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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED
SEPTEMBER 30, 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 No.: 001-13457
ORTHODONTIC CENTERS OF AMERICA, INC.
(Exact name of registrant as specified in its charter)
Delaware 72-1278948
(State or other jurisdiction of incorporation or (I.R.S. Employer Identification No.)
organization)
3850 N. CAUSEWAY BOULEVARD, SUITE 800
METAIRIE, LOUISIANA 70002
(504) 834-4392
(Address, including zip code, of principal executive
offices and Registrant's telephone number,
including area code)
- --------------------------------------------------------------------------------
(Former name, former address and former fiscal year, if changed since last
report)
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
--- ---
As of November 12, 2002 there were approximately 51,128,000 outstanding shares
of the Registrant's Common Stock, $.01 par value per share.
ORTHODONTIC CENTERS OF AMERICA, INC.
TABLE OF CONTENTS
Page
Part I. Financial Information
Item 1. Consolidated Financial Statements:
Consolidated Balance Sheets -
September 30, 2002 (Unaudited) and December 31, 2001......................................................3
Consolidated Statements of Income -
Three and Nine Months Ended September 30, 2002 and 2001 (Unaudited).......................................4
Consolidated Statements of Cash Flows -
Nine Months Ended September 30, 2002 and 2001 (Unaudited).................................................5
Notes to Consolidated Financial Statements - September 30, 2002 (Unaudited)..................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations...................15
Item 3. Quantitative and Qualitative Disclosures about Market Risk..............................................28
Item 4. Controls and Procedures.................................................................................28
Part II. Other Information
Item 1. Legal Proceedings ......................................................................................29
Item 2. Changes in Securities and Use of Proceeds...............................................................29
Item 6. Exhibits and Reports on Form 8-K........................................................................29
FORWARD-LOOKING STATEMENTS
Certain statements contained in this Report may not be based on historical facts
and are "forward looking statements" within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended. These forward-looking statements may be identified by
reference to a future period(s) or by the use of forward looking terminology,
such as "anticipate," "estimate," "believe," "expect," "foresee," "may,"
"would," "could" or "will." These forward-looking statements include, without
limitation, statements regarding the Company's future growth, fee revenue,
critical accounting policies and estimates, deferred tax asset, impairment of
assets, allowance for uncollectible amounts, liquidity, capital resources, cash
needs, amendments to existing service agreements, stock repurchases, pending
litigation against OrthAlliance, financial merits of the OrthAlliance merger and
the purchase price allocation of the merger, advances to affiliated practices,
repayment or replacement of outstanding indebtedness and impairment of goodwill.
We caution you not to place undue reliance on these forward-looking statements,
in that they involve certain risks and uncertainties that could cause actual
results to differ materially from anticipated results. These risks and
uncertainties include potential adverse changes in the Company's financial
results and conditions, disruption of the Company's relationships with its
affiliated practices or loss of a significant number of the Company's affiliated
practices, failure or delay in integrating OrthAlliance's affiliated practices,
adverse outcomes of litigation pending against the Company and OrthAlliance,
competition, inability to effectively manage an increasing number of affiliated
practices, changes in the general economy of the United States and the specific
markets in which the Company operates, risks relating to the Company's foreign
operations, changes in the Company's operating or expansion strategy, inability
of the Company to attract and retain qualified personnel and affiliated
practitioners, inability of the Company to effectively market its services and
those of its affiliated practices, changes in regulations affecting the
Company's business, inability to obtain alternative financing or to obtain
financing on acceptable terms, and other factors identified in the Company's
Annual Report on Form 10-K for the year ended December 31, 2001, other filings
with the Securities and Exchange Commission or in other public announcements by
the Company. We undertake no obligation to update these forward-looking
statements to reflect events or circumstances that occur after the date of this
Report.
2
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
Orthodontic Centers of America, Inc.
Consolidated Balance Sheets
(dollars in thousands, except per share amounts)
September 30, December 31,
2002 2001
------------- ------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents ............................................................ $ 10,996 $ 14,172
Service fees receivable, net of allowance for uncollectible amounts of $4,410 at
September 30, 2002 and $3,852 at December 31, 2001 ................................. 93,917 58,610
Advances to affiliated practices, net of allowance for uncollectible amounts
of $20,429 at September 30, 2002 and $9,000 at December 31, 2001 ................... 11,422 16,824
Deferred income taxes ................................................................ 5,449 4,374
Supplies inventory ................................................................... 10,656 8,843
Prepaid expenses and other assets .................................................... 8,576 6,963
--------- ---------
Total current assets .......................................................... 141,016 109,786
Property, equipment and improvements, net ............................................ 91,096 91,843
Advances to affiliated practices, less current portion, net .......................... 17,275 10,756
Deferred income taxes ................................................................ 63,269 56,694
Intangible assets, net ............................................................... 216,004 229,276
Goodwill ............................................................................. 78,748 71,782
Other assets ......................................................................... 4,739 6,173
--------- ---------
Total other assets ............................................................ 471,131 466,524
--------- ---------
TOTAL ASSETS .................................................................. $ 612,147 $ 576,310
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable ..................................................................... $ 3,876 $ 11,321
Accrued salaries and other accrued liabilities ....................................... 16,985 18,142
Deferred revenue ..................................................................... 909 1,929
Income taxes payable ................................................................. 30,992 1,363
Service fee prepayments .............................................................. 11,480 13,976
Amounts payable to affiliated practices .............................................. 162 5,471
Current portion of notes payable to affiliated practices ............................. 2,673 4,036
--------- ---------
Total current liabilities ..................................................... 67,077 56,238
Notes payable to affiliated practices, less current portion .......................... 10,691 11,564
Long-term debt ....................................................................... 107,639 119,000
Non-controlling interest in subsidiary ............................................... 10 56
Commitments and contingencies ........................................................ -- --
Shareholders' equity:
Preferred stock, $.01 par value: 10,000,000 shares authorized, no shares
outstanding ...................................................................... -- --
Common stock, $.01 par value: 100,000,000 shares authorized; approximately
51,255,000 shares issued and outstanding at September 30, 2002 and 50,914,000
shares issued and outstanding at December 31, 2001 ............................... 512 509
Additional paid-in capital ......................................................... 211,429 208,949
Retained earnings .................................................................. 232,161 182,715
Accumulated other comprehensive loss ............................................... (3,133) (1,989)
Due from key employees for stock purchase program .................................. (488) (488)
Capital contributions receivable from shareholders ................................. (244) (244)
Less - cost of approximately 962,000 shares of treasury stock at September 30,
2002 ............................................................................. (13,507) --
--------- ---------
Total shareholders' equity .................................................... 426,730 389,452
--------- ---------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY .................................... $ 612,147 $ 576,310
========= =========
See notes to consolidated financial statements.
3
Orthodontic Centers of America, Inc.
Consolidated Statements of Income
Unaudited
(in thousands, except per share data)
Three months ended Nine months ended
September 30, September 30,
------------------------- -------------------------
2002 2001 2002 2001
--------- --------- --------- ---------
Fee revenue ................................. $ 112,738 $ 86,840 $ 337,493 $ 246,552
Direct expenses:
Employee costs ......................... 31,068 25,359 94,973 71,011
Orthodontic supplies ................... 10,286 7,025 29,414 19,718
Rent ................................... 9,755 7,709 29,894 21,597
Marketing and advertising .............. 9,129 7,282 26,042 19,980
--------- --------- --------- ---------
Total direct expenses .............. 60,238 47,375 180,323 132,306
General and administrative .................. 13,810 9,521 42,984 26,939
Non-recurring recruiting expense ............ -- -- 12,772 --
Depreciation and amortization ............... 6,322 4,490 17,616 13,504
--------- --------- --------- ---------
Operating profit ............................ 32,368 25,454 83,798 73,803
Interest income (expense), net .............. (2,070) (1,105) (4,413) (3,352)
Non-controlling interest in subsidiary ...... 14 33 45 (47)
--------- --------- --------- ---------
Income before income taxes .................. 30,312 24,382 79,430 70,404
Provision for income taxes .................. 11,443 9,204 29,985 26,578
--------- --------- --------- ---------
Net income .................................. $ 18,869 $ 15,178 $ 49,445 $ 43,826
========= ========= ========= =========
Net income per share:
Basic .................................. $ 0.37 $ 0.31 $ 0.96 $ 0.90
========= ========= ========= =========
Diluted ................................ $ 0.37 $ 0.30 $ 0.95 $ 0.87
========= ========= ========= =========
Weighted average shares outstanding:
Basic .................................. 51,229 48,962 51,317 48,863
========= ========= ========= =========
Diluted ................................ 51,547 50,123 51,884 50,133
========= ========= ========= =========
See notes to consolidated financial statements.
4
Orthodontic Centers of America, Inc.
Consolidated Statements of Cash Flows
Unaudited
(in thousands)
Nine months ended
September 30,
-------------------------
2002 2001
-------- --------
Operating activities:
Net income ............................................................... $ 49,445 $ 43,826
Adjustments to reconcile net income to net cash provided by operating
activities:
Provision for uncollectible amounts .................................... 2,259 416
Depreciation and amortization .......................................... 17,616 13,504
Deferred income taxes .................................................. 8,066 --
Non-recurring recruiting expense ....................................... 4,771 --
Non-controlling interest in subsidiary ................................. (46) 80
Changes in operating assets and liabilities, net of acquisition:
Service fees receivable and prepayments .............................. (37,973) (15,823)
Supplies inventory ................................................... (1,813) (1,283)
Prepaid expenses and other assets .................................... (1,281) (4,214)
Amounts payable to affiliated practices .............................. (5,309) 962
Accounts payable and other current liabilities ....................... 14,936 1,669
-------- --------
Net cash provided by operating activities ................................... 50,671 39,137
Investing activities:
Purchases of property, equipment and improvements ........................ (9,939) (19,565)
Intangible assets acquired ............................................... (4,644) (17,701)
Proceeds from available-for-sale investments ............................. -- 999
Advances to affiliated practices, net .................................... (12,589) (3,223)
Other .................................................................... 126 --
-------- --------
Net cash used in investing activities ....................................... (27,046) (39,490)
Financing activities:
Repayment of notes payable to affiliated practices ....................... (3,835) (644)
Repayment of long-term debt .............................................. (12,000) (8,322)
Proceeds from notes payable to affiliated practices ...................... 287 --
Proceeds from long-term debt ............................................. 639 3,128
Repurchase of common stock ............................................... (13,507) --
Issuance of common stock ................................................. 2,759 12,634
-------- --------
Net cash (used in) provided by financing activities ......................... (25,657) 6,796
Effect of exchange rate changes on cash and cash equivalents ................ (1,144) --
Change in cash and cash equivalents ......................................... (3,176) 6,443
Cash and cash equivalents at beginning of period ............................ 14,172 4,690
-------- --------
Cash and cash equivalents at end of period .................................. $ 10,996 $ 11,133
======== ========
Supplemental cash flow information: Cash paid during period for:
Interest ............................................................. $ 1,809 $ 3,414
======== ========
Income taxes ......................................................... $ 366 $ 29,714
======== ========
Supplemental disclosures of non-cash investing and financing activities:
Notes payable and common stock issued
to obtain Service Agreements .......................................... $ 1,312 $ 796
======== ========
See notes to consolidated financial statements.
