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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
--------------------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004
COMMISSION FILE NO. 000-25064
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HEALTH FITNESS CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
MINNESOTA NO. 41-1580506
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
3600 AMERICAN BOULEVARD WEST, BLOOMINGTON, MINNESOTA 55431
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER (952) 831-6830
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Indicate by check mark whether the registrant (1) filed all reports
required to be filed by Section 13 or 15(d) of the 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 [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). YES [ ] NO [X]
The number of shares outstanding of the registrant's common stock as of
November 5, 2004 was: Common Stock, $0.01 par value, 12,560,976 shares
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HEALTH FITNESS CORPORATION
CONSOLIDATED FINANCIAL STATEMENTS
TABLE OF CONTENTS
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements (unaudited)
Consolidated Balance Sheets as of September 30, 2004 and
December 31, 2003 3
Consolidated Statements of Earnings for the three and nine
months ended September 30, 2004 and 2003 4
Consolidated Statements of Cash Flows for the nine
months ended September 30, 2004 and 2003 5
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk 16
Item 4. Controls and Procedures 16
PART II. OTHER INFORMATION 17
Item 1. Legal Proceedings 17
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 17
Item 3. Defaults Upon Senior Securities 17
Item 4. Submission of Matters to a Vote of Security Holders 17
Item 5 Not Applicable 17
Item 6. Exhibits and reports on Form 8-K 17
Signatures 18
Exhibit Index 19
2
HEALTH FITNESS CORPORATION
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
September 30, December 31,
2004 2003
------------- --------------
ASSETS
CURRENT ASSETS
Cash $ 206,458 $ 281,294
Trade and other accounts receivable, less allowances of $154,400 and 7,913,590 5,218,224
$131,000
Prepaid expenses and other 244,179 187,347
Deferred taxes 1,294,300 850,300
------------- -------------
Total current assets 9,658,527 6,537,165
PROPERTY AND EQUIPMENT, net 161,714 177,217
OTHER ASSETS
Goodwill 9,022,501 8,725,574
Customer contracts, less accumulated amortization of $673,600 and $67,400 1,056,389 1,662,639
Trademark, less accumulated amortization of $58,300 and $5,800 291,666 344,166
Other intangible assets, less accumulated amortization of $26,800 and $4,200 115,990 138,582
Cash held in escrow - 471,999
Deferred taxes 513,382 1,686,301
Other 41,275 64,458
------------- -------------
$ 20,861,444 $ 19,808,101
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Trade accounts payable $ 349,129 $ 569,730
Accrued salaries, wages, and payroll taxes 2,635,743 1,607,157
Other accrued liabilities 510,655 450,255
Accrued self funded insurance 497,043 228,084
Deferred revenue 1,525,068 1,427,057
------------- -------------
Total current liabilities 5,517,638 4,282,283
LONG-TERM OBLIGATIONS 2,666,353 4,350,012
COMMITMENTS AND CONTINGENCIES - -
CUMULATIVE CONVERTIBLE PREFERRED STOCK, 10,000,000 shares
authorized, 1,048,874 and 1,003,833 issued and outstanding 1,508,632 1,443,833
STOCKHOLDERS' EQUITY
Common stock, $0.01 par value; 50,000,000 shares authorized;
12,560,976 and 12,357,334 shares issued and outstanding 125,609 123,573
Additional paid-in capital 17,836,886 17,671,536
Accumulated comprehensive income 2,544 5,707
Accumulated deficit (6,796,218) (8,068,843)
------------- -------------
11,168,821 9,731,973
------------- -------------
$ 20,861,444 $ 19,808,101
============= =============
See notes to consolidated financial statements.
3
HEALTH FITNESS CORPORATION
CONSOLIDATED STATEMENTS OF EARNINGS
(UNAUDITED)
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
REVENUE $ 13,154,340 $ 7,445,094 $ 38,950,429 $ 22,695,925
COSTS OF REVENUE 9,807,257 5,979,326 29,074,051 17,994,616
------------ ------------ ------------ ------------
GROSS PROFIT 3,347,083 1,465,768 9,876,378 4,701,309
OPERATING EXPENSES
Salaries 1,408,482 834,781 4,180,760 2,407,539
Other selling, general and administrative 784,560 393,018 2,438,170 1,223,937
Amortization of acquired intangible assets 219,583 - 658,750 -
------------ ------------ ------------ ------------
Total operating expenses 2,412,625 1,227,799 7,277,680 3,631,476
------------ ------------ ------------ ------------
OPERATING INCOME 934,458 237,969 2,598,698 1,069,833
OTHER INCOME (EXPENSE )
Interest expense (118,102) (59,031) (380,698) (82,987)
Other, net 908 (32,949) 2,298 (34,808)
------------ ------------ ------------ ------------
EARNINGS BEFORE INCOME TAXES 817,264 145,989 2,220,298 952,038
INCOME TAX EXPENSE 330,500 58,203 882,873 378,939
------------ ------------ ------------ ------------
NET EARNINGS 486,764 87,786 1,337,425 573,099
Dividend to preferred shareholders 21,600 - 64,800 -
------------ ------------ ------------ ------------
NET EARNINGS APPLICABLE TO
COMMON SHAREHOLDERS $ 465,164 $ 87,786 $ 1,272,625 $ 573,099
============ ============ ============ ============
NET EARNINGS PER SHARE:
Basic $ 0.04 $ 0.01 $ 0.10 $ 0.05
Diluted 0.03 0.01 0.08 0.05
WEIGHTED AVERAGE COMMON SHARES:
Basic 12,550,679 12,341,284 12,482,060 12,324,292
Diluted 16,122,175 12,743,441 16,078,873 12,542,024
See notes to consolidated financial statements.
