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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000 COMMISSION FILE NUMBER 0-12050
SAFEGUARD HEALTH ENTERPRISES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 52-1528581
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
95 ENTERPRISE
ALISO VIEJO, CALIFORNIA 92656-2605
(Address of principal executive offices) (Zip Code)
949.425.4300
(Registrant's telephone number, including area code)
949.425.4586
(Registrant's fax telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $0.01 PAR VALUE
NONE
(Name of exchange on which listed)
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 [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The aggregate market value of the voting stock held by non-affiliates of the
registrant as of March 15, 2001, was $7,206,480. The number of shares of the
registrant's common stock outstanding as of March 15, 2001, was 4,737,498 (not
including 3,257,788 shares held in treasury).
SAFEGUARD HEALTH ENTERPRISES, INC.
INDEX TO FORM 10-K
PAGE
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PART I:
Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . .1
Item 2. Properties . . . . . . . . . . . . . . . . . . . . . . . . 16
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . 17
Item 4. Submission of Matters to a Vote of Security Holders . . . .17
PART II:
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters . . . . . . . . . . . . . . . . . . . .18
Item 6. Selected Financial Data . . . . . . . . . . . . . . . . .19
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations . . . . . . . . . . . .20
Item 7A. Quantitative and Qualitative Disclosures About
Market Risk . . . . . . . . . . . . . . . . . . . . . . . .26
Item 8. Financial Statements and Supplementary Data . . . . . . . .26
Item 9. Changes in and Disagreements with Independent
Accountants on Accounting and Financial Disclosure. . . . .26
PART III:
Item 10. Directors and Executive Officers of the Registrant. .27
Item 11. Executive Compensation. . . . . . . . . . . . . . . . . . 30
Item 12. Security Ownership of Certain Beneficial Owners and
Management. . . . . . . . . . . . . . . . . . . . . . . . .32
Item 13. Certain Relationships and Related Transactions. . . . . .33
PART IV:
Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K. . . . . . . . . . . . . . . . . . . . 34
SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35
PART I
ITEM 1. BUSINESS
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In addition to historical information, the description of business below
includes certain forward-looking statements regarding SafeGuard Health
Enterprises, Inc. (the "Company"), including statements about growth plans,
business strategies, future operating results and financial position, and
general economic and market events and trends. The Company's actual results of
operations for future periods could differ materially from the results indicated
in the forward-looking statements as a result of various events that cannot be
predicted by the Company. Those possible events include an increase in
competition, changes in health care regulations, an increase in dental care
utilization rates, new technologies, an increase in the cost of dental care, the
inability to efficiently integrate the operations of acquired businesses, the
inability to realize the carrying value of the escrow account containing a
portion of the proceeds from the re-sale of the assets of certain dental and
orthodontic practices, the inability to realize the carrying value of certain
long-term promissory notes, and other risks and uncertainties as described below
under "RISK FACTORS." The following should be read in conjunction with the
Consolidated Financial Statements of the Company and Notes thereto.
(a) GENERAL DEVELOPMENT OF BUSINESS
The Company, a Delaware corporation, provides managed care dental plans (also
referred to as "dental HMOs"), preferred provider organization ("PPO")/indemnity
dental plans, vision benefit plans, administrative services, and preferred
provider organization services. The Company conducts its business through a
number of subsidiaries, one of which is an insurance company that is licensed in
a number of states, and a number of which are managed care dental plans that are
each licensed in the state in which it operates. The Company's operations are
primarily in California, Texas and Florida, but it also operates in a number of
other states.
The Company's predecessor, SafeGuard Health Plans, Inc., a California
corporation, (the "California Plan") commenced operations in 1974 as a nonprofit
corporation. The California Plan converted to for-profit status in December 1982
and is currently a subsidiary of the Company. The Company was incorporated in
California in November 1982 and acquired the California Plan in December 1982.
In August 1987 the Company reincorporated in Delaware. Unless the context
requires otherwise, all references to the "Company" or "SafeGuard" mean
SafeGuard Health Enterprises, Inc. and its subsidiaries.
The Company completed four acquisitions during the past several years, which
account for a significant portion of the Company's current operations. In
September 1992, the Company acquired a California life insurance company and
used this entity to begin offering PPO/indemnity dental plans to its customers.
In August 1996, the Company acquired a managed care dental company located in
Texas, which had approximately $12 million of annual revenue at the time of the
acquisition. In May 1997, the Company acquired a managed care dental company
located in Florida, which had approximately $7 million of annual revenue at the
time of the acquisition. In August 1997, the Company acquired another insurance
company, which had no active business but was licensed in a number of states in
which the Company was not previously licensed.
The Company sold all of its general dental practices in 1996 and 1997, and sold
all of its orthodontic practices in 1998. The proceeds from all of these sale
transactions consisted of long-term promissory notes. All revenues and expenses
related to the general dental practices and the orthodontic practices are
reflected under "discontinued operations" on the accompanying financial
statements.
Certain of the general dental practices and all of the orthodontic practices
were sold to a single purchaser (the "Purchaser"), in exchange for an aggregate
of $23.0 million of long-term promissory notes. In addition, in 1997 and 1998,
other entities that previously purchased four general dental practices from the
Company conveyed those practices to the Purchaser in exchange for the assumption
of the related promissory notes payable to the Company. Those promissory notes
had an aggregate outstanding principal balance of $1.9 million at the time of
those conveyances. In addition, during 1997 and 1998, the Company loaned a total
of $1.6 million to the Purchaser, which was used for working capital purposes by
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the Purchaser. Due to uncertainty about the Purchaser's ability to meet its
commitments to the Company under the promissory notes, the Company did not treat
the transactions with the Purchaser as sales for accounting purposes. See Note 2
to the accompanying financial statements for more information about the
accounting treatment applied to these transactions with the Purchaser. The
Purchaser ultimately defaulted on its obligations to the Company, and in 2000,
the Company completed a transaction in which the general dental and orthodontic
practices sold to the Purchaser were re-sold to another third party (the "New
Purchaser"). Pursuant to this transaction, a portion of the sale proceeds was
placed into an escrow account, pending satisfaction of certain conditions by the
Company, and the Company agreed to pay certain obligations related to the
practices sold, for which the Company may be contingently liable. These
obligations consisted primarily of dental office lease obligations and the
obligation to complete the orthodontic treatments for managed care patients who
previously paid for the treatments in full. The amount of the escrow account
that will be realized by the Company, and the ultimate cost of the obligations
assumed by the Company, are subject to uncertainties. See Note 2 to the
accompanying financial statements for more information about this transaction.
The Company's executive offices are located at 95 Enterprise, Aliso Viejo,
California 92656-2605. Its telephone number is 949.425.4300 and its fax number
is 949.425.4586.
DENTAL CARE MARKETPLACE
According to the United States Health Care Financing Administration ("HCFA"),
total expenditures for dental care in the United States grew from approximately
$31.5 billion in 1990 to an estimated $56.0 billion in 1999. HCFA also reported
that expenditures for dental services accounted for approximately 4.6% of total
national health care expenditures during 1999. According to the United States
Bureau of Labor Statistics (the "BLS), the cost of dental services has increased
in recent years at a rate higher than that for consumer goods as a whole. The
consumer price index for dental services for all urban consumers increased by
25.4% from 1994 to 1999, while the consumer price index for all items for all
urban consumers increased by 12.4% during the same period. As a result of
increases in the cost of dental services, the Company believes that employers
and other purchasers of dental care benefits have a significant interest in
effectively managing the cost of dental care benefits.
The National Association of Dental Plans (the "NADP") estimated that
approximately 153 million people, or approximately 56% of the total population
of the United States, were covered by some type of dental benefit plan in 1999.
The NADP also estimated that enrollment in managed care dental plans ("dental
HMOs") has grown from approximately 17.0 million people in 1994 to approximately
27.4 million people in 1999. The Company believes the high growth rate for
dental HMOs in recent years is attributable to acceptance of managed care by
employers and employees, a significant price advantage over conventional dental
insurance plans, and greater acceptance of dental HMOs by dentists, resulting in
improved accessibility and convenience for members.
The American Association of Health Plans (the "AAHP") estimated that
approximately 235 million people, or approximately 86% of the total population
of the United States, were covered by some type of medical benefit plan in 1999.
The AAHP also estimated that enrollment in managed care medical plans ("medical
HMOs") was approximately 168 million people in 1999. The Company believes the
number of people without dental coverage represents an opportunity for managed
care dental companies to increase their enrollments.