5
Orthodontic Centers of America, Inc.
Notes to Consolidated Financial Statements (Unaudited)
September 30, 2002
1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
Orthodontic Centers of America, Inc. (the "Company") provides business services
to 348 orthodontic and 27 pediatric dental practices in 45 states and 4 foreign
markets.
Number of Affiliated Practices
----------------------------------
Location Orthodontic Pediatric Total
- --------------------------- ----------- --------- --------
United States ............. 320 27 347
Japan ..................... 21 - 21
Mexico .................... 3 - 3
Puerto Rico ............... 2 - 2
Spain ..................... 2 - 2
----- ----- -----
Total ..................... 348 27 375
===== ===== =====
The Company provides purchasing, financial, marketing and administrative
services under service, management service and consulting agreements ("Service
Agreements"). The Company provides services to orthodontic and pediatric dental
practices operated by orthodontists and pediatric dentists and/or their
wholly-owned professional entities ("Affiliated Practices"). These amounts
exclude 49 orthodontists and pediatric dentists that are in litigation with
OrthAlliance, Inc. ("OrthAlliance"), which was acquired by the Company in
November 2001, and have ceased paying service fees. Because the Company does not
control the Affiliated Practices, it does not consolidate their financial
results.
The Company's consolidated financial statements include service fees earned
under the Service Agreements and the expenses of providing the Company's
services. These expenses include all expenses of the Affiliated Practices
excluding the practitioners' compensation and certain expenses directly related
to the Affiliated Practices, including professional insurance coverage.
Certain reclassifications have been made to the prior period's financial
statements in order to conform to the current period's presentation.
The accompanying unaudited consolidated financial statements have been prepared
in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments considered
necessary for a fair presentation have been included. Operating results for the
three- and nine-month periods ended September 30, 2002 are not necessarily
indicative of the results that may be expected for the year ending December 31,
2002. For further information, refer to the consolidated financial statements
and footnotes thereto included in the Company's Annual Report on Form 10-K for
the year ended December 31, 2001.
2. REVENUE RECOGNITION
Fee revenue consists of service fees earned by the Company under the Service
Agreements, which are generally calculated as a percentage of the operating
profits or patient revenue of the Affiliated Practices plus reimbursement of
practice-related expenses. The Company recognizes Fee revenue based upon a
straight-line allocation of Affiliated Practices' patient contract balances over
the terms of the patient contracts, less amounts retained or estimated to be
retained by Affiliated Practices. Amounts retained or to
6
be retained by Affiliated Practices are reduced by practice-related expenses
that the Company has incurred but for which it has not been reimbursed by the
Affiliated Practices. The term of an orthodontic patient contract averages about
26 months.
Under most of the Company's Service Agreements, service fees are calculated
based upon an allocation of approximately 24% of patient contract balances
during the first month of treatment with the remainder allocated equally over
the remaining term of the patient contracts, less amounts actually retained by
Affiliated Practices. This may result in the Company recognizing a portion
of its Fee revenue after corresponding service fees have become contractually
due under the Company's Service Agreements.
Many Affiliated Practices that are affiliated with OrthAlliance require
that their patients pay a down payment of approximately 25% of the total
treatment fee at the commencement of treatment. This results in the Company
receiving cash in advance of incurring certain practice-related expenses and
recognizing certain service fees as fee revenue. The Company records these
amounts as service fee prepayments and defers recognition of these amounts as
fee revenue.
3. RECEIVABLES
The Company generally earns service fees under the Service Agreements as a
percentage of the operating profits or patient revenue of the Affiliated
Practices plus reimbursement of practice-related expenses. The Company
generally collects its service fees as patient fees are collected on behalf of
Affiliated Practices and deposited. A portion of the Company's service fees
receivable relates to a retainer fee that averages approximately 12.8% of a
patient's total treatment fee and is generally collected in the final month of
a patient's treatment.
Most of the Affiliated Practices pledge their billed and unbilled patient fees
receivable to the Company as collateral for the Company's service fees. The
Company is generally responsible for billing and collection of the patient fees
receivable, which are conducted in the name of the applicable Affiliated
Practice. Collections from patient fees receivable are generally deposited into
depository bank accounts that the Company establishes and maintains.
The Company generally collects its service fees receivable from funds that are
collected from patient fees receivable and deposited into depository bank
accounts. This results in deferral of collection of a portion of the Company's
service fees receivable until the related patient fees receivable that have been
pledged to the Company are collected and the funds are deposited. This deferral
is generally for a period that averages less than 90 days, as patient fees
receivable are generally collected within that period of time. The Company does
not generally charge Affiliated Practices any interest on these deferred
balances of service fees receivable. For newly-developed centers (which
typically generate operating losses during their first 12 months of operations),
the Company generally defers payment of a portion of its service fees relating
to unreimbursed expenses over a five-year period that generally commences in the
second year of the center's operations, and charges the Affiliated Practices
interest on those deferred amounts at market rates. Under the Company's revenue
recognition policy, those unreimbursed expenses are not recognized as revenue or
recorded as service fees receivable until such revenue is collateralized by
patient fees receivable pledged by Affiliated Practices. Pledged patient fees
receivable which prove to be uncollectible have the effect of reducing the
amount of service fees receivable collected by the Company.
In some cases, the Company assists Affiliated Practices in obtaining financing
for their share of operating expenses by providing a guaranty of loans from a
third-party lender. Information about amounts guaranteed by the Company is
discussed in Note 6 and "ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL
RESOURCES."
7
4. INTANGIBLE ASSETS
The Company generally affiliates with an existing orthodontic or pediatric
dental practice by entering into a Service Agreement and acquiring substantially
all of the non-professional assets of the practice or professional corporation.
The acquired assets generally consist of equipment, furniture, fixtures and
leasehold interests. The Company records these acquired tangible assets at their
fair value as of the date of acquisition and depreciates or amortizes these
assets using the straight-line method over their useful lives. The remainder of
the purchase price is allocated to an intangible asset, which represents the
cost of obtaining the Service Agreement. The Company obtains the exclusive right
to provide business operations, financial, marketing and administrative services
to the Affiliated Practice during the term of the Service Agreement. The Service
Agreements generally provide that the professional corporation or entity is
responsible for providing orthodontic or pediatric dental services and for
employing all orthodontists or pediatric dentists. The terms of the Service
Agreements range from 20 to 40 years, with most ranging from 20 to 25 years. In
many cases, the Affiliated Practice has the option to terminate the Service
Agreement after a certain length of time as prescribed in the Service Agreement.
If the Affiliated Practice terminates its affiliation with the Company, it
generally is required to purchase all of the related assets, including the
unamortized portion of the intangible assets, at the current book value or sell
its interests in the practice to another licensed orthodontist or pediatric
dentist.
Subsequent to affiliation, an Affiliated Practice may acquire an existing
practice, center or patient base. The Company may pay additional consideration
to the Affiliated Practice to amend its Service Agreement to extend the
Company's affiliation to such newly acquired practice. This provides the Company
with the opportunity to earn additional service fees. This consideration is also
allocated to an intangible asset.
Service Agreements are amortized on a straight-line basis over the shorter of
their term or 25 years. Amortization expense relating to intangible assets was
$2.4 million and $7.8 million, respectively, for the three- and nine-month
periods ended September 30, 2002, compared to $2.0 million and $6.1 million,
respectively, for the comparable periods in 2001. Accumulated amortization was
$39.8 million and $29.4 million as of September 30, 2002 and 2001, respectively.
Intangible assets and the related accumulated amortization are written off when
fully amortized. See Note 14 for additional discussion about intangible assets
and SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets."
5. BUSINESS COMBINATION WITH ORTHALLIANCE
On November 9, 2001, a newly-formed subsidiary of the Company merged with
OrthAlliance. As a result of the merger, OrthAlliance became a wholly-owned
subsidiary of the Company. OrthAlliance provides management and consulting
services to orthodontic and pediatric dental practices throughout the United
States.
The merger was accounted for using the purchase method of accounting. The
results of operations of OrthAlliance subsequent to November 9, 2001 have been
included in the Company's consolidated statements of income. The results of
OrthAlliance do not include results of operations relating to Service Agreements
with certain affiliated practices that are parties to litigation pending against
OrthAlliance and have ceased remitting service fees to OrthAlliance (the
"Excluded OrthAlliance Affiliated Practices").
During 2002, the Company began finalizing the purchase price allocation by
assessing the fair value of assets acquired and liabilities assumed in the
merger. The following are significant changes to the Company's initial purchase
price allocation:
- - adjustment of certain advances to OrthAlliance Affiliated Practices to
expected realizable value;
8
- - decrease of the net book value of property, equipment and improvements and
intangible assets to their fair value; and
- - increase of liabilities assumed to reflect revised estimated legal expenses
to be incurred in connection with litigation with OrthAlliance Affiliated
Practices.
The Company believes the recoverability of these advances, property, equipment
and improvements and intangible assets is uncertain and, therefore, has reduced
the amount of these assets to reflect the amounts the Company expects to
recover. The Company recorded corresponding adjustments to goodwill and deferred
taxes as a result of the above changes to the purchase price allocation. At
September 30, 2002, the balance of goodwill was $78.7 million. These purchase
price allocations are subject to change as the Company obtains more information
and as certain pre-acquisition contingencies, particularly those related to
litigation, are resolved.