4
HEALTH FITNESS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Nine Months Ended
September 30,
---------------------------
2004 2003
------------ -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net earnings $ 1,337,425 $ 573,099
Adjustments to reconcile net earnings to net cash provided by
operating activities:
Depreciation of property and equipment 71,520 66,921
Amortization of intangible assets and other 746,171 -
Deferred taxes 728,917 325,632
Common stock issued for compensation 60,600 -
Changes in operating assets and liabilities, net of assets acquired:
Trade and other accounts receivable (2,695,366) 436,581
Prepaid expenses and other (96,832) 59,629
Other assets 23,183 (439,320)
Trade accounts payable (223,765) (120,042)
Accrued liabilities and other 1,357,945 406,121
Deferred revenue 98,011 (178,301)
------------ -----------
Net cash provided by operating activities 1,407,809 1,130,320
------------ -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (56,017) (107,515)
Acquisition of business (256,927) -
------------ -----------
Net cash used in investing activities (312,944) (107,515)
------------ -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings under note payable 13,087,343 2,252,934
Repayments of note payable (14,835,830) (2,557,523)
Proceeds from issuance of common stock 71,540 24,039
Proceeds from the exercise of stock options 35,247 -
Proceeds from closing cash escrow account 471,999 -
Proceeds from the issuance of bridge note financing - 3,000,000
Payment to cash escrow account - (3,000,000)
Payment of financing costs - (89,433)
------------ -----------
Net cash used in financing activities (1,169,701) (369,983)
------------ -----------
NET INCREASE (DECREASE) IN CASH (74,836) 652,822
CASH AT BEGINNING OF PERIOD 281,294 91,658
------------ -----------
CASH AT END OF PERIOD $ 206,458 $ 744,480
============ ===========
SUPPLEMENTAL CASH FLOW DISCLOSURES
Supplemental cash flow information
Cash paid for interest $ 293,226 $ 74,558
Cash paid for taxes 116,365 79,637
Noncash investing and financing activities affecting cash flows:
Dividend to preferred shareholders 64,800 -
Proceeds from Wells Loan escrowed for pending acquisition - 2,250,000
See notes to consolidated financial statements.
5
HEALTH FITNESS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United States
of America for interim financial information. They should be read in conjunction
with the annual financial statements included in the Company's Annual Report on
Form 10-K for the year ended December 31, 2003. In the opinion of management,
the interim consolidated financial statements include all adjustments
(consisting of normal recurring accruals) necessary for the fair presentation of
the results for interim periods presented. Operating results for the three and
nine months ended September 30, 2004 are not necessarily indicative of the
operating results for the year ending December 31, 2004.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Business - Health Fitness Corporation and its wholly owned subsidiaries (the
Company) provide fitness and wellness management services and programs to
corporations, hospitals, communities and universities located in the United
States and Canada. Fitness and wellness management services include the
development, marketing and management of corporate, hospital, community and
university based fitness centers, injury prevention and work-injury management
consulting, and on-site physical therapy. Programs include wellness and health
programs for individual customers, including health risk assessments, nutrition
and weight loss programs, smoking cessation, massage therapy, back care and
ergonomic injury prevention.
Consolidation - The consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries. All intercompany balances and
transactions have been eliminated in consolidation.
Cash - The Company maintains cash balances at several financial institutions,
and at times, such balances exceed insured limits. The Company has not
experienced any losses in such accounts and believes it is not exposed to any
significant credit risk on cash.
Trade and Other Accounts Receivable - Trade and other accounts receivable
represent amounts due from companies and individuals for services and products.
The Company grants credit to customers in the ordinary course of business, but
generally does not require collateral or any other security to support amounts
due. Management performs ongoing credit evaluations of customers. The Company
determines its allowance for discounts and doubtful accounts by considering a
number of factors, including the length of time trade accounts receivable are
past due, the Company's previous loss history, the customer's current ability to
pay its obligation to the Company, and the condition of the general economy and
the industry as a whole. The Company writes off accounts receivable when they
become uncollectible, and payments subsequently received on such receivable are
credited to the allowance. Concentrations of credit risk with respect to trade
receivables are limited due to the large number of customers and their
geographic dispersion.
Property and Equipment - Property and equipment are stated at cost. Depreciation
and amortization are computed using both straight-line and accelerated methods
over the useful lives of the assets.
Goodwill - Goodwill represents the excess of the purchase price and related
costs over the fair value of net assets of businesses acquired. The carrying
value of goodwill is not amortized, but is tested for impairment on an annual
basis or when factors indicating impairment are present. Projected discounted
cash flows are used in assessing these assets.