In recent years, there has been a significant increase in the enrollment in
dental insurance plans that include preferred provider organization ("PPO")
networks. Under these plans, the insurance company creates a PPO network by
negotiating reduced fees with dentists in exchange for including the dentists in
a "preferred provider" list that is distributed to subscribers who are enrolled
in the PPO dental plan. The subscribers who are enrolled in the plan receive a
higher level of benefits, in the form of reduced out-of-pocket cost at the time
of service, if they choose to receive services from a dentist in the PPO
network. The NADP estimated that enrollment in fully insured PPO dental plans
has grown from approximately 6.8 million people in 1994 to approximately 22.9
million people in 1999. The Company believes that PPO dental plans have been
rapidly gaining in popularity because they provide customers with a balance of
cost-effectiveness and flexibility in the choice of providers.
The managed care dental industry is characterized by participation of several
large, national insurance companies and numerous independent organizations. The
NADP estimated that there were approximately 90 firms offering dental HMO
benefit plans in the United States in 1999.
The average monthly cost of dental insurance coverage is much lower than that of
medical insurance coverage. Dental care is provided almost exclusively on an
outpatient basis, and general dentists, as opposed to specialists, perform most
dental procedures. Most dental problems are not life-threatening and do not
represent serious impairments to overall health. Therefore, there is a higher
degree of discretion exercised by patients in determining whether to obtain
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dental services, and a higher degree of sensitivity to the cost of dental
services. Many dental conditions have a range of appropriate courses of
treatment, each of which has a different out-of-pocket cost for patients who are
covered by a conventional dental insurance plan. For example, a deteriorated
filling may be replaced with another filling (a low-cost alternative), a
pin-retained crown build-up (a more costly alternative), or a crown with
associated periodontal treatment (the most costly alternative). The design of a
patient's dental insurance plan can have an impact on the type of dental
services selected by the patient or recommended by the dentist. Dental benefit
plans generally do not include coverage for hospitalization, which is typically
the most expensive component of medical services.
Common features of dental insurance plans include annual deductibles of varying
amounts, maximum annual benefits of less than $2,000 per person and significant
patient cost-sharing. Patient cost-sharing typically varies by the type of
dental procedure, ranging from no cost-sharing for preventive procedures to 50%
cost-sharing for bridgework or dentures, and even greater cost-sharing for
orthodontic care. The relatively high patient cost-sharing and the relatively
predictable nature of the need for dental services substantially reduces the
underwriting risk of a dental insurance plan, compared to the underwriting risk
of a medical insurance plan, which typically covers catastrophic illnesses and
injuries.
Under a conventional dental insurance plan, dentists have little incentive to
deliver cost-effective treatments because they are compensated on a
fee-for-service basis. In contrast, under a managed care dental plan, each
general dentist is typically reimbursed primarily in the form of a fixed monthly
payment for each member who selects that dentist as his or her primary dental
care provider (a "capitation" payment). Under a managed care dental plan, each
dentist also typically receives co-payments from the patient for certain dental
services, in addition to the capitation payments. The co-payments received from
patients mitigate the level of utilization risk assumed by the dentist, but are
typically small enough to discourage the dentist from delivering treatments that
are not cost-effective. Capitation payments create an incentive for dentists to
emphasize preventive care, to deliver cost-effective treatments, and to develop
a long-term relationship with their patients. Capitation payments also
substantially reduce the underwriting risk associated with varying utilization
of dental services, from the perspective of the entity providing managed care
dental plans.
(b) FINANCIAL INFORMATION ABOUT SEGMENTS
The Company has only one reportable business segment, which provides dental
benefit plans to employers, individuals and other purchasers.
(c) NARRATIVE DESCRIPTION OF BUSINESS
GENERAL DESCRIPTION OF THE COMPANY
The Company provides dental benefit plans, vision benefit plans and other
related products, to government and private sector employers, associations, and
individuals. The Company currently has group contracts with over 4,000 employer
or association groups and delivers its services to approximately 750,000 covered
individuals. Dental care is provided to the covered individuals through a
managed care network of approximately 3,500 general dentists and specialty
providers, and through a preferred provider network of approximately 7,700
dentists.
Under the Company's managed care dental plans, its customers pay a monthly
premium for each subscriber enrolled in the plan, and the Company usually agrees
to a monthly rate that is fixed for a period of one or two years. The amount of
the monthly premium varies depending on the dental services covered, the amount
of the member co-payments that are required for certain types of dental
services, and the number of dependents enrolled by each subscriber. Each
subscriber and dependent is required to select a general dentist from the
Company's managed care provider network, and to receive all general dental
services from that dentist. A referral to a specialist must be requested by the
general dentist and approved in advance by the Company, in order for the cost of
the service to be reimbursed by the Company, provided the service is covered by
the member's benefit plan. Under managed care dental plans, subscribers and
dependents are not required to pay deductibles or file claim forms, and are not
subject to a maximum annual benefit.
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Under the Company's PPO/indemnity dental plans, its customers also pay a monthly
premium for each subscriber enrolled in the plan, and the Company usually agrees
to a monthly rate that is fixed for a period of one year. The amount of the
monthly premium varies depending on the dental services covered, the amount of
the annual deductible, the portion of the cost of dental services that is paid
by the subscriber or dependent, the maximum annual benefit amount, and the
number of dependents enrolled by each subscriber. Under PPO/indemnity dental
plans, subscribers are required to pay deductibles and co-payments that are
typically higher than the co-payments required under a dental HMO plan, and the
benefits covered are typically subject to an annual maximum amount. However,
under PPO/indemnity dental plans, subscribers and dependents can choose to
receive dental services from any dentist of their choice.
The Company's goal is to be a leading dental benefits provider in each of the
geographic markets in which it operates. The Company's business is primarily in
California, Texas and Florida, but it also provides dental HMO plans and
PPO/indemnity dental plans in a number of other states. The Company offers a
comprehensive range of dental benefit plans that is based on a set of standard
plan designs that are available in each of the markets in which the Company
operates. By standardizing the dental plans offered, the Company believes it can
deliver a consistent product and a high level of customer service through the
consistent application of policies and procedures, and by streamlining
administrative functions. The standardized plans also allow employers to offer
substantially the same benefits in all states in which the Company is licensed
to operate. However, the Company also has the information technology and the
flexibility to deliver highly customized benefit plans, which are frequently
requested by large employer groups.
The Company uses multiple distribution methods to sell its products. The Company
has an internal sales force that primarily works with independent brokers, and
to a lesser extent, directly with small and mid-sized employer groups, to sell
the Company's benefit plans. The Company also works directly with large benefits
consulting firms, who are often engaged by large employers to assist in
selecting the best dental benefit plans for those employers. The Company also
offers its dental plans to medical HMOs, which in turn, include the Company's
dental plans in comprehensive medical plans offered by those medical HMOs. The
Company utilizes general agency relationships in certain markets, which
generally target small employers and individuals.
The Company is committed to providing quality dental care to its members through
a network of qualified, accessible dentists. By providing both dental HMO plans
and PPO/indemnity dental plans, the Company is able to maintain a competitive
network of providers by delivering patients to dentists under both types of
provider reimbursement. In addition, the Company also offers stand-alone
administrative services and preferred provider organization access products to
its customers, which deliver additional patient volume to its contracted
providers. The Company has provider relations representatives who maintain the
relationships with the network providers in each of the Company's significant
geographic markets. The local knowledge and expertise of these representatives
enables the Company to develop competitive provider networks that are convenient
for plan members, which is an important factor to employers in selecting a
dental HMO plan.
ACQUISITIONS
In 1996, the Company completed the acquisition of First American Dental
Benefits, Inc. ("First American"), a privately-held managed care dental company
based in Dallas, Texas, for total consideration of approximately $23.6 million.
The purchase price included $20 million paid at closing and an aggregate of $3.6
million paid over three years pursuant to non-competition agreements with the
former owners of First American. First American had approximately $12 million of
annual revenue at the time of the acquisition. The acquisition of First American
was recorded using the purchase method of accounting, and its results of
operations are included in the Company's financial statements beginning on the
date of acquisition.
In 1997, the Company completed the acquisition of Advantage Dental HealthPlans
("Advantage"), a privately-held managed care dental company based in Fort
Lauderdale, Florida, for total consideration of approximately $10.0 million. The
purchase price included $8.5 million paid at closing, in the form of a note
payable to the seller, and an aggregate of $1.5 million paid over two years,
pursuant to a non-competition agreement with the former owner of Advantage.
Advantage had approximately $7 million of annual revenue at the time of the
acquisition. The acquisition of Advantage was recorded using the purchase method
of accounting, and its results of operations are included in the Company's
financial statements beginning on the date of acquisition.