During 2001, a number of OrthAlliance's affiliated practices commenced
litigation against OrthAlliance. The affiliated practices alleged, among other
things, that OrthAlliance breached the terms of their Service Agreements by
failing to provide certain services and/or that certain provisions of their
Service Agreements may be unenforceable. In determining the purchase price
allocation, the Company has assigned no value to advances to affiliated
practices, property, equipment and improvements, notes receivable, and Service
Agreements relating to the Excluded OrthAlliance Affiliated Practices because of
the inherent uncertainties of the litigation process. Also, the allocation does
not reflect any proceeds that may be received by OrthAlliance from these
Affiliated Practices in consideration for certain assets or termination of their
Service Agreements. Therefore, the estimated values are preliminary and may
change as more facts become known. The assignment of no value to assets related
to these Affiliated Practices does not reflect a belief by management that these
lawsuits have merit or that the plaintiffs will ultimately prevail in these
actions. In connection with the OrthAlliance merger, the Company assumed a
liability for certain estimated additional merger-related costs that may be
incurred by the Company, including estimated attorneys' fees and legal expenses
anticipated to be incurred in connection with these lawsuits.
Intangible assets associated with OrthAlliance's Service Agreements are
amortized on a straight-line basis over the terms of the Service Agreements (up
to 25 years), with a weighted-average life of approximately 20 years. A portion
of the amortization expense generated with respect to these intangible assets is
not deductible for federal income tax purposes.
In connection with the OrthAlliance merger, the Company assumed liabilities for
estimated employee severance and for operating lease agreements expected to be
terminated. The severance accrual relates to approximately 30 OrthAlliance
corporate employees. The operating lease payment accrual relates to facility
leases assumed by the Company for facilities that are being vacated. Amounts
accrued represent management's estimates of the cost to exit these leases.
Components and activity for the liabilities assumed, which are included in
"accrued salaries and other liabilities" in the accompanying consolidated
balance sheets, are as follows (in thousands):
December 31, Charges and September 30,
2001 adjustments 2002
----------- ----------- -------------
Accrued severance liability ............ $ 2,579 $ 2,325 $ 254
Accrued operating facility leases ...... 1,203 451 752
-------- -------- --------
$ 3,782 $ 2,776 $ 1,006
======== ======== ========
9
6. TRANSACTIONS WITH AFFILIATED PRACTICES
Net advances to Affiliated Practices totaled $28.7 million at September 30, 2002
and $27.6 million at December 31, 2001. As part of the allocation of the
OrthAlliance purchase price (discussed in more detail in Note 5), the Company
assigned no value to advances to the Excluded OrthAlliance Affiliated Practices
that are parties to pending litigation and have ceased paying fees to
OrthAlliance. Due to the uncertainty of the recoverability of these assets, the
Company recorded an allowance for uncollectible amounts of $9.0 million related
to such advances at December 31, 2001. During the nine months ended September
30, 2002, the Company reassessed the advances to OrthAlliance Affiliated
Practices and determined that an additional allowance of $9.4 million was needed
to adjust these advances to fair value. As discussed in Note 5, a corresponding
adjustment to goodwill was recorded. In addition, during the nine months ended
September 30, 2002, the Company provided an allowance of $2.1 million for
certain advances to Affiliated Practices that the Company believes will not be
realizable.
Orthodontic centers that have been newly developed by the Company have typically
generated initial operating losses as they begin to build a patient base. A new
center typically begins to generate operating profits after approximately 12
months of operations. To assist Affiliated Practices in obtaining financing for
their portion of initial operating losses and capital improvements, the Company
entered into an agreement with a financial institution under which the financial
institution funds these operating losses and capital improvements. The Company
remains a guarantor of the related debt. The Company was a guarantor for
approximately $0.9 million and $1.9 million at September 30, 2002 and December
31, 2001, respectively, of loans under this arrangement. The Company no longer
guarantees new debt for its Affiliated Practices.
7. PROPERTY, EQUIPMENT AND IMPROVEMENTS
Property, equipment and improvements consisted of the following (in thousands):
September 30, December 31,
2002 2001
------------- ------------
Leasehold improvements ................................ $ 70,892 $ 61,784
Furniture and fixtures ................................ 64,669 60,995
Other equipment ....................................... 209 192
Centers in progress ................................... 1,882 6,947
--------- ---------
137,652 129,918
Less accumulated depreciation and amortization ........ 46,556 38,075
--------- ---------
Property, equipment and improvements, net ............. $ 91,096 $ 91,843
========= =========
Depreciation expense on property, equipment and improvements was $3.0 million
and $8.9 million for the three and nine months ended September 30, 2002,
respectively, compared to $2.0 million and $6.1 million for the comparable
periods in 2001. See "ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL RESOURCES" for
additional discussion of purchases of property, equipment and improvements.
10
8 LONG-TERM DEBT
At September 30, 2002, $69.6 million of indebtedness was outstanding under the
Company's $100 million revolving line of credit (the "Senior Credit Facility").
The Senior Credit Facility, which expires in October 2003, provides funding for
the Company's general working capital and expansion of the Company's affiliated
centers, and bears interest at varying rates above the lender's prime rate or
LIBOR. Amounts borrowed under the Senior Credit Facility are secured by a
security interest in the Company's ownership of operating subsidiaries. The
Company is reviewing its projections for cash needs and the possibility of
obtaining a new long-term financing arrangement.
The Company also had outstanding at September 30, 2002, $38.0 million of
indebtedness under the Company's $50.0 million bridge credit facility (the
"Bridge Credit Facility"). On October 10, 2002, the Company timely notified the
lenders and extended the maturity of the Bridge Credit Facility to October 7,
2003.
The interest rates that apply to outstanding indebtedness under the Bridge
Credit Facility follow:
Time Period Interest Rate
- ----------- -------------
November 9, 2002 - January 31, 2003......................... 10.00%
February 1, 2003 - April 30, 2003........................... 10.50%
May 1, 2003 - July 31, 2003................................. 11.00%
August 1, 2003 - October 7, 2003............................ 11.50%
The Senior Credit Facility and the Bridge Credit Facility require the Company to
maintain certain financial and nonfinancial covenants. These covenants include a
maximum leverage ratio, minimum fixed charge coverage ratio and minimum
consolidated net worth ratio. The Senior Credit Facility and the Bridge Credit
Facility also restrict certain activities of the Company, including
acquisitions, stock repurchases and cash dividends. At September 30, 2002, the
Company was in compliance with the covenants and restrictions of the Senior
Credit Facility and the Bridge Credit Facility.
9. TREASURY STOCK
On August 6, 2002, the Board of Directors of the Company authorized the
repurchase of up to 2.0 million shares of the Company's common stock during the
18 months following approval of the program. On August 23, 2002, the Company
received approval from its lenders to repurchase up to $15.0 million of the
Company's common stock in the open market prior to the termination date of the
Bridge Credit Facility. For the nine months ended September 30, 2002, the
Company repurchased approximately 962,000 common shares at a cost of
approximately $13.5 million. The repurchased shares are held in treasury for use
in connection with the Company's stock option plans, stock programs, incentive
programs and acquisitions, and for other general corporate purposes. The
treasury stock is accounted for using the cost method. Subsequent to September
30, 2002, the Company repurchased approximately an additional 90,000 shares of
common stock at a cost of approximately $1.5 million.
10. ORTHODONTIST INCENTIVE PROGRAMS
During 2002, the Company implemented the Stock Pool II and Target Stock II
incentive programs for OrthAlliance Affiliated Practices. To be eligible to
participate in these incentive programs, participants must, among other things,
enter into amendments to their Service Agreements with OrthAlliance and to their
employment agreements with their professional entities, or enter into the
Company's general form of business services agreement.
11
Amounts to be issued under the Stock Pool II program are based on service fees
paid to OrthAlliance for the twelve months ended October 31, 2001. Participants
in the program are eligible for awards that are payable, at their election, in
shares of the Company's common stock or a promissory note. Awards under the
program are subject to various conditions specified in the program document and
vest in four annual installments of 25% of the total amount to be issued. The
following is the vesting schedule for initial installments under the Stock Pool
II program:
Amendment Date First Installment
- --------------------------- ------------------
By 10/1/2002 25% on 11/9/2002
10/2/2002 through 12/31/2002 25% on 1st anniversary of amendment date
At September 30, 2002, there were 54 eligible participants in the Stock Pool II
program.
Amounts to be issued under the Target Stock II Program are based on a value
equal to three times the increase, up to 70%, in service fees paid to
OrthAlliance in the third year following the completion of the OrthAlliance
merger compared to service fees paid to OrthAlliance during the 12 months prior
to the merger. Awards under the program are subject to various conditions
specified in the program document. These awards vest in four annual installments
of 25% of the total amount to be issued. The first installment under the program
is payable beginning on the fourth anniversary of the OrthAlliance merger.
Awards are payable in shares of the Company's common stock or a promissory note,
at the Company's election. At September 30, 2002, there were 5 eligible
participants in the Target Stock II Program.
11. NON-RECURRING RECRUITING EXPENSE
On April 30, 2002, the Company reached agreement with a former employee on the
number of affiliated orthodontists that the former employee was credited with
recruiting and the amount payable to the former employee in consideration for
his prior services. These amounts had been disputed by the parties and were the
subject of a lawsuit pending between the parties. On May 10, 2002, that lawsuit
was dismissed, and the Company paid the former employee approximately $8.0
million in cash and forgave approximately $4.8 million of indebtedness owed by
the former employee to the Company. These amounts have been included in the
Company's Consolidated Statements of Income for the nine months ended September
30, 2002 as a non-recurring recruiting expense. The Company does not have
similar recruiting arrangements with any other employee or affiliated
practitioner.
12. INCOME TAXES
At September 30, 2002, the Company had approximately $56.8 million of deferred
tax assets resulting from its change in method for recognizing fee revenue
effective January 2000. In April 2002, the Company filed an application with the
Internal Revenue Service ("IRS") to change the Company's tax accounting method
of recognizing revenue. The Company has not made any estimated federal income
tax payments during 2002 based on the expectation that the change in accounting
will at least alleviate the Company's tax liability for the first three
quarterly estimated tax installments for 2002. The Company has recorded such
estimated payments as income taxes payable rather than reducing the deferred tax
asset because a ruling is still pending from the IRS. Additional correspondence
between the Company and the IRS regarding the application has occurred recently.