Intangible Assets - The Company's intangible assets include customer contracts,
trademark, and deferred financing costs and are amortized on a straight-line
basis. Customer contracts represent the fair value assigned to acquired
management contracts and are amortized over the remaining life of the contracts,
of which 26
6
months remain at September 30, 2004. Trademark represents the value assigned to
an acquired trademark and is amortized over a period of five years. Deferred
financing costs are amortized over the term of the related credit agreement.
Cash Held In Escrow - Cash held in escrow at December 31, 2003 represented the
funds remaining after payment of the purchase price for the Company's December
2003 acquisition. In September 2004, the parties subject to the escrow agreement
agreed that all conditions to the acquisition had been satisfied, at which time
the remaining funds of $474,610 were remitted to the Company.
Revenue Recognition - Revenue is recognized at the time the service is provided
to the customer. For annual contracts, monthly amounts are recognized ratably
over the term of the contract. Certain services provided to the customer may
vary on a periodic basis and are invoiced to the customer in arrears. The
revenues relating to these services are estimated in the month the service is
performed based on the cost of the services.
Amounts received from customers in advance of providing the services of the
contract are recorded as deferred revenue and recognized when the services are
provided.
The Company has contracts with third-parties (e.g. janitorial services) to
provide ancillary services in connection with their fitness and wellness
management services and programs. Under such arrangements the third-parties
invoice and receive payments from the Company based on services provided to the
ultimate customer. The Company does not recognize revenues related to such
transactions as the ultimate customer assumes the risk and rewards of the
contract and the amounts billed to the customer are either at cost or with a
fixed markup.
Comprehensive Income - Comprehensive income represents net earnings adjusted for
foreign currency translation adjustments. Total comprehensive income was
$1,269,462 and $573,099 for the nine months ended September 30, 2004 and 2003.
Net Earnings Per Share - Basic net earnings per share is computed by dividing
net earnings applicable to common shareholders by the number of weighted average
common shares outstanding. Diluted net earnings per share is computed by
dividing net earnings applicable to common shareholders plus dividends to
preferred shareholders (net earnings) by the number of weighted average common
shares outstanding, and common share equivalents relating to stock options and
stock warrants, when dilutive.
Common stock options and warrants to purchase 470,100 and 342,442 shares of
common stock were excluded from the three months ended September 30, 2004 and
2003 calculation, and 365,100 and 658,359 shares were excluded from the nine
month ended September 30, 2004 and 2003 calculation because they are
anti-dilutive.
Stock-based Compensation - The Company utilizes the intrinsic value method of
accounting for its stock based employee compensation plans. All options granted
had an exercise price equal to the market value of the underlying common stock
on the date of grant and accordingly, no compensation cost is reflected in net
earnings for the three and nine months ended September 30, 2004 and 2003. The
following table illustrates the effect on net earnings and earnings per share if
the Company had applied the fair value method of accounting for stock options:
7
Three Months ended Nine Months ended
September 30, September 30,
--------------------- --------------------------
2004 2003 2004 2003
--------- -------- ----------- -----------
Net earnings, applicable to common
Shareholders - basic $ 465,164 $ 87,786 $ 1,272,625 $ 573,099
Add: Dividends to preferred shareholders 21,600 - 64,800 -
--------- -------- ----------- -----------
Net earnings - diluted 486,764 87,786 1,337,425 573,099
--------- -------- ----------- -----------
Less: Compensation expense determined under
the fair value method, net of tax (23,445) (17,810) (137,438) (55,116)
--------- -------- ----------- -----------
Proforma net earnings - basic $ 441,719 $ 69,976 $ 1,135,187 $ 517,983
========= ======== =========== ===========
Proforma net earnings - diluted $ 463,319 $ 69,976 $ 1,199,987 $ 517,983
========= ======== =========== ===========
Earnings per Share:
Basic, as reported $ 0.04 $ 0.01 $ 0.10 $ 0.05
========= ======== =========== ===========
Basic, proforma $ 0.04 $ 0.01 $ 0.09 $ 0.04
========= ======== =========== ===========
Diluted, as reported $ 0.03 $ 0.01 $ 0.08 $ 0.05
========= ======== =========== ===========
Diluted, proforma $ 0.03 $ 0.01 $ 0.07 $ 0.04
========= ======== =========== ===========
The proforma information above should be read in conjunction with the related
historical information.
The fair value of each option grant is estimated on the grant date using the
Black-Scholes option-pricing model with the following assumptions and results
for the grants:
2004 2003
------------ -----------
Dividend yield None None
Expected volatility 88% 90-105%
Expected life of option 1-4 years 1-4 years
Risk-free interest rate 3.27% 2.9%
Weighted average fair value of options on grant date $ 1.01 $ 0.24
Fair Values of Financial Instruments - Due to their short-term nature, the
carrying value of the Company's current financial assets and liabilities
approximates their fair values. The fair value of long-term obligations, if
recalculated based on current interest rates, would not significantly differ
from the recorded amounts.