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In 1997, the Company also completed the acquisition of Consumers Life Insurance
Company of North Carolina ("Consumers"), a privately-held dental insurance
company with licenses in sixteen states, for total consideration of
approximately $3.2 million. Consumers had no significant business at the time of
the acquisition, but it was licensed in several states in which the Company was
not previously licensed to offer PPO/indemnity dental plans. The acquisition was
recorded based on the purchase method of accounting, and accordingly, the
results of operations of Consumers are included in the Company's financial
statements beginning on the date of the acquisition.
GEOGRAPHIC MARKETS
The Company operates primarily in California, Texas and Florida and its
marketing activities are currently focused on these states. It also maintains
both managed care and PPO provider networks in several other states, and obtains
new business in those other states from time to time. The Company uses its
provider networks in other states to serve employees of customers in its primary
markets who are located outside of California, Texas and Florida.
The Company started its business in California, and expanded to Texas and
Florida primarily through the acquisition of two managed care dental benefits
companies located in those two states. The Company has also expanded its
operations to certain other states in the past by obtaining a significant
customer contract in a new market, or by expanding an existing customer contract
to include additional geographic areas. It is possible that the Company could
expand its operations to additional markets as a result of future acquisitions
or new or expanded customer contracts, although the Company has no current plans
to do so.
PRODUCTS
The Company operates primarily in a single business segment, which is providing
dental benefit plans to employers, individuals and other purchasers. The Company
provides a broad range of dental benefit plan designs, depending on the demands
of its customers. In addition to offering a range of benefit plan designs, the
Company offers benefit plans with a restricted choice of providers, through its
managed care plans, and benefit plans with an unrestricted choice of providers,
through its PPO/indemnity plans. Premium rates for each benefit plan are
adjusted to reflect the benefit design, the cost of dental services in each
geographic area, and whether the covered individuals can select any provider at
the time of service. In addition to dental benefit plans, the Company also
offers other related products, as described below. The revenue currently
generated by these other related products is not significant compared to the
revenue generated by the Company's dental benefit plans.
Managed Care Dental Plans. The Company offers a comprehensive range of managed
care dental plans, under the names SafeGuard Health Plans and SafeGuard Dental
Plans. The Company's managed care dental plans typically cover basic dental
procedures, such as examinations, x-rays, cleanings and fillings, for no
additional charge at the time of service, although some benefit designs require
the member to pay a small co-payment for each office visit. Managed care dental
plans also typically cover more extensive procedures provided by the general
dentist, such as root canals and crowns, as well as procedures performed by
specialists in the Company's provider network, including oral surgery,
endodontics, periodontics, orthodontics, and pedodontics, in exchange for member
co-payments that vary depending on each member's benefit plan design. Any
procedure performed by a specialist must be requested by the member's general
dentist and approved in advance by the Company, in order for the procedure to be
a covered benefit. The Company's managed care dental plans also cover emergency
out-of-area treatments that are required when a member is temporarily outside
the geographic area served by his general dentist.
Under a managed care dental plan, each subscriber and dependent selects a
general dentist from the Company's managed care provider network, and receives
all general dental services from that dentist. The general dentist selected by
each member receives a monthly capitation payment from the Company, which is
designed to cover most of the total cost of the general dental services
delivered to that member. The monthly capitation payment does not vary with the
nature or the extent of dental services provided to the member by the general
dentist, but is variable based on the particular benefit plan purchased by each
member. In exchange for the monthly capitation payments, the general dentist
provides dental services to members of the Company's benefit plans, based on the
benefit design of each member's benefit plan. In addition to the capitation
payments, the general dentist also receives co-payments from the members for
certain types of services, and receives supplemental payments from the Company
for certain types of services. The Company typically pays for services delivered
by a specialist based on a negotiated fee schedule.
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PPO/Indemnity Dental Plans. The Company offers a comprehensive range of
PPO/indemnity dental plans, subject to regulatory restrictions in certain
states. PPO/indemnity dental plans typically cover the same dental procedures as
managed care dental plans. Under the Company's PPO/indemnity dental plans, the
covered individuals are required to make a co-insurance payment at the time of
each service, which is typically higher than the co-payments required under a
typical managed care dental plan. In addition, the benefits covered under the
Company's PPO/indemnity dental plans are subject to annual deductibles and
annual benefit maximums, which is not the case under the Company's managed care
dental plans.
Under PPO/indemnity dental plans, subscribers and dependents can choose to
receive covered services from any licensed dentist of their choice. In the case
of a benefit plan that includes a PPO component, the co-insurance amounts
required to be paid by subscribers and dependents are reduced if the services
are delivered by a dentist in the Company's preferred provider network. In
addition, the covered individual's annual deductible may be waived as long as
all services are delivered by a dentist in the Company's preferred provider
network. The Company pays for services delivered by dentists in its preferred
provider network based on negotiated fee schedules, and pays for services
delivered by other providers based on usual and customary dental fees in each
geographic area. The Company believes that offering an indemnity dental plan
with a PPO network is an attractive way to enter geographic areas where few
dentists have agreed to participate in managed care networks. In such areas,
participation in the PPO network can serve as a transitional step for dentists,
between the traditional system of reimbursement based on usual and customary
fees, to participation in a managed care network. PPO/indemnity dental plans
subject the Company to more significant underwriting risks than managed care
dental plans, because the Company assumes all the risk related to varying
utilization rates under its PPO/indemnity dental plans.
The Company believes that PPO/indemnity benefit plans are attractive to
employers and other purchasers because they are a cost-effective alternative to
traditional indemnity insurance, and they offer more freedom of choice of
providers than managed care dental plans.
Dual Option Product. The Company frequently combines one of its managed care
dental plans with one of its PPO/indemnity plans to create a "dual option"
product for its customers. As a result, each subscriber can choose whether to
enroll in the managed care dental plan or the PPO/indemnity plan. By offering a
dual option product, the Company can offer its customers more flexibility, and
can capture a larger portion of the total dental benefits expenditures by each
of its customers. This product also allows the Company to offer a managed care
dental plan to cost-conscious customers, while also providing PPO/indemnity
coverage to employees of those customers who are located outside the geographic
area served by the Company's managed care provider network. Certain states,
including Nevada and Oklahoma, require that managed care dental plans be offered
only as part of a dual option product and other states may do so in the future.
Vision Benefit Plans. The Company offers a vision benefit plan to employer
groups, which covers routine eye care in exchange for a fixed monthly premium.
Under the vision plan, subscribers can choose to receive services from any
licensed optometrist of their choice. Alternatively, they can choose to receive
services from an optometrist in the preferred provider network, in which case
their co-insurance payments at the time of service would be reduced. Currently,
the annual revenue from vision benefit plans is not material.
Other Dental Benefits Products. For self-insured employers, the Company offers
claims administration under an administrative services only ("ASO") arrangement,
under which the Company does not assume the underwriting risk for the benefits
provided. The Company receives an administrative fee to process claims and the
underwriting risk is retained by the employer sponsoring the self-insured plan.
The Company also provides access to its PPO network for a fixed monthly fee
based on the number of potential patients covered by the product. Under this
product, the providers in the PPO network offer a reduced fee schedule for
services provided to participating patients. The Company makes no payments to
the providers in the PPO network under this product. Currently, the annual
revenue from ASO arrangements and PPO network access products is not material.
MARKETING
The Company markets its products to employer groups, individuals and other
purchasers primarily through independent brokers and consultants. Independent
brokers are typically engaged by employer groups and other purchasers to select
the dental plan that best suits the needs of the purchaser's employees, in terms
of price, benefit design, geographic coverage of the provider network, financial
stability, reputation for customer service, and other factors. Brokers are
typically paid by the Company, based on a specified percentage of the premium
revenue collected from each group contract generated by the broker. The largest
employers typically engage consultants, instead of brokers, to assist them in
selecting the dental plan that best suits their needs. The consultants generally
perform the same function as brokers, but are typically paid by the employer
instead of the Company. Consequently, large employers expect to pay premium
rates that have been reduced to reflect the fact that the Company is not paying
a broker commission. Brokers and consultants do not market the Company's benefit
plans on an exclusive basis.
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The Company has an internal sales force that is paid through a combination of
salary and incentive compensation based on the volume of business generated by
each salesperson. The function of the internal sales force is primarily to
cultivate relationships with brokers and consultants, and to help brokers and
consultants present the Company's benefit plans to their clients in the most
favorable way, although a small portion of the Company's sales are generated
directly by its internal sales force. The Company uses the same brokers,
consultants and internal sales force to market all of its products.