However, no indication of a ruling has been conveyed by the IRS at this time. To
the extent the IRS approves the change in accounting, the deferred tax assets
will be used to reduce the income tax payable for 2002.
12
13. EARNINGS PER SHARE
The calculation of earnings per share is performed using the treasury stock
method. Computations of basic and diluted earnings per share are presented
below:
Three months ended Nine months ended
September 30, September 30,
----------------------- -----------------------
2002 2001 2002 2001
------- ------- ------- -------
(in thousands)
Numerator:
Net income for basic and diluted earnings per share .... $18,869 $15,178 $49,445 $43,826
======= ======= ======= =======
Denominator:
Denominator for basic earnings per share ............... 51,229 48,962 51,317 48,863
Effect of dilutive securities .......................... 318 1,161 567 1,270
------- ------- ------- -------
Denominator for diluted earnings per share ............. 51,547 50,123 51,884 50,133
======= ======= ======= =======
14. NEW ACCOUNTING PRONOUNCEMENTS
On January 1, 2002, the Company adopted Statement of Financial Accounting
Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets." SFAS 142
requires that goodwill and intangible assets with indefinite lives, including
such assets recorded in past business combinations, no longer be amortized, but
instead be tested for impairment by measuring the reporting unit at fair value
with the initial impairment test performed within six months from the beginning
of the year in which the standard is adopted. SFAS No. 142 also requires that
the impairment test be performed at least annually thereafter, with interim
testing required if circumstances warrant. Intangible assets with finite lives
will continue to be amortized over their useful lives and reviewed for
impairment. During the nine months ended September 30, 2002, the Company
completed its initial evaluation of goodwill impairment as required with the
adoption of SFAS No. 142 and determined that the existing goodwill balance was
not impaired. However, no assurances can be given regarding future impairment.
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets,"
requires the Company evaluate whether events or circumstances have occurred that
indicate all or a portion of the carrying amount of the Company's intangible
assets may not be recoverable. The recoverability takes into account whether
these intangibles should be completely or partially written off or the
amortization period accelerated based on management's estimate of future
operating income over the remaining term of the Service Agreement. If the
intangible assets are considered to be impaired, the impairment to be recognized
is measured by the amount by which the carrying amount of the intangibles
exceeds its fair value using estimated discounted cash flows. The Company
adopted SFAS No. 144 on January 1, 2002. During the nine months ended September
30, 2002, the Company recorded impairments of intangibles of cost incurred
related to certain Service Agreements and expensed approximately $516,000 of
costs incurred related to these projects. In addition, the Company expensed
approximately $393,000 of property, equipment and improvements related to
offices closed during the nine months ended September 30, 2002. These amounts
are included as "depreciation and amortization" in the Company's Consolidated
Statements of Income.
In April 2002, the Financial Accounting Standards Board (FASB) issued SFAS No.
145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB
Statement No. 13, and Technical Corrections." SFAS 145 requires that gains or
losses on extinguishment of debt for all prior periods presented that do not
meet the criteria in Accounting Principles Board Opinion No. 30, "Reporting the
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events or
Transactions" should be reclassified into income from continuing operations.
SFAS No. 13, "Accounting for Leases," has been amended to require sale-leaseback
accounting for certain lease
13
modifications that are similar to sale-leaseback transactions. The rescission of
SFAS No. 4 and the amendment to SFAS No. 13 shall be effective for fiscal years
and transactions, respectively, occurring after May 15, 2002.
In June 2002, SFAS No. 146, "Accounting for Costs Associated with Exit or
Disposal Activities", replaced Emerging Issues Task Force Issue No. 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity". SFAS 146 requires companies to recognize certain costs
associated with exit or disposal activities when the liability is incurred
rather than at the date of a commitment to an exit or disposal plan. SFAS 146
will be effective for exit or disposal activities that are initiated after
December 31, 2002.
15. SUBSEQUENT EVENT
On October 24, 2002, the U.S. District Court for the Eastern District of
Louisiana ordered the dismissal of the class action lawsuit alleging securities
fraud filed against the Company and certain members of its senior management. In
its ruling, the Court found that the plaintiffs had failed to allege sufficient
facts to support their claim that the Company or its officers and directors
violated federal securities laws. The Court also ruled that the plaintiffs will
not be permitted to amend the lawsuit and dismissed the case with prejudice. The
ruling is subject to the possibility of an appeal by the plaintiffs.
16. COMMITMENTS AND CONTINGENCIES
The Company and its subsidiaries are parties to other pending litigation, as
disclosed in Note 12 to the Company's consolidated financial statements included
in the Company's Annual Report on Form 10-K for the year ended December 31,
2001. Except as discussed in Notes 11 and 15, there have been no material
changes to the other pending litigation.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion summarizes the financial position of Orthodontic
Centers of America, Inc. ("we," "our," "OCA" or the "Company") at September 30,
2002, and the results of operations for the three and nine months ended
September 30, 2002 and 2001. This discussion should be read in conjunction with
the consolidated financial statements and related notes included elsewhere in
this Report.
GENERAL
Our business was established in 1985. At September 30, 2002, we provided
business services to 375 orthodontic and pediatric dental practices. These
amounts exclude 49 orthodontists and pediatric dentists that are engaged in
litigation (the "Excluded OrthAlliance Affiliated Practices") with OrthAlliance,
Inc. ("OrthAlliance"), which we acquired in November 2001, and which have ceased
paying service fees.
Generally, when we develop a new center, all patients treated at the center are
new patients and, in the first several months after commencing operations, the
center is open only for a limited number of days each month as new patients are
added. Our affiliated centers have generally become increasingly more productive
and profitable as more new patients are added and existing patients return for
monthly follow-up visits. After approximately 26 months of operations, a
center's growth in patient base has typically begun to stabilize as the initial
patients complete treatment. At that point, a center can increase the number of
patients treated by improving the efficiency of its clinical staff, increasing
patient treatment intervals and adding operating days or practitioners. Our
affiliated centers may also increase revenue by implementing periodic price
increases. Established practices with which we have affiliated have typically
increased their revenue by applying our operating strategies and systems.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We provide business services to orthodontic and pediatric dental practices. Our
consolidated financial statements include service fees earned under our service
and consulting agreements and the expenses of providing those services. We do
not consolidate the patient revenue and other operations and accounts of our
affiliated practices. 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 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. Actual results could differ from those estimates.
We believe that the following critical accounting policies are important to the
portrayal of our financial condition and results of operations and require
management's most difficult subjective or complex judgements.
- - In acquiring the non-professional assets of an orthodontic or pediatric
dental practice, and entering into a service or consulting agreement with
the practice, we allocate part of the related costs to an intangible asset.
The intangible asset is amortized over the term of the service or consulting
agreement, up to 25 years. We evaluate the carrying amount of intangibles
quarterly based on SFAS No. 144. During the quarter ended September 30,
2002, we determined that $516,000 of intangibles were impaired and expensed
such costs.
- - We provide allowances for uncollectible amounts based on an estimate of the
unrealizable portion of the service fees receivable. We base that estimate
on an aging of service fees receivable. If circumstances change resulting in
an affiliated practice's inability to make required payments,
15
additional allowances may be required. The allowance for uncollectible
amounts on service fees receivable is calculated based on 80% of amounts
over 90 days past due and 100% of amounts over 120 days past due.
- - We have provided an allowance for uncollectible amounts based on estimates
of losses on advances to affiliated practices of $20.4 million, based on our
assessment of the collectibility of these advances. If circumstances change,
additional allowances may be required. See Note 6 to the Consolidated
Financial Statements included elsewhere in this Report for additional
discussion.
- - As of September 30, 2002, we had approximately $68.7 million in deferred tax
assets and have provided no valuation allowance related to these deferred
tax amounts. We believe that the deferred tax assets are realizable through
future reversals of existing taxable temporary differences. In the event
that we determine that the deferred tax assets would likely not be realized,
a valuation allowance would be required and charged to income when such
determination is made.
- - In connection with our acquisition of OrthAlliance on November 9, 2001, we
allocated a portion of the purchase price paid in connection with the
acquisition among OrthAlliance's assets, including its service, management
service and consulting agreements. This purchase price allocation required
that we make certain estimates and assumptions in assigning values to
OrthAlliance's assets and liabilities. We did not allocate any of the
purchase price to service, management service and consulting agreements for
the Excluded OrthAlliance Affiliated Practices. The allocation reflected in
the consolidated financial statements included elsewhere in this Report is
preliminary and the estimated values may change as more facts become known.
- - At September 30, 2002, our financial statements reflected $78.7 million of
goodwill related to the OrthAlliance merger. Goodwill is carried at cost and
is not amortized, but instead will be tested for impairment by applying a
fair value concept in accordance with SFAS No. 142. The evaluation of the
impairment loss requires management to make estimates and assumptions.
Adverse changes to our operations could result in impairment losses in the
future.
- - Under our revenue recognition policy, we must make certain estimates,
including amounts to be retained by our affiliated practices. Fee revenue
consists of service fees that we earn under our service, management service
and consulting agreements, which are generally calculated as a percentage of
the operating profits or patient revenue of our affiliated practices plus
reimbursement of practice-related expenses. We recognize fee revenue based
upon a straight-line allocation of our affiliated practices' patient
contract balances over the terms of the patient contracts, less amounts
retained or estimated to be retained by the affiliated practices. Amounts
retained or to be retained by affiliated practices are reduced by practice-
related expenses that we have incurred but for which we have not been
reimbursed by affiliated practices. The term of an orthodontic patient
contract averages about 26 months. Many of OrthAlliance's affiliated
practices require that their patients pay a down payment of approximately
25% of the total treatment fee at the commencement of treatment. This
results in us receiving cash in advance of incurring certain practice-
related expenses and recognizing certain service fees as fee revenue. We
record these amounts as service fee prepayments and defer recognition of
these amounts as fee revenue.
16
OVERVIEW OF SERVICE AND CONSULTING AGREEMENTS
We provide a wide range of services to our affiliated practices, including
marketing and advertising, management information systems, staffing, supplies
and inventory, scheduling, billing, financial reporting, accounting and other
administrative and business services. These services are provided under
long-term agreements with affiliated orthodontists and pediatric dentists and/or
their wholly-owned professional corporation or other entity, with terms that
generally range from 20 to 40 years (with most ranging from 20 to 25 years).