Use of Estimates - Preparing consolidated financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make certain estimates and assumptions that affect the
reported amounts of assets and liabilities, disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
NOTE 3. PURCHASE OF ASSETS
On December 8, 2003 (the "Effective Date"), the Company purchased the business
assets of the Health & Fitness Services Business of Johnson & Johnson Health
Care Systems Inc. (JJHCS). Assets acquired by the Company consist primarily of
client contracts, proprietary wellness, lifestyle and health promotion programs,
software, and other health and wellness services. As part of the transaction,
the Company entered into a multi-year management contract with another
subsidiary of Johnson & Johnson whereby the Company will manage more than 50
Johnson & Johnson affiliate fitness center sites. The Company also entered into
a one-year agreement to use 660 square feet of office space of JJHCS for a fee
of $1,500 per month.
8
The fair market value of the assets acquired resulted in the following purchase
price allocation:
Cash price paid for assets $4,990,862
Acquisition costs incurred 836,879
----------
Total purchase price $5,827,741
==========
Purchase Price Allocation
Inventory $ --
Property and equipment 34,000
Customer contracts 1,730,000
Trademark 350,000
Excess of cost over assets acquired 3,713,741
----------
$5,827,741
==========
During the nine months ended September 30, 2004, an additional $205,473 was paid
to JJHCS for four contract assignments. The Company also incurred an additional
$51,455 of acquisition related costs. During the quarter ended September 30,
2004, the Company determined that $40,000 previously allocated to inventory was
obsolete. These additional amounts were recorded to goodwill.
NOTE 4. FINANCING
On August 22, 2003, the Company entered into a $7,500,000 Credit Agreement with
Wells Fargo Bank, N.A. to provide the Company with acquisition financing and
general working capital (the Wells Loan). The initial draw on the Wells Loan
totaled $1,255,204, which was used to refinance a revolving line of credit with
Merrill Lynch Business Financial Services, Inc. (the Merrill Lynch Loan). The
Company repaid all amounts owed to Merrill Lynch Business Financial Services,
Inc. and canceled the line of credit, which accrued interest at the one-month
LIBOR rate plus 2.35%. On August 25, 2003, the Company made a draw of $2,250,000
on the Wells Loan, the proceeds of which were placed into escrow to fund a
portion of the JJHCS asset purchase.
Working capital advances from the Wells Loan are based upon a percentage of the
Company's eligible accounts receivable, less any amounts previously drawn. At
the option of the Company, the Wells Loan bears interest at prime or the
one-month LIBOR plus a margin of 2.25% to 2.75% based upon the Company's Senior
Leverage Ratio (effective rate of 4.75% at September 30, 2004 and 4.00% at
December 31, 2003). The availability of the Wells Loan will decrease $250,000 on
the last day of each calendar quarter, beginning September 30, 2003, and will
expire on June 30, 2007. Borrowing capacity under the Wells Loan totaled
$6,250,000 and $7,000,000 at September 30, 2004 and December 31, 2003. At
September 30, 2004, the Company had $1,026,513 outstanding under the Wells Loan.
Borrowings under the Wells Loan are collateralized by substantially all of the
Company's assets. The Company is required to comply with certain monthly
financial covenants, including a fixed charge coverage ratio, minimum earnings
before interest, taxes, depreciation and amortization, cash flow leverage ratio
and a balance sheet leverage ratio. Beginning on January 31, 2004 and continuing
to May 14, 2004, the Company was not in compliance with certain covenants
relating to the Wells Loan. On May 14, 2004, Wells Fargo agreed to waive the
noncompliance and amend the loan covenants, effective as of January 31, 2004.
The Company believes the new loan covenants are more appropriate after taking
into consideration the Company's actual financial position following the
acquisition of the business assets of JJHCS. Wells Fargo was made aware of the
noncompliance shortly after January 31, 2004 and agreed to continue making
capital advances to the Company throughout the period as new loan covenants were
negotiated. Therefore, the noncompliance had no impact on the Company's
liquidity, capital resources or results of operations. At September 30, 2004,
the Company was in compliance with all of its loan covenants.
On August 25, 2003, the Company entered into a $3,000,000 Securities Purchase
Agreement with Bayview Capital Partners LP ("Bayview") to provide the Company
with acquisition financing and general working
9
capital (the "Bayview Investment"). The Bayview Investment was initially
structured as a bridge note (the "Bridge Note"), the proceeds of which were
placed into escrow to fund a portion of the JJHCS asset purchase.
On December 8, 2003 (the "Effective Date"), the $3,000,000 Bridge Note issued to
Bayview was converted into a $2,000,000 term note (the "Term Note"), $1,000,000
of Series A Convertible Preferred Stock, $0.01 par value (the "Preferred Stock")
and a warrant to purchase common stock of the Company (the "Warrant") per the
terms set forth in the August 25, 2003 Securities Purchase Agreement. The Term
Note bears interest at 12% per year, payable monthly, and will mature on
December 8, 2008. The Term Note may be prepaid, in whole or in part, at any
time, provided that the prepayment is accompanied by a premium ranging from 5%
in year 1 to 1% in year 5. The Bayview Investment is secured by a subordinated
security interest in substantially all of the Company's assets. The Bayview
Investment contained identical financial covenants to those in the Wells Loan
described above, and on May 14, 2004 Bayview agreed to join with Wells Fargo in
waiving this noncompliance and amending the covenants. The noncompliance with
these financial covenants had no impact on the Company's liquidity, capital
resources or results of operations, and the Company believes the amended
covenants are more appropriate after taking into consideration the Company's
actual financial position following the acquisition of the business assets of
JJHCS. At September 30, 2004, the Company was in compliance with all of its loan
covenants.