After an employer group or other purchaser decides to make the Company's benefit
plan available to its employees, the Company's marketing efforts shift to the
individual potential subscribers. Typically, employees participate in an annual
open enrollment process, under which they select the employee benefit plans they
wish to use for the upcoming year. During the open enrollment process, employees
typically choose between benefit plans offered by the Company and benefit plans
offered by competitors of the company, and in some cases, whether to purchase
any benefit plans at all. In the case of some employers, the Company's benefit
plans are offered to employees on an exclusive basis. In the case of other
employers, the Company's benefit plans are offered in competition with benefit
plans offered by the Company's competitors. Generally, employees can enroll in
the Company's benefit plans or cancel their participation in the Company's
benefit plans only during this annual open enrollment process.
In addition to an internal sales force, the Company also employs account
managers who are responsible for meeting the needs of existing customers,
promoting retention of the individual subscribers who are enrolled in the
Company's benefit plans, and marketing additional products to existing
customers. These account managers are responsible for supporting the customer's
open enrollment process to ensure that difficulties experienced by the customer
during this process are minimized, and that the number of subscribers who enroll
in the Company's benefit plans is maximized. The account managers perform this
function for both new employer groups and renewing employer groups. Account
managers are paid through a combination of salary and incentive compensation
based on their success in retaining existing subscribers and selling additional
products to existing customers.
UNDERWRITING
When the Company has the opportunity to submit a proposal for a benefit plan to
a potential customer, it first obtains certain basic underwriting information
from the prospective client. This information includes whether the potential
customer currently has dental coverage, the benefit design of the existing
dental coverage, the geographic location of the potential customer's employees,
the number of employees and dependents who are currently enrolled and the number
who are eligible for coverage, the portion of the cost of dental coverage that
is paid by the employer, whether the potential customer is considering making
the Company the exclusive provider of dental coverage, and other similar
information. The Company then evaluates all of this information in order to
assess the underwriting risk associated with providing a dental benefit plan to
the potential customer. Based on this evaluation, the Company either makes a
proposal that includes a benefit design and premium rates that take into account
the Company's risk assessment, or declines to make a proposal due to an
excessive amount of underwriting risk.
CLIENTS AND CUSTOMER CONTRACTS
The Company currently provides services to an aggregate of approximately 750,000
individuals, who participate in the Company's benefit plans primarily through
group contracts with over 4,000 employers and other purchasers of dental
benefits. The Company's customers include many large employers, including Boeing
Corporation, City of Dallas, County of Los Angeles, Dallas Independent School
District, Joint Council of Teamsters #42 Welfare Trust, Southern California
Edison, Southern California Gas Company, and State of California, among others.
A small portion of the total covered individuals participates in the Company's
benefit plans through individual managed care dental plans purchased from the
Company. No single customer accounts for ten percent (10%) or more of the
Company's total premium revenue.
-7-
The Company's group contracts generally provide for a specified benefit program
to be delivered to plan participants for a period of one to two years at a fixed
monthly premium rate for each subscriber type. The contracts typically provide
for termination by the customer upon 60 days written notice to the Company.
PROVIDER NETWORKS
The Company currently has approximately 3,500 general dentists and specialists
in its managed care network, and has approximately 7,700 general dentists and
specialists in its PPO network. The Company believes that a key element of
success in the dental benefits business is an extensive network of participating
dentists in convenient locations. The Company believes that dentists who
participate in its managed care and PPO networks are willing to provide their
services at reduced fees in exchange for a steady stream of revenue from
patients enrolled in the Company's benefit plans. In addition, this revenue
source for the dentist is relatively free from collection problems and
administrative costs sometimes associated with other types of patients.
Therefore, qualified dentists and/or dental groups have generally been available
and willing to participate in the Company's managed care and PPO networks in
order to supplement their conventional patient base for which they are paid
based on usual and customary fees.
The Company requires that all dentists in its managed care network meet certain
quality assessment program standards. Those standards include current
professional license verification, current liability insurance, a risk
management review of the dental office facility to ensure that OSHA and
regulatory requirements are met, an inspection of the office's sterilization
practices, and a review of the dental office location, including parking
availability and handicap access.
The Company compensates each general dentist in its managed care network
primarily through monthly capitation payments. Each general dentist receives a
fixed monthly payment for each subscriber and dependent who selects that dentist
as his primary dentist. The amount of the capitation payment related to each
member varies based on the plan design in which each member is enrolled, but
does not vary with the nature or extent of the dental services provided to the
member. In addition to capitation payments, the general dentists also receive
supplemental payments from the Company and co-payments from the patients. The
Company makes a fixed supplemental payment to the general dentist each time the
dentist delivers specified procedures to members who have selected that dentist
as their general dentist. The amount of the supplemental payment varies
depending on the specific procedure performed. Each supplemental payment is
designed to mitigate the risk to the dentist associated with procedures that
require the payment of a laboratory fee by the dentist, and members who require
an extensive amount of dental services, but is low enough to avoid providing an
incentive for the dentist to increase the utilization of services by his managed
care patients. The Company believes the use of supplemental payments provides
for a higher level of member and provider satisfaction with the Company's
managed care program. The general dentist also receives co-payments from the
members for certain types of services, which vary based on the specific plan
design purchased by each member. No individual dental office provides services
to ten percent (10%) or more of the members enrolled in the Company's managed
care plans.
The Company's managed care network also includes specialists in the areas of
endodontics, oral surgery, orthodontics, pedodontics, and periodontics. In order
for a member to receive services from a specialist, those services must be
requested by the member's general dentist and approved in advance by the
Company. Specialists are reimbursed by the Company based on a negotiated fee
schedule, and also receive co-payments from members based on the benefit plan
design purchased on behalf of each member.
Dentists in the Company's PPO network are compensated based on a negotiated fee
schedule that is generally 20 to 40 percent less than the usual and customary
fees for that provider's geographic area. Non-contracted dentists who provide
services to subscribers and dependents enrolled in PPO/indemnity plans are
compensated based on usual and customary fees in each geographic area.
The Company employs provider relations representatives who are located in local
offices in the geographic markets served by the Company. These representatives
are responsible for maintaining the Company's extensive network of managed care
and PPO dentists. They negotiate contracts with the network dentists and also
assist the network providers in the administration of the Company's benefit
plans. In the event that a network dentist terminates his relationship with the
Company, the provider relations representative is responsible for recruiting new
providers to meet the needs of the patients enrolled in the Company's benefit
plans.
-8-
The dentists in the Company's managed care and PPO networks are free to contract
with other dental benefit plans, and both the provider and the Company can
typically terminate the contract at any time upon 60 days prior written notice.
In accordance with the contract, the Company may also terminate the contract
"for cause" upon 15 days prior written notice. The Company can also change the
reimbursement rates, member co-payments, and other financial terms and
conditions of the contract at any time, with ten (10) days notice to the
provider. The Company's contracts with dentists in its managed care and PPO
networks require them to maintain professional liability insurance with a
minimum coverage of $200,000 per claim, and $600,000 aggregate per year, and to
indemnify the Company for claims arising from the dentist's acts or omissions.
QUALITY MANAGEMENT
The Company maintains a quality management program with respect to its managed
care business, which is under the direction of its Vice President and Dental
Director. The Company's quality management program includes verification of
provider credentials, assessment of each dentist's compliance with applicable
state regulatory standards and practice standards established by the Company,
monitoring of patient appointment availability and accessibility of dental care,
monitoring of patient satisfaction through member surveys and other tools,
analysis of dental care utilization data, ensuring compliance with state
regulatory requirements, addressing member complaints and grievances, and
assessment of other qualifications of dentists to participate in the Company's
managed care network.
The Company maintains a credentialing committee, which uses information provided
by an NCQA-certified Credentialing Verification Organization ("CVO") to verify
each provider's licensing status, insurance coverage, and compliance with
applicable federal and state regulations, and to review the National
Practitioners Data Bank for complaints filed against the provider. The Company
also uses an outside contracting service to perform on-site dental office
quality assessment reviews to determine appropriateness of care and treatment
outcomes.
The Company uses an outside contracting service to conduct monthly member
satisfaction surveys. These surveys monitor the level of member satisfaction
with respect to the dental services provided by network dentists, the choice of
providers within the Company's network, the benefits covered by the Company's
benefit plans, and the customer service provided by the Company. The Company
also uses member surveys to monitor appointment availability at contracting
dentist offices, including availability of new patient, recall, routine and
emergency appointments, and to measure the waiting time in the reception area
and treatment room. The results are used by the Company to determine how it can
improve the level of service provided to its members.
