,031
Intersegments 9,226 51,427 5,877 (66,530) -
EBITDA 71,179 6,677 938 (21,523) 57,271
Total assets 495,942 20,823 8,731 236,322 761,818
Capital expenditures 6,486 114 765 2,480 9,845
"Other" EBITDA presented in the preceding table consists of corporate general
and administrative expenses.
F-33
NOTE P - SEGMENT AND RELATED INFORMATION (CONTINUED)
The following table reconciles EBITDA to consolidated net income (loss):
2002
----
EBITDA $ 94,394
Depreciation and amortization 9,892
Unusual charges 1,860
Interest expense, net 38,314
Provision for income taxes 17,947
Extraordinary item 2,811
-----------
Net income $ 23,570
===========
2001
----
EBITDA $ 84,213
Depreciation and amortization 24,686
Unusual charges 24,438
Interest expense, net 43,065
Provision for income taxes 907
-----------
Net loss $ (8,883)
===========
2000
----
EBITDA $ 57,271
Depreciation and amortization 23,328
Unusual charges 2,364
Interest expense, net 47,072
Benefit for income taxes (1,497)
-----------
Net loss $ (13,996)
==========
F-34
NOTE P - SEGMENT AND RELATED INFORMATION (CONTINUED)
The following table presents the details of "Other" total assets at December 31:
2002 2001 2000
------------ ------------- -------------
(in thousands)
Corporate intercompany receivable (payable) from:
Patient-Care Centers segment $ 76,711 $ 133,195 $ 159,416
Manufacturing segment - - 21,926
Distribution segment (11,374) (11,428) (588)
Other 45,036 39,923 55,568
------------ ------------- -------------
$ 110,373 $ 161,690 $ 236,322
==========================================
"Other" total assets presented in the preceding table primarily consist of
corporate cash and deferred taxes not specifically identifiable to the
reportable segments.
The Company's foreign and export sales and assets located outside of the United
States are not significant. Additionally, no single customer accounted for more
than 10% of revenues in 2002, 2001 or 2000.
NOTE Q - CONSOLIDATING FINANCIAL INFORMATION
The Company's Senior Notes and Senior Subordinated Notes are guaranteed fully,
jointly and severally, and unconditionally by all of the Company's current and
future domestic subsidiaries. The following is summarized condensed
consolidating financial information, as of December 31, 2002 and 2001 and for
the three years in the period ended December 31, 2002, of the Company,
segregating the parent company (Hanger Orthopedic Group) and its guarantor
subsidiaries, as each of the Company's subsidiaries is wholly-owned.
F-35
NOTE Q - CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)
Hanger
Orthopedic
Group
(Parent Guarantor Consolidating Consolidated
BALANCE SHEET - December 31, 2002 Company) Subsidiaries Adjustments Totals
- ------------------------------------------------------------ ----------- -------------- ------------- --------
(in thousands)
ASSETS
Cash and cash equivalents $ 570 $ 5,996 $ - $ 6,566
Accounts receivable - 107,604 - 107,604
Inventories - 56,454 - 56,454
Prepaid expenses, other assets, and income taxes receivable 8,865 6,567 - 15,432
Intercompany receivable 513,802 - (513,802) -
Deferred income taxes 6,586 - - 6,586
---------------------------------------------------------
Total current assets 529,823 176,621 (513,802) 192,642
Property, plant and equipment, net 4,633 30,913 - 35,546
Intangible assets, net - 459,816 - 459,816
Investment in subsidiaries 98,258 - (98,258) -
Other assets 22,465 1,757 - 24,222
---------------------------------------------------------
Total assets $ 655,179 $ 669,107 $ (612,060) $ 712,226
=========================================================
LIABILITIES, REDEEMABLE PREFERRED STOCK,
AND SHAREHOLDERS' EQUITY
Current portion of long-term debt $ - $ 5,181 $ - $ 5,181
Accounts payable 334 14,542 - 14,876
Accrued expenses 4,446 1,014 - 5,460
Accrued interest payable 7,340 167 - 7,507