The Preferred Stock was issued to Bayview at a price of $1.00 per share,
resulting in 1,000,000 shares issued on the Effective Date. The Preferred Stock
has a stated dividend rate of 6% per year, computed on a simple interest basis,
paid in kind in the form of additional shares of Preferred Stock using a price
of $1.00 per share ("PIK Dividends"). At the option of the holder, the Preferred
Stock, including any PIK Dividends, may be converted, at any time and from time
to time, into common stock of the Company at a price of $0.50 per share. In
addition, Bayview may require redemption of the Preferred Stock and PIK
Dividends upon a change of control or default (including default under the Term
Note).
The Warrant issued to Bayview on the Effective Date represents the right to
purchase 1,210,320 shares of common stock, which represented 8% of the Company's
common stock outstanding on a fully diluted basis at the Effective Date,
excluding the common stock issuable to Bayview upon conversion of the Preferred
Stock. The Warrant is exercisable at any time for a period of ten years at an
exercise price equal to $0.50 per share, and the shares obtainable upon exercise
of the Warrant may be put to the Company at fair market value (net of the
exercise price) upon a change of control or default.
The investment proceeds received from Bayview were allocated based upon the
relative fair value of each instrument, which resulted in the following
allocation:
Value assigned to Preferred Stock $ 783,904
Value assigned to Warrants 648,288
Value assigned to Term Note 1,567,808
-----------
$ 3,000,000
The $432,192 difference between the $2,000,000 face value of the Term Note and
its assigned relative fair value is being amortized as interest expense over the
5-year term of the Term Note. Balances of long-term obligations are as follows:
10
September 30, December 31,
2004 2003
------------- ------------
Wells Loan $ 1,026,513 $ 2,775,000
Bayview Term Note 2,000,000 2,000,000
----------- -----------
3,026,513 4,775,000
Discount on Bayview Term Note (360,160) (424,988)
----------- -----------
$ 2,666,353 $ 4,350,012
=========== ===========
Outstanding principal balances on the Wells Loan and Bayview Term Note mature in
June 2007 and August 2008, respectively.
NOTE 5. INCOME TAXES
The Company records income taxes in accordance with the liability method of
accounting. Deferred income taxes are provided for temporary differences between
the financial reporting and tax basis of assets and liabilities and federal
operating loss carryforwards. Deferred tax assets and liabilities are adjusted
for the effects of changes in tax laws and rates on the date of the enactment.
Income taxes are calculated based on management's estimate of the Company's
effective tax rate, which takes into consideration a federal tax rate of 34% and
a blended state tax rate of 6%.
NOTE 6. STOCK OPTIONS
The Company maintains a stock option plan for the benefit of certain eligible
employees and directors of the Company. A total of 1,537,350 shares of common
stock are reserved for additional grants of options under the plan at September
30, 2004. Generally, the options outstanding (1) are granted at prices equal to
the market value of the stock on the date of grant, (2) vest over various terms
and, (3) expire over a period of five or ten years from the date of grant.
A summary of stock option activity for the nine months ended September 30, 2004
is as follows:
Weighted
Number of Average
Shares Exercise Price
---------- ---------------
Outstanding at December 31, 2003 1,710,900 $0.88
Granted 165,100 2.07
Exercised (59,750) 0.53
Forfeited (31,250) 0.44
---------
Outstanding at March 31, 2004 1,785,000 1.01
Granted 120,000 1.51
Exercised (6,350) 0.53
Forfeited (1,350) 0.47
---------
Outstanding at June 30, 2004 1,897,300 1.04
Forfeited (5,000) 0.38
---------
Outstanding at September 30, 2004 1,892,300 1.04
=========
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our consolidated financial
statements and related notes included in Item 1 of Part 1 of this Quarterly
Report and the audited consolidated financial statements and notes thereto and
Management's Discussion and Analysis of Financial Condition and Results of
Operations contained in the Company's Annual Report on Form 10-K for the fiscal
year ended December 31, 2003.
CRITICAL ACCOUNTING POLICIES. Our most critical accounting policies, which are
those that require significant judgment, include: revenue recognition, trade and
other accounts receivable, goodwill and stock-based compensation. A more
in-depth description of these can be found in our Annual Report on Form 10-K for
the fiscal year ended December 31, 2003.
GENERAL. Health Fitness Corporation and its wholly owned subsidiaries (the
Company), provide fitness and wellness management services and programs to
corporations, hospitals, communities and universities located in the United
States of America and Canada. Fitness and wellness management services include
the development, marketing and management of corporate, hospital, community and
university-based fitness centers, injury prevention and work-injury management
consulting, and on-site physical therapy and occupational health services.