UTILIZATION REVIEW
The Company monitors the utilization rates for various dental procedures
provided by general dentists in its managed care network, as well as the
frequency of specialist referrals initiated by those dentists, based on paid
claim information. The analysis of this information, including comparisons among
providers in the network, enables the Company to determine whether any of its
providers display practice patterns that are not cost-effective, or practice
patterns that are otherwise inappropriate. When this information shows a
potentially inappropriate practice pattern, the Company conducts a more focused
review of the dental practice in question.
The Company also monitors the utilization rates for various dental procedures
provided by dentists in its PPO network, based on paid claim information. The
analysis of this information, including comparisons among providers in the
network, enables the Company to focus its provider contracting efforts to
develop a more cost-effective PPO network, as well as to improve the design of
its PPO/indemnity benefit plans. This information also allows the Company to
demonstrate savings achieved by the Company and its subscribers and dependents,
as a result of the contracting arrangements between the Company and the
providers in its network.
MEMBER SERVICES
The Company provides basic member services from its National Service Center in
Aliso Viejo, California through the use of toll-free telephone numbers. The
toll-free telephone numbers provide members and dental offices with access to
automated services 24 hours per day, and with access to member services
representatives during regular business hours. Automated service is available
for inquiries such as selection of a network dentist, requests for
-9-
identification cards, and eligibility verification. The Company uses an
automated call distribution ("ACD") system for its management of customer
service calls. The ACD system prioritizes customer service calls, and provides
statistics on the number of calls received, the average time to answer calls,
the number of callers who terminated the call before a member services
representative answered the call, and other similar statistics. These statistics
are used by the Company to determine its staffing needs in the area of member
services, and to identify ways to improve the level of its customer service. The
Company receives approximately 75,000 calls per month, of which approximately 25
percent access the Company's automated service features.
The Company maintains a Quality Management ("QM") Committee under the direction
of its Vice President and Dental Director. The QM Committee is responsible for
the disposition of all types of member grievances with respect to the Company's
managed care dental plans. Member grievances are typically originated through a
member services call or a letter written to the Company by the member. The
Company has a standard grievance resolution process that begins with a member
services representative who attempts to resolve the grievance. In the event this
is not successful, or the grievance is related to dental care issues that are
beyond the expertise of a member services representative, the grievance is
addressed by the Company's Quality Management department. The QM Committee
addresses grievances that cannot be resolved by the Quality Management
department. The Company responds to all member grievances with a written
disposition of the grievance within 30 days of receipt of the grievance. After
the QM Committee has responded to the grievance, the member has the option of
submitting the grievance to binding arbitration, which is conducted according to
the rules and regulations of the American Arbitration Association.
The QM Committee monitors the frequency of member grievances by type, and the
average time in which the Company responds to grievances, in order to determine
ways it can improve its communications with members and network providers, and
otherwise improve its customer service. Statistics on member grievances are also
used to determine ways to improve the efficiency of the grievance resolution
process.
MANAGEMENT INFORMATION SYSTEMS
The Company currently uses two primary business applications for its eligibility
files, billing and collections, claims processing, and provider network
activities, one for its managed care dental business and one for its
PPO/indemnity dental business. The Company is currently in the process of
combining these two systems into a single application that is expected to reduce
administrative expenses and enhance customer service. Both of the primary
business applications include comprehensive information on the Company's
eligibility files, benefit plan designs, billing and collections activities,
claims processing activities, and provider payment parameters. Both systems are
also flexible enough to accommodate a wide variety of benefit plan designs to
meet the needs of the Company's customers. The system used in the Company's
managed care business is a proprietary application that is continuously modified
by the Company to meet the changing needs of this business. The system used in
the PPO/indemnity business is a standard application purchased from a well-known
vendor, which generally meets the needs of the Company's PPO/indemnity business.
The Company is currently in the process of implementing an enhanced billing and
collections system that would be used for both its managed care business and its
PPO/indemnity business. This project includes the purchase of a new billing and
collections application, new hardware, the integration of this system with the
Company's two primary business applications, and the training of employees
involved in billing and collections activities in the use of the features of the
new application. This project is designed to provide greater assurance that the
Company is collecting appropriate amounts from its customers, to improve the
efficiency of the billing and collections process, and to improve customer
service related to billing and collections issues.
The Company uses a personal computer network-based general ledger system that
includes reporting and analysis tools that allow the extraction and download of
data to spreadsheet programs for further analysis. The Company also makes
extensive use of its email system in coordinating the activities of employees in
various office locations and communicating with customers, brokers and
providers. The Company is currently in the process of selecting software and
hardware for a Customer Relationship Management system, which it intends to use
to manage customer and provider relationships. The Company also uses a variety
of other, less significant applications in various areas of its business. All of
the Company's applications are integrated into a single network, so that
employees can easily access any needed application from their desktop computers.
During 2000, the Company purchased a new computer to run its primary business
applications, which has significantly faster processors and a significantly
larger amount of storage capacity than the computer previously used. The Company
believes this computer will serve the Company's needs for at least the next two
to three years.
-10-
RISK MANAGEMENT
The Company is generally indemnified against professional liability claims by
the dentists in its managed care and PPO networks. Pursuant to the contracts
between the Company and the dentists in its networks, each dentist is required
to maintain professional liability insurance with specified minimum amounts of
coverage. The Company also maintains $10 million of general and professional
liability insurance coverage, which covers losses on a claims made basis. The
Company believes this amount of coverage is adequate to manage the ordinary
exposure of operating its business. However, there can be no assurance that this
amount of coverage would be adequate to cover potential claims against the
Company, or that adequate general and professional liability insurance coverage
will be available to the Company at a reasonable cost.
COMPETITION
The Company operates in a highly competitive environment and faces numerous
competitors in each of its geographic markets, and with respect to all of the
products offered by the Company. The Company's competitors include large
insurance companies that offer managed care dental benefit plans and
PPO/indemnity dental benefit plans, medical HMOs that offer dental benefit
plans, self-insured dental plans provided by employers, and numerous local or
regional companies that offer various types of dental benefit plans. Many
competitors are significantly larger than the Company, and have substantially
greater financial resources than the Company.
The Company believes that the key factors in an employer's selection of a
particular dental benefit plan include the premium rates charged, the
comprehensiveness of the dental benefits offered, the range of benefit designs
offered, the responsiveness related to customer service activities, and the
perceived quality, accessibility and convenience of the dental offices in the
provider network. There are competitors that compete aggressively with respect
to all of these factors in each of the geographic markets in which the Company
operates, and many employers, particularly large employers, make their selection
of a dental benefit plan through a competitive bidding process. There is
significant price competition in each of the Company's geographic markets, which
could impair the Company's ability to sell its dental benefit plans at
profitable premium rates. The Company anticipates that this price competition
will continue to exist during the foreseeable future.
Large national insurance companies that offer both managed care dental plans and
PPO/indemnity dental plans may have a competitive advantage over smaller
competitors, such as the Company, due to larger provider networks located across
the United States, the availability of multiple product lines other than dental
benefits, established business relationships with large employers, better name
recognition, and greater financial and information system resources. The Company
believes it can effectively compete with these insurance companies by offering a
comprehensive array of benefit plan designs, and by maintaining a high level of
customer service with respect to its employer group customers, its members, and
its dental service providers. Some medical HMOs have developed managed care and
PPO/indemnity dental benefit plans in-house, and others contract with dental
benefits companies to provide those products. The Company believes it can
compete effectively with medical HMOs that offer dental benefit plans, and the
Company may pursue opportunities to form relationships with medical HMOs, under
which the medical HMOs offer the Company's dental benefit plans to its
customers.
Other than the minimum net worth requirements imposed by state regulators, there
are no substantial capital requirements related to entering the dental benefit
plan business. Other than the need to obtain a license from the applicable state
regulator, which could take a substantial period of time to obtain, there are no
other significant barriers to entry into the dental benefits business by
potential competitors. There can be no assurance that the Company will be able
to compete successfully with any new competitors. Additional competition could
adversely impact the Company's profitability and growth prospects through
decreases in premium rates, and the loss of customers or dental service
providers.
-11-
GOVERNMENT REGULATION
The Company's operations are subject to an extensive amount of state regulation
in each of the states in which it operates. The Company's most significant
managed care dental plan subsidiaries are regulated by the California Department
of Managed Health Care, the Texas Department of Insurance and the Florida
Department of Insurance. In addition, several other subsidiaries of the Company
are managed care dental plans that are each licensed in the state in which it
operates. The Company's dental insurance subsidiary is primarily regulated by
the California Department of Insurance, but is also subject to regulation by
state insurance regulatory agencies in all of the states in which it is
licensed.