The specific form of agreement is based upon the dental regulatory provisions of
the particular state in which an affiliated practice is located. We use a form
of service agreement in most states. We use a form of consulting agreement in a
small number of states with relatively restrictive laws relating to the practice
of dentistry. OrthAlliance and its affiliated practices are parties to service,
management service and consulting agreements that differ in some respects from
the service and consulting agreements that OCA has historically used. Please
refer to our Annual Report on Form 10-K for the year ended December 31, 2001 for
a more detailed discussion of these forms of agreements.
OCA SERVICE AGREEMENTS. Under OCA's general form of service agreement,
we provide affiliated practices with a wide range of business services in
exchange for monthly service fees. The monthly service fees under these service
agreements are generally computed based upon 24% of new patient contract
balances in the first month of treatment plus the balance of the patient
contract balances allocated equally over the remaining terms of the patient
contracts (which average about 26 months), minus amounts retained by the
affiliated practice. The amounts retained by an affiliated practice are based on
a percentage of the operating profits of the practice on a cash basis, generally
cash collections minus expenses during the period (in some cases, after
reduction for any hourly-based service fees or hourly-based amounts retained by
the affiliated practice), plus, in some cases, certain hourly-based amounts.
These service fees generally represent reimbursement for direct and indirect
expenses that we incur in providing services to an affiliated practice
(including employee costs, marketing and advertising costs, office rent,
utilities expense, supply costs and general and administrative expenses), a
portion of the operating profits of the affiliated practice on a cash basis and,
in some cases, hourly-based service fees. Excluding reimbursement of direct and
indirect expenses and any hourly-based service fees, service fees based on the
operating profits of the affiliated practice generally range from 40% to 50% of
a mature practice's cash operating profits. In some cases, this is after
reduction for any hourly-based service fees or hourly-based amounts retained by
an affiliated practice.
OCA CONSULTING AGREEMENTS. Under OCA's general form of consulting
agreement, the types of services we provide to affiliated practices are
generally similar to the services we provide under our general form of service
agreement. Fees paid to us under the consulting agreements generally are a
combination of, depending on the service being performed, cost-based types of
fees, flat monthly fees and hourly fees.
ORTHALLIANCE SERVICE, MANAGEMENT SERVICE AND CONSULTING AGREEMENTS.
Under OrthAlliance's general form of service agreements, OrthAlliance generally
must provide or arrange for certain services for its affiliated practices, and
advise and assist the practices with respect to certain other services. These
services are similar to those provided under OCA's service agreements.
OrthAlliance is generally responsible for paying certain practice expenses, for
which it is to be reimbursed by the affiliated practice. If the practice's
collections are insufficient to fund the practice's current practice expenses,
then OrthAlliance is generally obligated to advance funds for those expenses.
Under these service agreements, OrthAlliance generally receives service fees
based on a percentage of adjusted practice revenue (generally about 17%),
subject in some cases to annual adjustments based upon improvements in the
affiliated practice's operating margin and a minimum dollar amount of annual
service fees during the first five years of the agreement, or a flat monthly fee
with annual fixed-dollar increases.
17
Under OrthAlliance's general form of consulting agreements, OrthAlliance must
provide certain specified services to its affiliated practices, provide other
services at the request of the practices and consult with or advise the
affiliated practices with respect to other services. These services are
generally similar to those provided under OCA's service agreements. Under these
agreements, OrthAlliance receives a consulting fee based on one of the three fee
structures described above with respect to OrthAlliance's service agreements.
Under OrthAlliance's general form of management service agreements, OrthAlliance
is to provide and remit payment for a wide range of services for its affiliated
practices, including providing facilities, equipment, support personnel,
utilities, supplies, bookkeeping, marketing and billing and collections
services. These management service agreements generally provide for a service
fee that varies from month to month depending on the particular practice's
practice revenue and operating expenses with a maximum of up to 19.5% of the
practice's practice revenue on a cash basis plus reimbursement of
practice-related expenses. A few of OrthAlliance's management service agreements
provide for a fixed percentage service fee.
SEASONALITY
Our affiliated practices have experienced their highest volume of new cases in
the summer and other periods when schools are not typically in session. During
these periods, children have a greater opportunity to visit an orthodontist or
pediatric dentist to commence treatment. Consequently, our affiliated practices
have typically experienced higher revenue during the first and third quarters of
the year as a result of increased patient starts. During the Thanksgiving and
Christmas seasons, our affiliated practices have typically experienced reduced
volume and fourth quarter revenue for our affiliated practices has been
generally lower as compared to other periods. Seasonality in recent periods has
been mitigated by the impact of additional affiliated practices.
EMERGING ISSUES TASK FORCE ISSUE NO. 97-2
We do not have a controlling financial interest in our affiliated practices. In
accordance with guidance in Emerging Issues Task Force Issue No. 97-2, we do not
consolidate the patient revenue and other operations and accounts of our
affiliated practices within our financial statements.
BUSINESS COMBINATION WITH ORTHALLIANCE
OrthAlliance became our wholly-owned subsidiary in a stock-for-stock merger in
November 2001. The OrthAlliance merger was accounted for using the purchase
method of accounting. The results of operations of OrthAlliance have been
included in our consolidated financial statements for the period from November
9, 2001 through December 31, 2001 and the nine months ended September 30, 2002.
However, our consolidated financial statements for the three and nine month
periods ended September 30, 2002 do not include any results of operations
associated with the Excluded OrthAlliance Affiliated Practices, which are
engaged in litigation with OrthAlliance and have ceased paying service fees to
OrthAlliance.
We believe that the OrthAlliance merger is a strategically important
transaction, which we believe will provide opportunities for growth in our Fee
revenue and increases in our operating margin. Our objective is to build sound,
long-term business relationships with OrthAlliance's affiliated practices. Since
entering into the merger agreement with OrthAlliance in May 2001, we have
devoted substantial resources to attempting to integrate OrthAlliance's
affiliated practices into our network of other affiliated practices. Some of
OrthAlliance's affiliated practices began using part of our computer and
business systems prior to the merger, under a license that we granted to
OrthAlliance in October 2001. We continue to implement our business systems for
these practices. We also continue to inform other OrthAlliance affiliated
practices about the quality and benefits of our systems and services.
18
Before we entered into the merger agreement with OrthAlliance, we anticipated
that some portion of OrthAlliance's affiliated practices would oppose such a
merger because of, among other things, disappointment with the market price of
OrthAlliance's common stock, unwillingness to affiliate with a competitor of
OrthAlliance or perceived differences in the companies' cultures and operating
strategies. Accordingly, we factored the likelihood of a number of dissident
practices into our analysis of the economic merits of the merger, and into the
structure of the merger agreement and merger consideration. Following the
announcement of the merger agreement with OrthAlliance in May 2001, a number of
OrthAlliance's affiliated practices did, in fact, file lawsuits against
OrthAlliance and/or notify OrthAlliance that it was in default under their
service, management service and consulting agreements, in response to which
OrthAlliance engaged outside counsel to represent its interests. We believe
that, despite these lawsuits, the OrthAlliance merger has financial merit and
has been a positive development for our company.
OrthAlliance intends to defend each of these lawsuits vigorously, and to
continue to demand that these practices honor their commitments under their
agreements with OrthAlliance. We believe that the plaintiffs' claims in these
actions lack merit, and that OrthAlliance has meritorious claims against each of
these plaintiffs. Based on our prior experience and discussions with some of
these litigating practices or their representatives, we currently believe that
some of these practices will settle their lawsuits by paying us an amount of
cash in exchange for termination or modification of their service, management
service and consulting agreements with OrthAlliance, depending upon the parties'
ability to reach an agreement as to the amount to be paid. However, we cannot
assure you that such an agreement or settlement will be reached in any of these
lawsuits. We also cannot, at this time, predict the outcome of these lawsuits or
assure you that we will prevail in any of them. Nor can we estimate the amount
of damages that we might incur or receive in these actions. Due to the
uncertainty of this litigation, we have currently assigned no value to service,
management service and consulting agreements with the Excluded OrthAlliance
Affiliated Practices that are engaged in litigation with OrthAlliance and which
had ceased to pay service fees to OrthAlliance as of September 30, 2002.
19
RESULTS OF OPERATIONS
The following table provides information about the percentage of Fee
revenue represented by some of the items in our consolidated statements of
income. These amounts exclude the Excluded OrthAlliance Affiliated Practices.
Three months Nine months
ended ended
September 30, September 30,
------------------------ ------------------------
2002 2001 2002 2001
------- ------- ------- -------
Fee revenue ................................. 100.0% 100.0% 100.0% 100.0%
------- ------- ------- -------
Direct expenses:
Employee costs ......................... 27.6 29.2 28.1 28.8
Orthodontic supplies ................... 9.1 8.1 8.7 8.0
Rent ................................... 8.7 8.9 8.9 8.8
Marketing and advertising .............. 8.1 8.4 7.7 8.1
------- ------- ------- -------
Total direct expenses .............. 53.5 54.6 53.4 53.7
General and administrative .................. 12.2 11.0 12.8 10.9
Non-recurring recruiting expense ............ -- -- 3.8 --
Depreciation and amortization ............... 5.6 5.1 5.2 5.5
------- ------- ------- -------
Operating profit ............................ 28.7 29.3 24.8 29.9
Interest (income) expense ................... 1.8 1.2 1.3 1.3
Non-controlling interest in subsidiary ...... -- -- -- --
------- ------- ------- -------
Income before income taxes .................. 26.9 28.1 23.5 28.6
Provision for income taxes .................. 10.1 10.6 8.9 10.8
------- ------- ------- -------
Net income .................................. 16.8% 17.5% 14.6% 17.8%
======= ======= ======= =======
OVERVIEW. Our net income increased $3.7 million and $5.6 million for the
three and nine months ended September 30, 2002, respectively, compared to the
same periods in 2001. These increases were primarily due to significant growth
in Fee revenue from centers opened since September 30, 2001, including increases
in Fee revenue resulting from our merger with OrthAlliance in November 2001. Fee
revenue increased $25.9 million and $90.9 million for the three and nine months
ended September 30, 2002, respectively, compared to the same periods in 2001.