Programs include wellness and health programs for individual customers,
including health risk assessments, nutrition and weight loss programs, smoking
cessation, massage therapy, back care and ergonomic injury prevention.
RESULTS OF OPERATIONS FOR THE QUARTER ENDED SEPTEMBER 30, 2004 AS COMPARED TO
THE QUARTER ENDED SEPTEMBER 30, 2003.
REVENUE. Revenues increased $5,709,000, or 76.7%, to $13,154,000 for the three
months ended September 30, 2004, from $7,445,000 for the three months ended
September 30, 2003. This increase is primarily attributed to the December 2003
acquisition of the business assets of the Health & Fitness Services Business of
Johnson & Johnson Health Care Systems Inc. ("JJHCS").
GROSS PROFIT. Gross profit increased $1,881,000, or 128.3%, to $3,347,000 for
the three months ended September 30, 2004, from $1,466,000 for the three months
ended September 30, 2003. This increase is primarily attributed to the
acquisition of JJHCS. In addition, primarily as a result of the JJHCS
acquisition, gross profit as a percent of revenue increased to 25.4% for the
three months ended September 30, 2004, compared to 19.7% for the three months
ended September 30, 2003.
OPERATING EXPENSES. Operating expenses increased $1,185,000 to $2,413,000 for
the three months ended September 30, 2004, from $1,228,000 for the three months
ended September 30, 2003. Of this increase, $220,000 represents a non-cash
expense related to the amortization of acquired intangible assets. The remaining
increase of $965,000 is primarily attributed to the cost of salaries, benefits
and other expenses of the JJHCS management team.
OTHER INCOME AND EXPENSE. Interest expense increased $59,000 to $118,000 for the
three months ended September 30, 2004, from $59,000 for the same period in 2003.
This increase is due to debt facilities the company secured to finance the JJHCS
acquisition and to provide working capital for the combined company. The
Company's cost of borrowed funds increased to an average of 9.76% for the third
quarter of 2004 from 3.5% for the third quarter of 2003.
INCOME TAXES. Income tax expense increased $272,000 to $330,000 for the three
months ended September 30, 2004 compared to $58,000 for the same period in 2003.
The increase is due to the increase in operating profit.
12
DIVIDENDS TO PREFERRED SHAREHOLDERS. To finance the Company's acquisition of
JJHCS, the Company sold $1,000,000 of Preferred Stock to Bayview. The Preferred
Stock was issued at a price of $1.00 per share, resulting in the issuance of
1,000,000 shares. The Preferred Stock has a stated dividend rate of 6% per year,
computed on a simple interest basis, paid in kind in the form of additional
shares of Preferred Stock using a price of $1.00 per share ("PIK Dividends").
For the quarter ended September 30, 2004, the Company accrued dividends of
$22,000, including a dividend of approximately $7,000 related to a beneficial
conversion feature associated with the PIK Dividends.
NET EARNINGS APPLICABLE TO COMMON SHAREHOLDERS. As a result of the above, net
earnings applicable to common shareholders for the three months ended September
30, 2004 increased $377,000, or 428.4%, to $465,000, from $88,000 for the three
months ended September 30, 2003.
RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AS COMPARED
TO THE NINE MONTHS ENDED SEPTEMBER 30, 2003.
REVENUE. Revenues increased $16,254,000, or 71.6%, to $38,950,000 for the nine
months ended September 30, 2004, from $22,696,000 for the nine months ended
September 30, 2003. This increase is primarily attributed to the acquisition of
JJHCS.
GROSS PROFIT. Gross profit increased $5,175,000, or 110.1%, to $9,876,000 for
the nine months ended September 30, 2004, from $4,701,000 for the nine months
ended September 30, 2003. This increase is primarily attributed to the
acquisition of JJHCS. In addition, primarily as a result of the JJHCS
acquisition, gross profit as a percent of revenue increased to 25.4% for the
nine months ended September 30, 2004, compared to 20.7% for the nine months
ended September 30, 2003.
OPERATING EXPENSES. Operating expenses increased $3,647,000 to $7,278,000 for
the nine months ended September 30, 2004, from $3,631,000 for the nine months
ended September 30, 2003. Of this increase, $659,000 represents a non-cash
expense related to the amortization of acquired intangible assets. The remaining
increase of $2,988,000 is primarily attributed to the cost of salaries, benefits
and other expenses of the JJHCS management team.
OTHER INCOME AND EXPENSE. Interest expense increased $298,000 to $381,000 for
the nine months ended September 30, 2004, compared to $83,000 for the same
period in 2003. This increase is due to debt facilities the company secured to
finance the JJHCS acquisition and to provide working capital for the combined
company. The Company's cost of borrowed funds increased to an average of 7.5%
for the nine months ended September 30, 2004, from 3.6% for the same period in
2003.
INCOME TAXES. Income tax expense increased $504,000 to $883,000 for the nine
months ended September 30, 2004, compared to $379,000 for the same period in
2003. The increase is due to the increase in operating profit.
DIVIDENDS TO PREFERRED SHAREHOLDERS. For the nine months ended September 30,
2004, the Company accrued dividends on the Preferred Stock held by Bayview in
the amount of $65,000, including a dividend of approximately $20,000 related to
a beneficial conversion feature associated with the PIK Dividends.