The Company's managed care dental plans are subject to regulations that vary
from state to state. However, the Company's managed care dental plans are
typically subject to state regulation with respect to the scope of benefits
provided to members enrolled in the plans, the content of all contracts with
customers, dental service providers and others, the amount of financial
resources maintained by the Company, the Company's procedures related to quality
assurance, the Company's enrollment procedures, the maximum percentage of
premium revenue that the Company can spend on general and administrative
expenses, certain "any willing provider" requirements which may limit the
Company's ability to restrict the size of its provider network, the relationship
between the Company and the dentists in its provider network, the Company's
procedures for resolving member grievances, and the premium rates charged by the
Company.
The Company's PPO/indemnity dental plans are subject to state regulations with
respect to the maintenance of a minimum amount of tangible net worth, the
maintenance of restricted deposits for the benefit of certain state regulators,
the nature of investments held by the Company, advertising, insurance policy
forms, and claims processing procedures. Insurance companies in general are
subject to extensive regulation and are typically required to have significantly
greater financial resources than managed care dental companies.
The Company's ability to expand its operations into states in which it is not
currently licensed is dependent on the regulatory review process conducted by
the applicable state regulatory agency in each state. Such reviews may take
anywhere from six to twenty-four months, and must be satisfactorily completed
before the Company can commence operations in the applicable state.
Since some states will only license full service health plans, the Company
cannot offer its managed care dental plans in those states, except pursuant to
an arrangement with a full service medical HMO. Other states permit only
nonprofit organizations to become licensed as managed care dental plans, again
limiting the Company's access to business in those states. The heavily regulated
nature of the Company's business imposes a variety of potential obstacles to any
geographic expansion by the Company, and could limit the Company's future growth
potential. On the other hand, this regulatory environment also governs the
conduct and expansion prospects of existing and new competitors, thereby
providing a potential barrier to entry for potential competitors.
There is currently no regulation of the Company's business at the federal level.
TRADEMARKS, SERVICEMARKS AND TRADENAMES
The Company has filed, received approval, and obtained renewal protection from
the United States Patent and Trademark office for certain trademarks and
tradenames for names and products used by the Company in its ordinary course of
business. The Company has received a trademark, service mark or tradename for
the following words and phrases used with and without distinctive logos
maintained by the Company:
o SafeGuard(R) used with a distinctive logo depicting a modified smile used
in connection with its managed care dental plans;
o SafeGuard Health Plans(R) used in descriptive material to describe the
products offered by the Company;
o SafeGuard Dental Plans(TM) used to describe the various managed care dental
plans offered by the Company;
o SafeHealth Life(R) used with a descriptive logo depicting a modified smile
used by the Company to describe its PPO/indemnity dental plans; and
o American Dental Corporation(R) adjacent to a flag of the State of Texas
used in connection with its managed care dental plans, the use of which
ended in 1999.
-12-
Collectively, these trademarks, service marks and tradenames were first used in
commerce in 1984 and have been continuously used thereafter. In addition, the
Company has nearly completed and is about to receive trademark/service mark
protection from the United States Assistant Commissioner for Trademarks of its
distinctive logo depicting a smile that the Company is currently utilizing in
interstate commerce.
EMPLOYEES
At March 15, 2001, the Company had 206 employees, of which 36 were office and
clerical employees represented by a labor union. The Company considers its
relations with its employees to be satisfactory. The Company provides typical
employee benefits, including a portion of the cost of health insurance, dental
insurance, vision benefits, life insurance, and the opportunity to take
advantage of a 401(k) plan and a flexible spending account under Section 125 of
the Internal Revenue Code. Employees are eligible to participate in the 401(k)
plan upon completion of six months of service with the Company. Under the 401(k)
plan, an employee is allowed to contribute up to 20 percent of his total
compensation to the plan each pay period. The Company may, at its option, make
an employer contribution to the plan, which would be allocated among the
employees in the plan in proportion to the contribution made by each employee.
The Company made no contributions to the 401(k) plan during the three years
ended December 31, 2000. Employees are fully vested in their contributions to
the 401(k) plan at all times.
RISK FACTORS
The Company's business and competitive environment includes numerous factors
that expose the Company to risk and uncertainty. Some risks are related to the
dental benefits industry in general and other risks are related to the Company
specifically. Due to the risks and uncertainties described below, as well as
other risks described elsewhere in this Annual Report on Form 10-K, there can be
no assurance that the Company will be able to maintain its current market
position or to return its operations to profitability. Some of the risk factors
described below have adversely affected the Company's operating results in the
past, and all of these risk factors could affect its future operating results.
Recent Operating Losses. The Company incurred significant net losses during each
of the three years ended December 31, 2000. The Company's ability to continue as
a going concern on a long-term basis depends on returning its operations to
profitability. The Company has taken several actions since the beginning of 2000
to improve its profitability, including increases in premium rates, reductions
in certain types of provider payments, a decrease in the amount of office space
used, consolidation of its administrative operations in one location, which
facilitated a decrease in the number of its employees, and decreases in various
other selling, general and administrative expenses. The results of the
Company's operations improved during the course of 2000, as shown in its
quarterly results of operations, which are included in Note 13 to the
accompanying consolidated financial statements. The Company plans to further
improve its profitability in the future through various actions, including the
improvement of various customer service functions, further streamlining of its
operations, increasing customer retention, and increasing its volume of new
business and new products. However, there can be no assurance that the Company
will be successful in returning to profitability.
Shareholder Litigation. In December 1999, a stockholder lawsuit against the
Company was filed, which alleged that the Company and certain of its officers
violated certain securities laws by issuing a series of alleged false and
misleading statements concerning the Company's publicly reported revenues and
earnings during a specified class period. On September 12, 2000, after the
plaintiffs had filed a first amended complaint, the Federal District Trial Court
dismissed the lawsuit with prejudice, stating that the plaintiffs had failed to
state a claim against the Company. On October 6, 2000, the plaintiffs filed an
appeal of the dismissal of the lawsuit, and that appeal is currently pending.
The Company has directors and officers liability insurance and intends to
vigorously contest the appeal. However, there can be no assurance that the
ultimate outcome of this litigation will not have an adverse impact on the
Company's financial position.
Government Regulation. The dental benefit plan industry is subject to extensive
federal, state and local laws, rules and regulations. Each of the Company's
operating subsidiaries is subject to various requirements imposed by state laws
and regulations related to the operation of a managed care dental plan or a
dental insurance company, including the maintenance of a minimum amount of
tangible net worth by certain subsidiaries. In addition, regulations applicable
to dental benefit plans could be changed in the future. There can be no
assurance that the Company will be able to meet all applicable regulatory
requirements in the future.
-13-
Sale Proceeds in Escrow Account. In connection with the sale of certain assets
related to general dental practices and orthodontic practices in October 2000, a
portion of the proceeds were placed in an escrow account by the purchaser,
pending the satisfaction of certain conditions by the Company. See Note 2 to the
accompanying consolidated financial statements for more information about this
transaction. The failure to satisfy the relevant conditions and collect the sale
proceeds from the escrow account could have an adverse impact on the Company's
financial position.
Liabilities Related to Dental and Orthodontic Practices. The Company has various
liabilities in connection with the dental and orthodontic practices sold in
October 2000, including but not limited to, dental office lease obligations, the
obligation to complete orthodontic treatments for certain managed care patients
who previously paid for the treatments in full, the obligation to pay for
completing certain dental treatments, and possibly, other operating expenses
related to the practices that were sold. The amount of these liabilities is
subject to uncertainties, due to the inability to predict future developments.
There can be no assurance that the ultimate amount of these liabilities will not
exceed the amounts accrued on the Company's balance sheet as of December 31,
2000.
Contingent Lease Obligations. The Company is contingently liable for an
aggregate of approximately $5.5 million of office lease obligations related to
the dental and orthodontic practices sold by the Company in 1996, 1997 and 1998,
including those practices sold again by the Company in October 2000. These
leases have been assigned to the purchasers of those practices, or in the case
of the practices re-sold in October 2000, the Company is in the process of
assigning the leases to the purchaser. There can be no assurance that the
entities to which these office leases were assigned will make the lease
payments, and that the Company will not be liable for those payments.
Risk of Acquisitions. The Company completed two acquisitions of managed care
dental plan companies in 1997 and 1996. The Company is still in the process of
integrating the operations of these businesses into its other managed care
dental plan business. There can be no assurance that the Company will be able to
successfully complete this integration in a cost-effective manner. In addition,
successful completion of this integration could still require significant
amounts of management's time. A failure to successfully complete this
integration could have a material adverse effect on the Company's financial
results.