Accrued compensation related cost 3,062 29,888 - 32,950
---------------------------------------------------------
Total current liabilities 15,182 50,792 - 65,974
Long-term debt, less current portion 373,398 4,703 - 378,101
Deferred income taxes 22,965 - - 22,965
Intercompany payable - 513,802 (513,802) -
Other liabilities 26 1,552 - 1,578
---------------------------------------------------------
Total liabilities 411,571 570,849 (513,802) 468,618
---------------------------------------------------------
Redeemable preferred stock 75,941 - - 75,941
---------------------------------------------------------
Common stock 203 35 (35) 203
Additional paid-in capital 150,287 7,460 (7,460) 150,287
Retained earnings (accumulated deficit) 17,833 91,303 (91,303) 17,833
Treasury stock (656) (540) 540 (656)
---------------------------------------------------------
Total shareholders' equity 167,667 98,258 (98,258) 167,667
---------------------------------------------------------
Total liabilities, redeemable preferred stock,
and shareholders' equity $ 655,179 $ 669,107 $ (612,060) $ 712,226
=========================================================
F-36
NOTE Q - CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)
Hanger
Orthopedic
Group
(Parent Guarantor Consolidating Consolidated
BALANCE SHEET - December 31, 2001 Company) Subsidiaries Adjustments Totals
- ------------------------------------------------------------ ----------- -------------- ------------- --------
(in thousands)
ASSETS
Cash and cash equivalents $ (212) $ 10,255 $ - $ 10,043
Accounts receivable - 104,040 - 104,040
Inventories - 55,946 - 55,946
Prepaid expenses, other assets, and income taxes receivable 591 4,310 - 4,901
Intercompany receivable 126,124 - (126,124) -
Deferred income taxes 20,957 - - 20,957
---------------------------------------------------------
Total current assets 147,460 174,551 (126,124) 195,887
Property, plant and equipment, net 4,767 33,011 - 37,778
Intangible assets, net (156) 452,536 - 452,380
Investment in subsidiaries 60,673 - (60,673) -
Other assets (1) 417,672 (403,810) - 13,862
---------------------------------------------------------
Total assets $ 630,416 $ 256,288 $ (186,797) $ 699,907
=========================================================
LIABILITIES, REDEEMABLE PREFERRED STOCK,
AND SHAREHOLDERS' EQUITY
Current portion of long-term debt $ 19,199 $ 11,313 $ - $ 30,512
Accounts payable 520 16,381 - 16,901
Accrued expenses 4,586 3,610 - 8,196
Accrued interest payable 1,577 440 - 2,017
Accrued compensation related cost 2,438 26,607 - 29,045
---------------------------------------------------------
Total current liabilities 28,320 58,351 - 86,671
Long-term debt, less current portion (1) 359,188 8,127 - 367,315
Deferred income taxes 26,495 - - 26,495
Intercompany payable - 126,124 (126,124) -
Other liabilities - 3,013 - 3,013
---------------------------------------------------------
Total liabilities 414,003 195,615 (126,124) 483,494
---------------------------------------------------------
Redeemable preferred stock 70,739 - - 70,739
---------------------------------------------------------
Common stock 191 35 (35) 191
Additional paid-in capital 146,674 7,461 (7,461) 146,674
Retained earnings (accumulated deficit) (535) 53,717 (53,717) (535)
Treasury stock (656) (540) 540 (656)
---------------------------------------------------------
Total shareholders' equity 145,674 60,673 (60,673) 145,674
---------------------------------------------------------
Total liabilities, redeemable preferred stock,
and shareholders' equity $ 630,416 $ 256,288 $ (186,797) $ 699,907
=========================================================
(1) Other assets of the parent company and long-term debt of the guarantor
subsidiaries include a $406.7 million note payable from a subsidiary to the
parent.