NET EARNINGS APPLICABLE TO COMMON SHAREHOLDERS. As a result of the above, net
earnings applicable to common shareholders for the nine months ended September
30, 2004 increased $700,000, or 122.2%, to $1,273,000, from $573,000 for the
nine months ended September 30, 2003.
13
LIQUIDITY AND CAPITAL RESOURCES
The Company's working capital increased $1,886,000 to $4,141,000 at September
30, 2004, compared to working capital of $2,255,000 at December 31, 2003. The
increase in working capital is primarily due to an increase in accounts
receivable resulting from the fitness and wellness management contracts acquired
in the JJHCS transaction.
On August 22, 2003, the Company entered into a $7,500,000 Credit Agreement with
Wells Fargo Bank, N.A. to provide the Company with acquisition financing and
general working capital (the Wells Loan). The initial draw on the Wells Loan
totaled $1,255,204, which was used to refinance a revolving line of credit with
Merrill Lynch Business Financial Services, Inc. (the Merrill Lynch Loan). The
Company repaid all amounts owed to Merrill Lynch Business Financial Services,
Inc. and canceled the line of credit, which accrued interest at the one-month
LIBOR rate plus 2.35%. On August 25, 2003, the Company made a draw of $2,250,000
on the Wells Loan, the proceeds of which were placed into escrow to fund a
portion of the JJHCS asset purchase.
Working capital advances from the Wells Loan are based upon a percentage of the
Company's eligible accounts receivable, less any amounts previously drawn. At
the option of the Company, the Wells Loan bears interest at prime or the
one-month LIBOR plus a margin of 2.25% to 2.75% based upon the Company's Senior
Leverage Ratio (effective rate of 4.75% at September 30, 2004 and 4.00% at
December 31, 2003). The availability of the Wells Loan will decrease $250,000 on
the last day of each calendar quarter, beginning September 30, 2003, and will
expire on June 30, 2007. Borrowing capacity under the Wells Loan totaled
$6,250,000 and $7,000,000 at September 30, 2004 and December 31, 2003. At
September 30, 2004, the Company had $1,026,513 outstanding under the Wells Loan.
Borrowings under the Wells Loan are collateralized by substantially all of the
Company's assets. The Company is required to comply with certain monthly
financial covenants, including a fixed charge coverage ratio, minimum earnings
before interest, taxes, depreciation and amortization, cash flow leverage ratio
and a balance sheet leverage ratio. Beginning on January 31, 2004 and continuing
to May 14, 2004, the Company was not in compliance with certain covenants
relating to the Wells Loan. On May 14, 2004, Wells Fargo agreed to waive the
noncompliance and amend the loan covenants, effective as of January 31, 2004.
The Company believes the new loan covenants are more appropriate after taking
into consideration the Company's actual financial position following the
acquisition of the business assets of JJHCS. Wells Fargo was made aware of the
noncompliance shortly after January 31, 2004 and agreed to continue making
capital advances to the Company throughout the period as new loan covenants were
negotiated. Therefore, the noncompliance had no impact on the Company's
liquidity, capital resources or results of operations. At September 30, 2004,
the Company was in compliance with all of its loan covenants.
On August 25, 2003, the Company entered into a $3,000,000 Securities Purchase
Agreement with Bayview to provide the Company with acquisition financing and
general working capital (the "Bayview Investment"). The Bayview Investment was
initially structured as a bridge note (the "Bridge Note"), the proceeds of which
were placed into escrow to fund a portion of the JJHCS asset purchase.
On December 8, 2003 (the "Effective Date"), the $3,000,000 Bridge Note issued to
Bayview was converted into a $2,000,000 term note (the "Term Note"), $1,000,000
of Preferred Stock and a warrant to purchase common stock of the Company (the
"Warrant") per the terms set forth in the August 25, 2003 Securities Purchase
Agreement. The Term Note bears interest at 12% per year, payable monthly, and
will mature on December 8, 2008. The Term Note may be prepaid, in whole or in
part, at any time, provided that the prepayment is accompanied by a premium
ranging from 5% in year 1 to 1% in year 5. The Bayview Investment is secured by
a subordinated security interest in substantially all of the Company's assets.
The Bayview Investment contained identical financial covenants to those in the
Wells Loan described above, and on May 14, 2004, Bayview agreed to join with
Wells Fargo in waiving this noncompliance and amending the covenants. The
noncompliance with these financial covenants had no impact on the Company's
liquidity, capital resources or results of operations, and the Company believes
the amended covenants are more appropriate after taking into
14
consideration the Company's actual financial position following the acquisition
of the business assets of JJHCS. At September 30, 2004, the Company was in
compliance with all of its loan covenants.