Our operating profit for the three months ended September 30, 2002 was $32.4
million, an increase of $6.9 million, or 27.2%, from $25.5 million for the three
months ended September 30, 2001. Operating profit for the nine months ended
September 30, 2002 was $83.8 million, an increase of $10.0 million, or 13.5%,
from $73.8 million for the nine months ended September 30, 2001. We recorded a
non-recurring recruiting expense of $12.8 million ($8.0 million, net of income
tax benefit) during the nine months ended September 30, 2002. Excluding the
impact of the non-recurring expense, operating profit was $96.6 million for the
nine months ended September 30, 2002, an increase of $22.8 million, or 30.8%,
compared to the same period in 2001. The factors affecting our net income are
discussed below.
FEE REVENUE. Fee revenue during the three months ended September 30,
2002 was $112.7 million, an increase of $25.9 million, or 29.8%, from $86.8
million recorded for the same period in 2001. We attribute $13.0 million of this
increase to the growth in Fee revenue of centers open throughout both periods
and $12.9 million of this increase to centers opened since September 30, 2001 or
added through our acquisition of OrthAlliance in November 2001. For the nine
months ended September 30, 2002, Fee revenue was $337.5 million, an increase of
$90.9 million, or 36.9%, from $246.6 million for the comparable period in 2001.
We attribute $41.3 million of this increase to the growth in Fee revenue of
centers open throughout both periods and $49.6 million of this increase to
centers opened since September
20
30, 2001 or added through our acquisition of OrthAlliance in November 2001. The
increase in Fee revenue during 2002 was also due to an increase in the number of
patients being treated by our affiliated practices and an increase in the
average amount of fees that patients were charged for treatment. During the nine
months ended September 30, 2002, our affiliated practices initiated treatment of
about 187,900 patients, an increase of 27.4% from about 147,500 patients during
the same period in 2001. This represents new patient contract balances of $608.5
million for the nine months ended September 30, 2002, compared to $470.1 million
for the nine months ended September 30, 2001. At September 30, 2002, our
affiliated practitioners were treating a total of approximately 541,500
patients, an increase of 35.0% from approximately 401,200 patients at
September 30, 2001.
We adopted a change in accounting for revenue effective January 1, 2000 and
recorded a cumulative effect of change in accounting principles of $50.6
million, net of an income tax benefit, in 2000. During the three and nine months
ended September 30, 2001, we recognized revenue of $5.2 million and $22.1
million, respectively, that was included in the cumulative effect of change in
accounting principles. No revenue was recognized from this cumulative effect
during 2002.
EMPLOYEE COSTS. Employee costs are costs incurred to employ all
employees in our affiliated orthodontic and pediatric dental centers and staff
in our corporate headquarters. We do not employ orthodontists, pediatric
dentists or general dentist assistants. Employee costs were $31.1 million for
the three months ended September 30, 2002, an increase of 22.5% from $25.4
million for the comparable period in 2001. For the nine months ended September
30, 2002, employee costs were $95.0 million, an increase of 33.7% from $71.0
million for the comparable period in 2001. These increases primarily resulted
from the addition of employees in connection with the OrthAlliance merger in
November 2001. As a percentage of Fee revenue, employee costs were 27.6% and
28.1% for the three and nine months ended September 30, 2002, respectively,
compared to 29.2% and 28.8%, respectively, for the same periods in 2001. As a
result of developments in orthodontic technology, a patient may be seen every
six to eight weeks, rather than the traditional four weeks, without compromising
quality of care and without extending the patient's total term of treatment.
Consistent with industry trends, our affiliated orthodontists have begun
increasing the intervals between patient treatments. During the nine months
ended September 30, 2002, patients in our affiliated orthodontic centers
averaged 46.0 days between office visits, compared to an average of 45.9 days
during the comparable period in 2001. This increase in patient treatment
interval reduces the number of office visits during the term of a patient's
treatment, which continues to average about 26 months, and results in lower
employee costs per patient. The increased interval does not, however, reduce the
amount of treatment fees per patient. Therefore, the increased interval reduces
the employee costs incurred with respect to an individual patient relative to
the patient's treatment fee.
ORTHODONTIC SUPPLIES. Orthodontic supplies primarily are the costs of
bands, brackets and wires used during orthodontic treatments and the costs of
other removable or fixed appliances used prior to or after orthodontic
treatments. Orthodontic supplies was $10.3 million for the three months ended
September 30, 2002, an increase of 46.4% from $7.0 million for the comparable
period in 2001. For the nine months ended September 30, 2002, orthodontic
supplies was $29.4 million, an increase of 49.2% from $19.7 million for the
comparable period in 2001. As a percentage of Fee revenue, Orthodontic supplies
increased to 9.1% and 8.7% for the three and nine months ended September 30,
2002, respectively, from 8.1% and 8.0% for each of the same periods in 2001.
These increases were primarily due to increases in prices charged for
orthodontic supplies by certain of our vendors beginning in the fourth quarter
of 2001.
RENT. Rent expense primarily consists of costs incurred for the leasing
of office space for our affiliated orthodontic and pediatric dental practices
and corporate headquarters, including common area maintenance charges. Rent
expense was $9.8 million for the three months ended September 30, 2002, an
increase of 26.5% from $7.7 million for the comparable period in 2001. For the
nine months ended September 30, 2002, rent expense was $29.9 million, an
increase of 38.4% from $21.6 million for the comparable period in 2001. These
increases were primarily due to centers acquired, affiliated, opened or
21
relocated after September 30, 2001, including OrthAlliance affiliated practices.
As a percentage of Fee revenue, rent expense decreased to 8.7% for the three
months ended September 30, 2002 from 8.9% for the comparable period in 2001, and
increased to 8.9% for the nine months ended September 30, 2002 from 8.8% for the
comparable period in 2001. These increases were primarily attributable to rent
increases in certain markets and to an overall increase in common area
maintenance charges incurred during the nine months ended September 30, 2002,
compared to the same period in 2001.
MARKETING AND ADVERTISING. Marketing and advertising expense are costs
associated with television, radio and print media advertising for most of our
affiliated practices. Marketing and advertising expense was $9.1 million for the
three months ended September 30, 2002, an increase of 25.4% from $7.3 million
for the comparable period in 2001. For the nine months ended September 30, 2002,
Marketing and advertising expense was $26.0 million, an increase of 30.3% from
$20.0 million for the comparable period in 2001. The increase in this expense
primarily resulted from increases in Marketing and advertising related to growth
in Fee revenue for existing centers as well as marketing and advertising for
centers added after September 30, 2001. As a percentage of Fee revenue,
Marketing and advertising decreased to 8.1% and 7.7% for the three and nine
months ended September 30, 2002, respectively, from 8.4% and 8.1%, respectively,
for the same periods in 2001. These decreases were primarily due to OrthAlliance
affiliated practices generally advertising less than other OCA affiliated
practices.
GENERAL AND ADMINISTRATIVE. General and administrative expense are other
costs incurred in the operation of our business, including costs for telephone,
accounting and legal services, office supplies, and general liability and
property insurance coverage. General and administrative expense was $13.8
million for the three months ended September 30, 2002, an increase of 45.0% from
$9.5 million for the comparable period in 2001. For the nine months ended
September 30, 2002, General and administrative expense was $43.0 million, an
increase of 59.6% from $26.9 million for the comparable period in 2001. The
increase was primarily due to the increase in number of affiliated practices,
including OrthAlliance affiliated practices. Some of the key increases in
General and administrative expense for the nine months ended September 30, 2002
include: increased telephone costs associated with web-based system conversions
of $3.5 million, increased office supplies of $1.8 million and increased
provision for uncollectible amounts of $1.5 million compared to the comparable
prior year period. The increase in office supplies expense was primarily
attributable to price increases by vendors beginning in the fourth quarter of
2001 and an increase in the number of patients and affiliated practices during
the nine months ended September 30, 2002. For the three and nine months ended
September 30, 2002, accounting and legal expense increased due to the increase
in the number of practices and higher legal costs associated with litigation and
compliance.
NON-RECURRING RECRUITING EXPENSE. During the nine months ended September
30, 2002, we recorded a non-recurring charge of $12.8 million ($8.0 million, net
of income tax benefit) for amounts paid to a former employee for past recruiting
services. We reached an agreement with the former employee regarding the
previously disputed amounts and, in accordance with our accounting policies for
such costs, the amounts paid to the former employee were treated as a
non-recurring recruiting expense. We do not have similar recruiting arrangements
with any other employee or affiliated practitioner.
DEPRECIATION AND AMORTIZATION. We depreciate our property, equipment and
improvements using the straight-line method over their estimated useful lives.
This amount is recorded as depreciation expense. We amortize our intangibles
over the terms of the related service agreements, up to 25 years. This amount is
recorded as amortization expense. Depreciation and amortization was $6.3 million
for the three months ended September 30, 2002, an increase of 40.8% from $4.5
million for the comparable period in 2001. For the nine months ended September
30, 2002, depreciation and amortization was $17.6 million, an increase of 30.4%
from $13.5 million for the comparable period in 2001. The increase in this
expense is a result of the fixed assets acquired and service agreements entered
into for centers developed, acquired or relocated during the last 18 months.
Also included in depreciation and amortization for the
22
nine months ended September 30, 2002 were approximately $516,000 of impairment
of intangibles and approximately $393,000 of impairment of property, equipment
and improvements associated with closed offices during 2002. As a percentage of
Fee revenue, depreciation and amortization was 5.6% and 5.2% for the three and
nine months ended September 30, 2002, respectively, compared to 5.1% and 5.5%
for each of the same periods in 2001, primarily due to an increase in Fee
revenue at centers affiliated with OrthAlliance and at centers open throughout
both periods, which required significantly less investment in additional fixed
assets or service agreements than new centers. There was no amortization of the
goodwill amount recorded in connection with the OrthAlliance acquisition.
INTEREST. Net interest expense consists of interest charges from our
lines of credit and notes payable to affiliated practices. Net interest expense
for the three months ended September 30, 2002 was $2.1 million, an increase of
87.4% from $1.1 million for the comparable period in 2001. For the nine months
ended September 30, 2002, net interest expense was $4.4 million, an increase of
31.6% from $3.4 million for the comparable period in 2001. The increase in
interest expense resulted from larger balances outstanding on debt during 2002
compared to 2001. As a percentage of Fee revenue, net interest expense was 1.8%
and 1.3% for the three and nine months ended September 30, 2002, respectively,
compared to 1.2% and 1.3% for the same periods in 2001.