F-37
NOTE Q - CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)
Hanger
Orthopedic
Group
(Parent Guarantor Consolidating Consolidated
STATEMENTS OF OPERATIONS - December 31, 2002 Company) Subsidiaries Adjustments Totals
- --------------------------------------------------------------------- ----------- -------------- ------------- --------
(in thousands)
Year ended December 31, 2002
Net sales $ - $ 525,535 $ - $ 525,535
Cost of goods sold (exclusive of depreciation and amortization) - 241,372 - 241,372
---------------------------------------------------------
Gross profit - 284,163 - 284,163
Selling, general and administrative 19,762 170,007 - 189,769
Depreciation and amortization 1,339 8,553 - 9,892
Unusual charges 1,860 - 1,860
---------------------------------------------------------
Income (loss) from operations (21,101) 103,743 - 82,642
Interest income (expense), net (6,207) (32,107) (38,314)
Equity in earnings of subsidiaries 71,636 - (71,636) -
---------------------------------------------------------
Income (loss) before taxes 44,328 71,636 (71,636) 44,328
Provision for income taxes 17,947 - - 17,947
---------------------------------------------------------
Income (loss) before extraordinary item 26,381 71,636 (71,636) 26,381
Extraordinary item (2,811) - - (2,811)
---------------------------------------------------------
Net income (loss) $ 23,570 $ 71,636 $ (71,636) $ 23,570
=========================================================
Year ended December 31, 2001
Net sales $ - $ 508,053 $ - $ 508,053
Cost of goods sold (exclusive of depreciation and amortization) - 240,868 - 240,868
---------------------------------------------------------
Gross profit - 267,185 - 267,185
Selling, general and administrative 19,468 163,504 - 182,972
Depreciation and amortization 1,666 9,947 - 11,613
Amortization of excess cost over net assets acquired (5) 13,078 - 13,073
Unusual charges 11,470 12,968 - 24,438
---------------------------------------------------------
Income (loss) from operations (32,599) 67,688 - 35,089
Interest income (expense), net 7,452 (50,517) - (43,065)
Equity in earnings of subsidiaries 17,171 - (17,171) -
---------------------------------------------------------
Income (loss) before taxes (7,976) 17,171 (17,171) (7,976)
Provision for income taxes 907 - - 907
---------------------------------------------------------
Net income (loss) $ (8,883) $ 17,171 $ (17,171) $ (8,883)
=========================================================
F-38
NOTE Q - CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)
Hanger
Orthopedic
Group
(Parent Guarantor Consolidating Consolidated
Company) Subsidiaries Adjustments Totals
---------- ------------ ------------- -------------
(in thousands)
--------------------------------------------------------
STATEMENT OF OPERATIONS
Year ended December 31, 2000
Net sales $ - $ 486,031 $ - $ 486,031
Cost of goods sold (exclusive of depreciation and amortization) - 251,368 - 251,368
--------------------------------------------------------
Gross profit - 234,663 - 234,663
Selling, general and administrative 21,523 155,869 - 177,392
Depreciation and amortization 1,100 9,203 - 10,303
Amortization of excess cost over net assets acquired (5) 13,030 - 13,025
Unusual charges 1,298 1,066 - 2,364
--------------------------------------------------------
Income (loss) from operations (23,916) 55,495 - 31,579
Interest income (expense), net 3,379 (50,451) - (47,072)
Equity in earnings of subsidiaries 5,044 - (5,044) -
Income (loss) before taxes (15,493) 5,044 (5,044) (15,493)
Benefit for income taxes (1,497) - - (1,497)
--------------------------------------------------------
Net income (loss) $ (13,996) $ 5,044 $ (5,044) $ (13,996)
========================================================
STATEMENT OF CASH FLOWS
Year ended December 31, 2002
Cash flows from operating activities:
Net cash provided by (used in) operating activities $ (10,317) $ 57,851 $ - $ 47,534
--------------------------------------------------------
Cash flows from investing activities:
Purchase of property, plant and equipment (1,260) (7,852) - (9,112)
Acquisitions, net of cash acquired, and earnouts - (10,407) - (10,407)
Dividend Distribution from HSC 34,052 (34,052) - -
Proceeds from sale of certain assets, net of cash - 1,507 - 1,507
--------------------------------------------------------
Net cash provided by (used in) investing activities 32,792 (50,804) - (18,012)
--------------------------------------------------------
Cash flows from financing activities: -
Borrowings under revolving credit agreement 46,975 - - 46,975
Repayments under revolving credit agreement (106,775) - - (106,775)
Proceeds from sale of Senior Notes 200,000 - - 200,000
Repayment and termination of bank loans (153,587) - - (153,587)
Scheduled repayment of long-term debt - (11,306) - (11,306)