Payments Due on Promissory Notes. In connection with the sale of certain dental
practices by the Company in 1996 and 1997, the dentists who purchased those
practices issued long-term promissory notes to the Company secured by the assets
purchased. There can be no assurance that each of these dentists will make
timely payments on these promissory notes in the future.
Possible Volatility of Stock Price. The market price of the Company's common
stock has fluctuated significantly during the past few years. Stock price
volatility can be caused by actual or anticipated variations in operating
results, announcements of new developments, actions of competitors, developments
in relationships with clients, and other events or factors. Even a modest
shortfall in the Company's operating results, compared to the expectations of
the investment community, can cause a significant decline in the market price of
the Company's common stock. In addition, the trading volume of the Company's
common stock is relatively low, which can cause fluctuations in the market price
and a lack of liquidity for holders of the common stock. The fact that the
Company's common stock is no longer listed on the NASDAQ National Market can
have a negative influence on the trading volume of the stock. Broad stock market
fluctuations, which may be unrelated to the Company's operating performance,
could also have a negative effect on the Company's stock price.
Competitive Market. The Company operates in a highly competitive industry. Its
ability to achieve profitability is affected by significant competition for
employer groups and for contracting dental providers. There can be no assurance
the Company will be able to compete successfully enough to achieve and maintain
profitability. Existing or new competitors could have a negative impact on the
Company's revenues, earnings and growth prospects. The Company expects the level
of competition to remain high for the foreseeable future.
Ability to Increase Revenue. The Company has not increased its annual premium
revenue significantly during the past four years. The Company intends to expand
its business in the future and to increase its annual revenue, but there can be
no assurance the Company will be able to maintain its current level of revenue
or to increase it in the future. The ability of the Company to expand its
business depends on a number of factors, including existing and emerging
competition, its ability to maintain effective control over the cost of dental
services, and its ability to obtain sufficient working capital to support an
increase in revenue.
-14-
Utilization of Dental Care Services. Under the Company's PPO/indemnity dental
plans, the Company assumes a significant amount of underwriting risk related to
the rate at which dental care services are utilized by subscribers and
dependents, and to the cost of those services. If the Company does not
accurately assess these underwriting risks, the premium rates charged to its
customers may not be sufficient to cover the cost of the dental services
delivered to subscribers and dependents. This could have a material adverse
effect on the Company's operating results.
Under the Company's managed care dental plans, the Company also assumes
underwriting risk related to the rate at which specialist services are utilized
by subscribers and dependents, and to the cost of those services. If the Company
does not accurately assess these underwriting risks, the premium rates charged
to its customers may not be sufficient to cover the cost of the dental services
delivered to subscribers and dependents. This could have a material adverse
effect on the Company's operating results.
Effect of Adverse Economic Conditions. The Company's business could be
negatively affected by periods of general economic slowdown or recession which,
among other things, may be accompanied by layoffs by the Company's customers,
which could reduce the number of subscribers enrolled in the Company's benefit
plans, and by an increase in the pricing pressure from customers and
competitors.
Relationships with Dental Providers. The Company's success is dependent on
maintaining competitive networks of dentists in each of the Company's geographic
markets. Generally, the Company and the network dentists enter into
non-exclusive contracts that may be terminated by either party with limited
notice. The Company's operating results could be negatively affected if it is
unable to establish and maintain contracts with a competitive number of dentists
in locations that are convenient for the subscribers and dependents enrolled in
the Company's benefit plans.
Dependence on Key Personnel. The Company believes its success is dependent to a
significant degree upon the abilities and experience of its senior management
team. The loss of the services of one or more of its senior executives could
negatively affect the Company's operating results.
RECENT DEVELOPMENTS
On March 1, 2000, the Company entered into a recapitalization transaction with
an investor group (the "Investors"), the revolving credit facility lender (the
"Bank"), and the holder of the senior notes payable (the "Senior Note Holder").
In this transaction, the Investors loaned $8.0 million to the Company in the
form of an investor senior loan, which was due April 30, 2001, and had an
interest rate of 10% annually. The Investors, the Bank, and the Senior Note
Holder agreed to convert the $8.0 million investor senior loan, the outstanding
balance of $7.0 million under the revolving credit facility plus accrued
interest, and the $32.5 million of senior notes payable plus accrued interest to
convertible preferred stock, subject to regulatory approval and an increase in
the authorized shares of common stock.
In connection with the recapitalization transaction, both the Bank and the
Senior Note Holder agreed not to demand or accept any payment of principal or
interest under their respective credit agreements, and not to take any
enforcement actions of any kind under those agreements until April 30, 2001. As
of December 31, 2000, the Company was subject to various financial covenant
requirements under the credit agreements with the Bank and the Senior Note
Holder. The Company was not in compliance with those requirements as of December
31, 2000.
Effective as of January 31, 2001, the recapitalization transaction was completed
and the Company converted the investor senior loan ($8.0 million), the
outstanding balance under the revolving credit facility ($7.0 million), the
senior notes payable ($32.5 million), and the accrued interest on the revolving
credit facility and the senior notes payable ($5.0 million as of December 31,
2000) into 300,000 shares of convertible preferred stock. The estimated value of
the convertible preferred stock as of January 31, 2001, was $137.50 per share,
which is based on the closing price of the Company's common stock on January 31,
2001, which was $1.375 per share, and the fact that each share of convertible
preferred stock is convertible into 100 shares of common stock. Based on this
estimated value, the conversion transaction resulted in a pre-tax gain of $11.3
million. It is expected that there will be no income tax effect related to this
transaction, due to the Company's net operating loss carry-forwards for tax
purposes, as discussed in Note 9 to the accompanying financial statements.
-15-
The convertible preferred stock does not accrue dividends of any kind. Each
share of convertible preferred stock is convertible into 100 shares of common
stock at the option of the holder. The convertible preferred stock entitles the
holder to one vote for each share of common stock into which the preferred stock
is convertible, with respect to all matters voted on by the common stockholders
of the Company, except for the election of directors. The holders of the
convertible preferred stock have the right to elect a total of five members of
the board of directors, and the holders of the common stock have the right to
elect the remaining two directors. The convertible preferred stock has a
liquidation preference over the common stock of the Company.
As a result of the conversion transaction, the previously existing common
stockholders of the Company now own approximately 14% of the common stock
interests of the Company. In March 2000, in connection with the recapitalization
transaction, the Company agreed to place four new directors, who represent the
Investors, the Bank, and the Senior Note Holder, on its board of directors.
Three of those directors were placed on the board in March 2000, and the fourth
director was placed on the board as of January 31, 2001. These four new
directors constitute a majority of the board of directors, which currently has a
total of seven members.
In connection with a restructuring of the senior notes payable in 1999, the
Company issued warrants to acquire 382,000 shares of the Company's common stock
to the Senior Note Holder. The warrants were exercisable any time between
January 1, 2000, and December 31, 2003, at a price of $4.51 per share. The
warrants were cancelled in connection with the recapitalization transaction
completed as of January 31, 2001, as discussed above.
In October 2000, the Company completed a transaction in which the assets
reflected on the Company's balance sheet under the caption "Assets of
discontinued operations transferred under contractual arrangements" were sold.
These assets consisted of the assets of general dental practices and orthodontic
practices that were originally sold by the Company to a single purchaser (the
"Purchaser") in 1997 and 1998. These assets were sold to the Purchaser in
exchange for long-term promissory notes. The Purchaser ultimately defaulted on
its obligations to the Company under those notes, and in October 2000, the
Company completed a transaction in which the general dental and orthodontic
practices sold to the Purchaser were re-sold to another third party (the "New
Purchaser"). In this transaction, the Purchaser transferred its interest in the
dental and orthodontic practices to the New Purchaser, the New Purchaser paid
$2.4 million to the Company and placed an additional $1.5 million in an escrow
account for the benefit of the Company, and the Company agreed to pay certain
obligations related to these practices. These obligations consisted primarily of
payroll, dental office lease obligations, patient refunds, and the obligation to
complete the orthodontic treatments for managed care patients who previously
paid for the treatments in full. These obligations either had to be paid in
order to complete the transaction, or were obligations for which the Company may
be contingently liable in any event. The amount of the escrow account that may
be realized by the Company, and the ultimate cost of the obligations assumed by
the Company, are subject to uncertainties. Based on the Company's estimates of
the outcome of these uncertainties, the Company estimates that it will realize
no net proceeds from this transaction, after satisfaction of all the obligations
assumed from the Purchaser. However, the Company believes that by completing
this transaction, it may avoid being responsible for a significant amount of
contingent lease obligations related to the dental and orthodontic practices
sold to the New Purchaser, which are described in Note 10 to the accompanying
consolidated financial statements. This transaction resulted in a $2.5 million
charge to earnings during 2000 to reduce the carrying value of "Assets of
discontinued operations transferred under contractual arrangements" to their
estimated realizable value. See Note 5 to the accompanying consolidated
financial statements for a discussion of impairment charges that were recognized
in 2000 in connection with this transaction.