PROVISION FOR INCOME TAXES. Our effective income tax rate was 37.8% for
each of the three and nine months ended September 30, 2002 and 2001.
NET INCOME. Net income for the three months ended September 30, 2002 was
$18.9 million, an increase of 24.3% from $15.2 million for the three months
ended September 30, 2001. Net income for the nine months ended September 30,
2002 was $49.4 million, an increase of 12.8% from $43.8 million for the nine
months ended September 30, 2001. Excluding the non-recurring recruiting expense,
net income for the nine months ended September 30, 2002 was $57.4 million, an
increase of $13.6 million, or 31.1%, compared to the nine months ended September
30, 2001.
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 2002, our balance sheet reflected significant liquidity with
cash generated primarily from operations. We have not had to make significant
additional borrowings under our credit and bridge facilities during 2002 and
have used excess cash to repurchase shares of our common stock and to reduce our
long-term debt. Our working capital at September 30, 2002 was $73.9 million,
including cash and cash equivalents of $11.0 million, compared to working
capital at December 31, 2001 of $53.5 million, including cash and cash
equivalents of $14.2 million. At September 30, 2002, the Company's current ratio
was 2.10 compared to a current ratio of 1.95 at December 31, 2001. The increase
of $20.4 million in working capital during the nine months ended September 30,
2002 was primarily due to an increase of $35.3 million in service fees
receivable, which was partially offset by an overall increase in current
liabilities primarily caused by an increase in income taxes payable.
23
CASH FLOWS
The following table summarizes cash flow information for the nine months ended
September 30, 2002 and 2001 (in thousands):
Nine months ended
September 30,
--------------------------
2002 2001
-------- --------
Net cash provided by operating activities ............... $ 50,671 $ 39,137
Net cash used in investing activities ................... (27,046) (39,490)
-------- --------
Free cash flow .......................................... 23,625 (353)
Net cash provided by (used in) financing activities ..... (25,657) 6,796
Net change in cash ...................................... $ (3,176) $ 6,443
OPERATING ACTIVITIES. Net cash provided by operating activities was
$50.7 million for the nine months ended September 30, 2002, an increase of 29.5%
from $39.1 million for the nine months ended September 30, 2001. The increase in
cash provided by operating activities for the nine months ended September 30,
2002 compared to the nine months ended September 30, 2001 was primarily due to
increases of: $10.7 million in noncash items, $13.3 million in accounts payable
and other current liabilities, $8.1 million in deferred income taxes, and $5.2
million in net income. These increases were partially offset by an increase in
service fees receivables and prepayments of $22.2 million and a decrease in
amounts payable to affiliated practices of $6.3 million. The following is a
discussion of these activities.
- Noncash items. The increase in noncash items is primarily due to increases
of $4.1 million in depreciation and amortization expense, $4.8 million in
non-recurring recruiting expense and $1.8 million in provision for bad debt
expense during the nine months ended September 30, 2002, as compared to the
same period in 2001. As discussed above in "--RESULTS OF OPERATIONS," we
recorded $12.8 million in non-recurring recruiting expense during the nine
months ended September 30, 2002 related to amounts paid to a former employee
for his past recruiting services. Of this amount, $8.0 million was paid in
cash and the remaining amount of $4.8 million, included in noncash items,
relates to forgiven debt owed by the former employee.
- Deferred income taxes. The increase in cash flow of $8.1 million results
from a refund of a portion of the deferred income taxes recorded from the
OrthAlliance acquisition.
- Accounts payable and other current liabilities. The increase in accounts
payable and other current liabilities during the nine months ended September
30, 2002, as compared to the same period in 2001, was primarily due to an
increase in our income taxes payable. In April 2002, we filed an application
with the Internal Revenue Service ("IRS") to change our tax accounting
method of recognizing revenue. We have not made any estimated federal income
tax payments during 2002 based on our expectation that the authorized change
in accounting will at least alleviate any liability for the first three
quarterly estimated federal income tax installments. We have recorded such
estimated payments as income taxes payable rather than reducing the deferred
tax asset because a ruling is still pending from the IRS. To the extent the
IRS approves the change in tax accounting method, the long-term deferred tax
assets resulting from this change will be used to reduce the income tax
payable in the amount of $31.0 million as of September 30, 2002.
24
- Service fees receivable and prepayments. Service fees receivable and
prepayments increased by $38.0 million during the nine months ended
September 30, 2002. The increase in service fees receivable and prepayments
was primarily due to the net increase in patient contracts and, to a lesser
extent, an increase in the average amount charged for treatment. Most of
these patient contracts provide for a retainer fee to be paid during the
final month of treatment, which represents an average of approximately 12.8%
of the total patient contract balance. Under our revenue recognition policy,
patient contract balances, including the retainer fees, are allocated on a
straight-line basis over the term of the patient contract (which averages
about 26 months for orthodontic patients). Therefore, our fee revenue
includes service fees relating to a portion of these retainer fees, even
though payment of the retainer fees may not be received until the final
month of treatment. This generally results in an increasing amount of
service fee receivables relating to the retainer fees over the course of a
patient's treatment.
- Amounts payable to affiliated practices. The $6.3 million decrease in
amounts payable to affiliated practices was primarily due to timing of
payments to our affiliated practices.
INVESTING ACTIVITIES. Net cash used in investing activities was $27.0
million for the nine months ended September 30, 2002, from $39.5 million for the
nine months ended September 30, 2001. This decrease was primarily due to $13.1
million less cash used to acquire service or consulting agreements and $9.6
million less cash used to purchase property, equipment and improvements during
the nine months ended September 30, 2002, as compared to the same period in
2001. Partially offsetting the overall decrease in cash used was an increase of
$9.4 million in advances to affiliated practices during the nine months ended
September 30, 2002, compared to the same period in 2001.
- Intangible assets acquired. We paid $4.6 million during the nine months
ended September 30, 2002, compared to $17.7 million during the nine months
ended September 30, 2001, to acquire and amend service or consulting
agreements, pursuant to which we obtain the exclusive right to provide
operations, financial, marketing and administrative services to the practice
during the term of the service agreement. We may, from time to time, provide
consideration to existing practices for amendments to their service
agreements to include terms that are beneficial to us and/or to extend the
service agreements to include newly acquired practices, centers or patient
bases. Of the $4.6 million paid for intangibles during the nine months ended
September 30, 2002, approximately 95.7% related to new affiliations and 4.3%
related to existing affiliated practices.
- Purchases of property, equipment and improvements. We purchased $9.9
million and $19.6 million in property, equipment and improvements for the
nine months ended September 30, 2002 and 2001, respectively. The following
table provides information about the composition of these purchases during
the nine months ended September 30, 2002 (in millions):
Center additions............................................... $3.2
Remodeling of existing centers................................. 2.2
Additional capital expenditures at existing centers............ 1.2
International development...................................... 3.3
----
Total....................................................... $9.9
====
- Advances to affiliated practices. We advanced $12.6 million to affiliated
practices during the nine months ended September 30, 2002, compared to $3.2
million for the nine months ended September 30, 2001. Of the amount advanced
during the nine months ended September 30, 2002, approximately 41.3% was to
practitioners at newly-developed practices or to existing affiliated
practitioners adding new centers, 34.9% to affiliated practitioners for
their percentage of net operating margin, and 23.8% to affiliated
practitioners to provide funding for additional compensation and other
needs.
25
FINANCING ACTIVITIES. Net cash used in financing activities was $25.7
million for the nine months ended September 30, 2002, compared to $6.8 million
of net cash provided by financing activities during the nine months ended
September 30, 2001. The following activities contributed to the increase in net
cash used during the nine months ended September 30, 2002:
- repurchases of approximately 962,000 shares of common stock for
approximately $13.5 million;
- increase of $6.9 million in repayments on our long-term debt and notes
payable to affiliated practices;
- decrease of $9.9 million in issuance of our common stock related to the
exercise of stock options in 2002 compared to 2001; and
- decrease of $2.5 million in borrowings under our credit facilities.
Our net cash provided by operating activities for the nine months ended
September 30, 2002, adjusted for one-time payments, was $68.3 million compared
to $39.1 million for the comparable period in 2001. We paid approximately $8.0
million related to a non-recurring recruiting expense and an aggregate of
approximately $6.6 million for legal fees relating to litigation with
OrthAlliance affiliated practitioners, OrthAlliance employee severance and bonus
and facility leases on closed offices assumed in the OrthAlliance merger. We
also paid approximately $3.0 million of payables that were assumed in the
OrthAlliance acquisition.
USES OF CAPITAL
CAPITAL EXPENDITURES. Our capital expenditures consist primarily of the
costs associated with expenditures to facilitate growth and development in
existing centers, maintenance expenditures to sustain current levels of business
activity at existing centers, acquisitions of the fixed assets of newly
affiliated practices and development of de novo centers in the United States and
abroad. The average cost of developing a new orthodontic center in the United
States is about $325,000, including the cost of equipment, leasehold
improvements, working capital and start-up losses associated with the initial
operations of the orthodontic center. These costs are shared by us and the
particular affiliated practice. We generally bear an affiliated practice's share
of these costs until we are reimbursed by the practice. In some cases, we assist
our practices in obtaining financing for their share of these costs by providing
a guaranty of loans from our primary lender. The outstanding balance of these
amounts we guaranteed was $0.9 million and $1.9 million at September 30, 2002
and December 31, 2001, respectively.
During our rapid growth in the 1990's, we expended a disproportionately high
amount of our capital investment on de novo centers relative to expenditures on
our existing centers. During recent years, however, our capital expenditures
have been increasingly directed toward remodeling, improving and expanding our
existing affiliated centers to facilitate internal growth. During recent years,
we also invested significantly in computer systems infrastructure and other
technology for our affiliated centers, such as advanced digital cameras or DSL
data delivery capability. In addition, we continue to invest in the foundational
infrastructure of our international operations.
OTHER USES OF CAPITAL. Newly-developed affiliated practices and existing
affiliated practices that expand their capacity by adding additional centers or
practitioners typically experience cash flow needs until they begin generating
sufficient operating profits at the newly-developed or newly-expanded centers.