The Preferred Stock was issued to Bayview at a price of $1.00 per share,
resulting in 1,000,000 shares issued on the Effective Date. The Preferred Stock
has a stated dividend rate of 6% per year, computed on a simple interest basis,
paid in kind in the form of additional shares of Preferred Stock using a price
of $1.00 per share ("PIK Dividends"). At the option of the holder, the Preferred
Stock, including any PIK Dividends, may be converted, at any time and from time
to time, into common stock of the Company at a price of $0.50 per share. In
addition, Bayview may require redemption of the Preferred Stock and PIK
Dividends upon a change of control or default (including default under the Term
Note).
The Company has no off-balance sheet arrangements or transactions with
unconsolidated, limited purpose entities. Refer to the footnotes in the
Company's Annual Report on Form 10-K for the year ended December 31, 2003, for
disclosure related to the Company's "Commitments and Contingencies."
On a short and long-term basis, the Company believes that sources of capital to
meet future obligations will be provided by cash generated through operations
and the Wells Loan. The Company does not believe that inflation has had a
significant impact on the results of its operations.
RECENTLY ISSUED ACCOUNTING POLICIES
We are not aware of any recently issued accounting pronouncements that will have
a material impact on the Company's financial position or results of operations.
RECENTLY PASSED LEGISLATION
HIPPA. The Administrative Simplification provisions of the Health Insurance
Portability and Accountability Act of 1996, or HIPAA, require group health plans
and health care providers who conduct certain administrative and financial
transactions electronically to (a) comply with a certain data format and coding
standards when conducting electronic transactions; (b) use appropriate
technologies to protect the security and integrity of individually identifiable
health information transmitted or maintained in an electronic format; and (c)
protect the privacy of patient health information. The Company's occupational
health line of business, which accounts for approximately five percent of the
Company's total revenue, and the group health plan the Company sponsors for its
employees are subject to HIPAA's requirements. The Company expects to be in
compliance with HIPPA requirements within the timeline specified for the
Company's affected business areas. The Company's corporate, hospital, community
and university based fitness center management lines of business are not subject
to the requirements of HIPAA.
CAUTIONARY STATEMENT
The foregoing discussion and other statements in this report contain various
"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. Forward-looking statements are based on current expectations or
beliefs concerning future events. Such statements can be identified by the use
of terminology such as "anticipate," "believe," "estimate," "expect," "intend,"
"may," "could," "possible," "plan," "project," "will," "forecast" and similar
words or expressions, specifically including a statement regarding the Company's
belief that sources of capital to meet future obligations will be provided by
cash generated through operations and its Wells Loan. These forward-looking
statements are not guarantees of future performance and involve a number of
risks and uncertainties that may cause the Company's actual results to differ
materially from the results discussed in these statements. Please refer to
Management's Discussion and Analysis contained within the Company's Annual
Report on Form 10-K for the year ended December 31, 2003, for cautionary
statements on important factors to consider in evaluating the forward-looking
statements included in this Form 10-Q.
15
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company has no history of, and does not anticipate in the future, investing
in derivative financial instruments, derivative commodity instruments or other
such financial instruments. Transactions with international customers are
entered into in U.S. dollars, precluding the need for foreign currency hedges.
As a result, the exposure to market risk is not material.
ITEM 4. CONTROLS AND PROCEDURES
The Company's Chief Executive Officer and Chief Financial Officer (collectively,
the "Certifying Officers") are responsible for establishing and maintaining
disclosure controls and procedures for the Company. The Certifying Officers have
concluded (based upon their evaluation of these controls and procedures as of
the end of the period covered by this report) that the Company's disclosure
controls and procedures are effective to ensure that information required to be
disclosed by the Company in reports that it files or submits under the Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in the rules of the Securities and Exchange Commission. The Certifying
Officers also have indicated that there were no significant changes in the
Company's internal control over financial reporting that occurred during the
period covered by this report that have materially affected, or are reasonably
likely to materially affect, the Company's internal control over financial
reporting.
16
PART II. - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Refer to Item 3 (Legal Proceedings) of the Company's Annual Report on Form 10-K
for the year ended December 31, 2003.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
See Exhibit Index on page following signatures
(b) Reports on Form 8-K
On August 3, 2004, the Company filed a Form 8-K providing a press release dated
August 2, 2004 regarding its 2004 second quarter financial results.
17
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Company has duly caused this Report to be signed on its behalf
by the undersigned, thereunto duly authorized.Dated: November 8, 2004
HEALTH FITNESS CORPORATION.
By /s/ Jerry V. Noyce
-----------------------------------------
Jerry V. Noyce
Chief Executive Officer
(Principal Executive Officer)
By /s/ Wesley W. Winnekins
-----------------------------------------
Wesley W. Winnekins
Chief Financial Officer(Principal
Financial and Accounting Officer)
18
EXHIBIT INDEX
HEALTH FITNESS CORPORATION
FORM 10-Q
Exhibit # Description
*10.10 Agreement Regarding Closing of Escrow Account, by and among Health Fitness Corporation, Johnson & Johnson
Healthcare Systems Inc., Wells Fargo Bank, National Association (as Lender) and Wells Fargo Bank, National
Association (as Escrow Agent)
*11.0 Statement re: Computation of Earnings per Share
*31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
*31.2 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
*32.1 Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
*32.2 Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
- ---------------------
* Filed herewith
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