Increase in financing costs (9,831) - - (9,831)
Proceeds from issuance of Common Stock 3,918 - - 3,918
Repurchase of Outstanding Stock Options (2,393) - - (2,393)
--------------------------------------------------------
Net cash used in financing activities (21,693) (11,306) - (32,999)
--------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 782 (4,259) - (3,477)
Cash and cash equivalents, beginning of period (212) 10,255 - 10,043
--------------------------------------------------------
Cash and cash equivalents, end of period $ 570 $ 5,996 $ - $ 6,566
========================================================
F-39
NOTE Q - CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)
Hanger
Orthopedic
Group
(Parent Guarantor Consolidating Consolidated
STATEMENTS OF CASH FLOWS Company) Subsidiaries Adjustments Totals
- ------------------------------------------------------------------ ---------- ------------ ------------- ------------
(in thousands)
-----------------------------------------------------------
Year ended December 31, 2001
Cash flows from operating activities:
Net cash provided by operating activities $ 39,318 $ 11,848 $ - $ 51,166
-----------------------------------------------------------
Cash flows from investing activities:
Purchase of property, plant and equipment (1,374) (5,323) - (6,697)
Acquisitions, net of cash acquired, and earnouts - (8,277) - (8,277)
Proceeds from sale of certain assets, net of cash - 16,079 - 16,079
-----------------------------------------------------------
Net cash provided by (used in) investing activities (1,374) 2,479 - 1,105
-----------------------------------------------------------
Cash flows from financing activities:
Borrowings under revolving credit agreement 6,000 - - 6,000
Repayments under revolving credit agreement (15,900) - - (15,900)
Repayment and termination of bank loans (38,163) - - (38,163)
Scheduled repayment of long-term debt - (13,912) - (13,912)
Increase in financing costs (1,172) - - (1,172)
Proceeds from issuance of Common Stock 250 - - 250
-----------------------------------------------------------
Net cash used in financing activities (48,985) (13,912) - (62,897)
-----------------------------------------------------------
Net increase (decrease) in cash and cash equivalents (11,041) 415 - (10,626)
Cash and cash equivalents, beginning of period 10,829 9,840 - 20,669
-----------------------------------------------------------
Cash and cash equivalents, end of period $ (212) $ 10,255 $ - $ 10,043
===========================================================
Year ended December 31, 2000
Cash flows from operating activities:
Net cash provided by (used in) operating activities $ (1,840) $ 5,447 $ - $ 3,607
-----------------------------------------------------------
Cash flows from investing activities:
Purchase of property, plant and equipment (2,480) (7,365) - (9,845)
Acquisitions, net of cash acquired, and earnouts - (9,958) - (9,958)
Cash received pursuant to purchase price adjustment - 24,700 - 24,700
Purchase of other intangible assets - (273) - (273)
-----------------------------------------------------------
Net cash provided by (used in) investing activities (2,480) 7,104 - 4,624
-----------------------------------------------------------
Cash flows from financing activities:
Borrowings under revolving credit agreement 54,300 - - 54,300
Repayments under revolving credit agreement (24,600) - - (24,600)
Repayment and termination of bank loans (8,250) - - (8,250)
Scheduled repayment of long-term debt - (13,521) - (13,521)
Increase in financing costs (1,226) - - (1,226)
-----------------------------------------------------------
Net cash provided by (used in) financing activities 20,224 (13,521) - 6,703
-----------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 15,904 (970) - 14,934
Cash and cash equivalents, beginning of period (5,075) 10,810 - 5,735
-----------------------------------------------------------
Cash and cash equivalents, end of period $ 10,829 $ 9,840 $ - $ 20,669
===========================================================
F-40
HANGER ORTHOPEDIC GROUP, INC.
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
ADDITIONS
BALANCE AT CHARGED TO
BEGINNING COSTS AND BALANCE AT
YEAR CLASSIFICATION OF YEAR EXPENSES WRITE OFFS END OF YEAR
------ ---------------- ------------ ------------ ------------ -------------
(in thousands)
2002 Allowance for doubtful accounts $ 17,625 $ 19,738 $ 28,714 $ 8,649
Inventory reserves $ 129 $ - $ 11 $ 118
2001 Allowance for doubtful accounts $ 23,005 $ 21,961 $ 27,341 $ 17,625
Inventory reserves $ 2,398 $ - $ 2,269* $ 129
2000 Allowance for doubtful accounts $ 17,866 $ 23,620 $ 18,481 $ 23,005
Inventory reserves $ 2,281 $ 120 $ 3 $ 2,398
* The decrease in the inventory reserves during 2001 was due to the Company's efforts to utilize and dispose of its
excess inventory.
S-1