We may advance funds to affiliated practices to assist them in maintaining
affiliated practitioner compensation during the start up or expansion phase of
their practices, as an advance against future service fees, as part of our role
to facilitate growth of our affiliated practices while reducing the financial
stress associated with that growth so that our affiliated practitioners can
focus on patient care. These advances are
26
interest free, unsecured loans to the affiliated practices. The affiliated
practice generally begins to repay the advances once the practice or center
becomes profitable, generally at the beginning of the second year that the
practice or center is open. We intend to fund these advances and any continued
financing through a combination of borrowings under our credit facility and cash
from operations.
On August 6, 2002, our Board of Directors approved a common stock repurchase
program. Under the program, we may repurchase up to 2.0 million shares of our
common stock from time to time in the open market at prevailing market prices or
in privately-negotiated transactions during the 18 months following approval of
the repurchase program. On August 23, 2002, we received approval from our
lenders to repurchase up to $15.0 million of our common stock by the termination
date of our bridge credit facility. As of the date of this Report, we have spent
the entire amount allowed by our lenders. The shares were repurchased in the
open market at prevailing market prices using cash from operations. Repurchased
shares are held in treasury, and may be available for use in connection our
stock option plans, stock programs and acquisitions, or for other corporate
purposes as determined by us. We expect to seek lender approval for future
repurchases.
In November 2002, we paid $4.7 million to certain OrthAlliance affiliated
practitioners for amounts earned under the following incentive programs: Stock
Pool Program, Stockholder Value Program and Stock Pool II Program. We used
available cash on hand to fund these payments. We are still finalizing amounts
earned by other affiliated practitioners under these programs and expect to pay
additional amounts during the remainder of the fourth quarter of 2002.
CAPITAL RESOURCES
We maintain a $100.0 million revolving line of credit, of which $69.6 million
was outstanding at September 30, 2002, with a lending group that consists of
Wachovia Bank, NA, Bank of America N.A., Bank One, N.A., and Hibernia National
Bank. The revolving line of credit, which expires in October 2003, provides
funding for our general working capital and expansion of the number of
affiliated centers, and bears interest at varying rates above the lender's prime
rate or LIBOR. Amounts borrowed under the line of credit are secured by a
security interest in our ownership interests in our operating subsidiaries.
In November 2001, we obtained a $50.0 million bridge credit facility from Bank
of America N.A. and Bank One, N.A., of which $38.0 million was outstanding at
September 30, 2002. On November 8, 2002, we repaid an additional $1.0 million
and expect to repay an additional $2.0 million during the remainder of the
fourth quarter of 2002. On October 10, 2002, we exercised our right to extend
the maturity of the bridge credit facility to October 7, 2003. Borrowings under
this bridge credit facility bear interest at varying rates above the lender's
prime rate or LIBOR.
We anticipate that we will further repay a portion of the bridge credit facility
through our cash from operations or enter into long-term financing arrangements
to replace the bridge credit facility and the revolving line of credit. We are
currently reviewing our projections for cash needs and the possibility of
obtaining a new long-term financing arrangement providing favorable interest
rates and terms.
Our revolving line of credit and our bridge credit facility require that we
maintain certain financial and nonfinancial covenants under the terms of the
credit agreements, including a maximum leverage ratio, minimum fixed charge
coverage ratio and minimum consolidated net worth ratio. These credit agreements
also impose restrictions on our acquisitions, investments, dividends, stock
repurchases and other aspects of our business. If we do not comply with these
covenants and restrictions, the lenders could demand immediate payment of all
amounts borrowed under both the revolving line of credit and the bridge credit
facility, and terminate our ability to borrow funds under those credit
facilities. At September 30, 2002, we were in compliance with these covenants
and restrictions.
27
We believe that our cash needs will primarily relate to development of
additional centers and affiliation with additional practices in the United
States and other countries, capital expenditures for our affiliated centers and
computer systems, repayment of amounts owing under our bridge credit facility
and other indebtedness, payment of income taxes, and general corporate purposes.
Our cash needs could vary significantly depending upon our growth, results of
operations and new affiliations with additional practices, as well as the
outcome of pending litigation and other contingencies. We expect to fund these
cash needs through a combination of cash flow from our operations and funds
available under our revolving line of credit, or new credit facilities. We
currently believe that we will be able to meet our anticipated funding
requirements for at least the next 12 months. However, our ability to meet these
funding needs could be adversely affected if we were to suffer adverse results
from our operations, or lose a material portion of our affiliated practices, if
our affiliated practices were to suffer adverse results of operations or a
material loss of patients, if we suffer adverse outcomes from pending litigation
and other contingencies, or an inability to replace our credit facilities on
favorable terms or if we violate the covenants and restrictions of our credit
facility.
NEW ACCOUNTING PRONOUNCEMENTS
We adopted several new accounting pronouncements during 2002. See Note 14 to the
Consolidated Financial Statements for a discussion of the impact on us regarding
these pronouncements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
During the nine months ended September 30, 2002, there were no material changes
to the quantitative and qualitative disclosures about market risks presented in
our Annual Report on Form 10-K for the year ended December 31, 2001.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures. The Company, with the
participation of its management, including its Chief Executive Officer and Chief
Financial Officer, carried out an evaluation of the effectiveness of the design
and operation of the Company's disclosure controls and procedures (as defined in
Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934) as of a date
within 90 days prior to the filing of this Report. Based upon, and as of the
date of, that evaluation, the Company's Chief Executive Officer and Chief
Financial Officer concluded that the Company's disclosure controls and
procedures are effective in timely alerting them to material and other
information required to be included in our periodic SEC filings.
Changes in Internal Controls. There have been no significant changes in the
Company's internal controls or in other factors that could significantly affect
these controls subsequent to the date of their evaluation by the Company's Chief
Executive Officer and Chief Financial Officer.
28
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On October 24, 2002, the U.S. District Court for the Eastern District of
Louisiana ordered the dismissal of a class action lawsuit alleging securities
fraud filed against us and certain members of our senior management by Joanne
Bay on April 9, 2001. In its ruling, the Court found that the plaintiffs had
failed to allege sufficient facts to support their claim that the Company or its
officers and directors violated federal securities laws. The Court also ruled
that the plaintiffs will not be permitted to amend the lawsuit and dismissed the
plaintiffs' amended complaint with prejudice because another pleading attempt
would be an inefficient use of the parties and the Court's resources, would
cause unnecessary and undue delay, and would be futile. The ruling is subject to
the possibility of an appeal by the plaintiffs.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
In the second quarter of 2002, pursuant to exemptions from registration provided
in Section 4(2) of the Securities Act of 1933 (the "Securities Act") and Rule
506 under the Securities Act, we offered certain OrthAlliance affiliated
practitioners the opportunity to participate in two incentive programs under
which participants may be issued shares of our common stock or a promissory note
in the future depending in part upon the future financial performance of the
affiliated practitioners' respective practices. Offers to participate in the
incentive program were made on a private basis to a limited number of
individuals who had a pre-existing relationship with our subsidiary,
OrthAlliance. To participate in the incentive programs, participants must, among
several other prerequisites to participation, enter into amendments to their
service, consulting or management service agreements with OrthAlliance and to
their employment agreements with their professional entities, or enter into our
general form of business services agreement. No underwriters are involved with
these incentive programs.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Exhibit number Description
- -------------- -----------
3.1 Bylaws of the Registrant (incorporated by reference to exhibits filed
with the Registrant's Registration Statement on Form S-1, Registration
Statement No. 33-85326)
3.2 Restated Certificate of Incorporation of the Registrant (incorporated
by reference to exhibits filed with the Registrant's Registration
Statement on Form S-1, Registration Statement No. 33-85326)
4 Specimen Stock Certificate (incorporated by reference to exhibits filed
with the Registrant's Registration Statement on Form S-1, Registration
Statement No. 33-85326)
(b) REPORTS ON FORM 8-K
During the three months ended September 30, 2002, we did not file any
current reports on Form 8-K (excluding current reports on Form 8-K filed on July
5, 2002 and August 14, 2002 reporting information under "Item 9. Regulation FD
Disclosure").
29
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.
Orthodontic Centers of America, Inc.
------------------------------------
(Registrant)
Date: November 14, 2002 /s/ Bartholomew F. Palmisano, Sr.
---------------------------------
Bartholomew F. Palmisano, Sr.
Chairman of the Board, President
and Chief Executive Officer
/s/ Thomas J. Sandeman
----------------------------------------
Thomas J. Sandeman
Chief Financial Officer
30
CERTIFICATION
I, Bartholew F. Palmisano, Sr., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Orthodontic Centers of
America, Inc.
2. Based on my knowledge, this quarterly 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 quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly report;
4. The registrant's other certifying officer 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 we 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 quarterly 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
quarterly report (the "Evaluation Date"); and
c) Presented in this quarterly 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 officer 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 function):
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 officer and I have indicated in this
quarterly report whether or not 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.
November 14, 2002 /s/ Bartholomew F. Palmisano, Sr.
-------------------------------------
Bartholomew F. Palmisano, Sr.
Chairman of the Board, President and
Chief Executive Officer
31
CERTIFICATION
I, Thomas J. Sandeman, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Orthodontic Centers of
America, Inc.
2. Based on my knowledge, this quarterly 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 quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly report;
4. The registrant's other certifying officer 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 we 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 quarterly 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
quarterly report (the "Evaluation Date"); and
c) Presented in this quarterly 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 officer 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 function):
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 officer and I have indicated in this
quarterly report whether or not 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.
November 14, 2002 /s/ Thomas J. Sandeman
----------------------------------
Thomas J. Sandeman
Chief Financial Officer
32
EXHIBIT INDEX
Exhibit number Description
- -------------- -----------
3.1 Bylaws of the Registrant (incorporated by reference to
exhibits filed with the Registrant's Registration Statement
on Form S-1, Registration Statement No. 33-85326)
3.2 Restated Certificate of Incorporation of the Registrant
(incorporated by reference to exhibits filed with the
Registrant's Registration Statement on Form S-1, Registration
Statement No. 33-85326)
4 Specimen Stock Certificate (incorporated by reference to
exhibits filed with the Registrant's Registration Statement
on Form S-1, Registration Statement No. 33-85326)