The Company incurred a significant operating loss during 2000, in addition to
interest expense on outstanding debt, and the impairment of discontinued net
assets transferred under contractual arrangements. However, the results of the
Company's operations improved during the course of 2000, as shown in its
quarterly results of operations, which are included in Note 13 to the
accompanying consolidated financial statements.
-16-
ITEM 2. PROPERTIES
- --------------------
The Company leases a total of approximately 68,000 square feet of office space
in a single location in Aliso Viejo, California, under a lease agreement that
expires in 2008. Approximately 12,000 square feet of this space is not currently
used by the Company, but is subleased to a third party through April 2002. The
remaining 56,000 square feet of office space is used for the Company's corporate
headquarters and its National Service Center, which includes member services
activities, eligibility file maintenance, billing and collections, claims
processing and other similar customer support activities. In addition, the
Company leases office space in Walnut Creek, California; Tamarac, Florida; St.
Louis, Missouri; and Dallas and Houston, Texas. The Company leased all of the
office space used by its previously owned dental and orthodontic practices,
which leases have been assigned, or are in the process of being assigned, to the
entities who purchased the dental practices. The Company remains contingently
liable for all of these leases, which expire on various dates through 2007, as
discussed in Note 10 to the accompanying consolidated financial statements. In
the opinion of management, the Company's facilities are adequate for its current
needs.
ITEM 3. LEGAL PROCEEDINGS
- ----------------------------
The Company is subject to various claims and legal actions in the ordinary
course of business. The Company believes all pending claims either are covered
by liability insurance maintained by the Company or by dentists in the Company's
provider network, or will not result in a significant adverse outcome. In
December 1999, a stockholder lawsuit against the Company was filed, which
alleged that the Company and certain of its officers violated certain securities
laws by issuing a series of alleged false and misleading statements concerning
the Company's publicly reported revenues and earnings during a specified class
period. On September 12, 2000, after the plaintiffs had filed a first amended
complaint, the Federal District Trial Court dismissed the lawsuit with
prejudice, stating that the plaintiffs had failed to state a claim against the
Company. On October 6, 2000, the plaintiffs filed an appeal of the dismissal of
the lawsuit, and that appeal is currently pending. The Company has directors and
officers liability insurance and intends to vigorously contest the appeal. In
the opinion of management, the ultimate outcome of this matter will not have a
material adverse effect on the Company's financial position or results of
operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- ---------------------------------------------------------------------
The Company held a Special Stockholders Meeting on October 25, 2000. At this
meeting, the stockholders of the Company elected six directors to serve until
the next annual stockholders meeting, approved an increase in the number of
authorized common shares from 30 million shares to 40 million shares, approved
an amendment to the Company's Restated Articles of Incorporation to eliminate
the classification of the board of directors so that all directors are elected
annually, and approved an amendment to the Company's Stock Option Plan (the
"Plan") to increase the number of shares issuable under the Plan from 1.3
million to 3.0 million shares. The reason for the increase in the authorized
common shares was to support the issuance of 300,000 shares of convertible
preferred stock effective as of January 31, 2001, as described in Note 14 to the
accompanying consolidated financial statements.
-17-
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
- --------------------------------------------------------------------------------
(a) MARKET INFORMATION
The Company's common stock is traded on the NASDAQ Over The Counter Bulletin
Board under the symbol SFGD. The following table sets forth the high and low
sale prices of the Company's common stock each calendar quarter, as reported by
NASDAQ. The prices shown are based on transactions between market makers in the
Company's stock, and do not necessarily represent transactions between
non-dealer principals.
HIGH LOW
--------- ---------
Year ended December 31, 2001:
First Quarter, through March 15, 2001. . . . . . . . . . . . . $ 2.75 $ 0.88
Year ended December 31, 2000:
First Quarter. . . . . . . . . . . . . . . . . . . . . . . . . $ 3.50 $ 0.41
Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . 1.50 0.50
Third Quarter. . . . . . . . . . . . . . . . . . . . . . . . . 0.91 0.40
Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . 1.00 0.42
Year ended December 31, 1999
First Quarter. . . . . . . . . . . . . . . . . . . . . . . . . $ 4.63 $ 2.50
Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . 5.09 2.53
Third Quarter. . . . . . . . . . . . . . . . . . . . . . . . . 5.25 3.13
Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . 4.00 0.38
(b) HOLDERS
As of March 15, 2001, there were approximately 500 holders of the Company's
common stock, including approximately 410 holders of record, and 21 holders of
the Company's convertible preferred stock
(c) DIVIDENDS
No cash dividends have been paid on the Company's common stock, and the Company
does not expect to pay cash dividends during the foreseeable future. The
Company's convertible preferred stock does not accrue dividends of any kind.
STOCKHOLDER RIGHTS PLAN
In March 1996, the board of directors of the Company declared a dividend of one
right to purchase a fraction of a share of its Series A Junior Participating
Preferred Stock, having rights, preferences, privileges and restrictions as
designated, and under certain circumstances, other securities, for each
outstanding share of the Company's common stock. The dividend was distributed to
stockholders of record at the close of business on April 12, 1996. The
description and terms of the Rights are set forth in a Rights Agreement, dated
as of March 22, 1996, as amended, between the Company and American Stock
Transfer and Trust Company, as Rights Agent.
-18-
ITEM 6. SELECTED FINANCIAL DATA
- -----------------------------------
The selected financial data in the following table was derived from the audited
consolidated financial statements of the Company. This data should be read in
conjunction with such financial statements and notes thereto, and Management's
Discussion and Analysis of Financial Condition and Results of Operations.
YEARS ENDED DECEMBER 31,
--------------------------------------------------
STATEMENT OF OPERATIONS DATA (IN THOUSANDS): 2000 1999 1998 1997 1996
-------- --------- --------- -------- --------
Premium revenue, net $97,251 $ 96,225 $ 97,449 $95,350 $72,709
Health care services expense 67,589 68,797 66,020 65,702 54,534
Selling, general and administrative expense 32,182 35,803 36,259 25,103 16,292
Loss on impairment of assets (1) 450 24,576 2,397 -- --
-------- --------- --------- -------- --------
Operating income (loss) (2,970) (32,951) (7,227) 4,545 1,883
Investment and other income 1,431 2,067 624 1,316 984
Interest expense (4,913) (5,855) (4,311) (2,871) (485)
-------- --------- --------- -------- --------
Income (loss) before income taxes and
discontinued operations (6,452) (36,739) (10,914) 2,990 2,382
Income tax expense (benefit) (2) -- 10,934 (3,406) 1,371 980
-------- --------- --------- -------- --------
Income (loss) before discontinued operations (6,452) (47,673) (7,508) 1,619 1,402
Discontinued operations:
Loss from assets transferred under contractual
arrangements (3) (2,500) (4,363) -- -- --
Loss from operations to be disposed of (4) -- -- (2,430) (7,408) (852)
Gain on sale of general dental practices -- -- -- 296 1,678
Cumulative effect of change in
accounting principle -- -- -- -- 824
-------- --------- --------- -------- --------
Income (loss) from discontinued operations (2,500) (4,363) (2,430) (7,112) 1,650
-------- --------- --------- -------- --------
Net income (loss) $(8,952) $(52,036) $ (9,938) $(5,493) $ 3,052
======== ========= ========= ======== ========
Basic net income (loss) per share:
Income (loss) from continuing operations $ (1.36) $ (10.04) $ (1.58) $ 0.34 $ 0.30
Income (loss) from discontinued operations (0.53) (0.92) (0.51) (1.50) 0.17
Cumulative effect of change
in accounting principle -- -- -- -- 0.17
-------- --------- --------- -------- --------
Net income (loss) per basic share $ (1.89) $ (10.96) $ (2.09) $ (1.16) $ 0.65
======== ========= ========= ======== ========
Weighted average basic shares outstanding 4,747 4,747 4,747 4,723 4,711
Diluted net income (loss) per share:
Income (loss) from continuing operations $ (1.36) $ (10.04) $ (1.58) $ 0.33 $ 0.28
Income (loss) from discontinued operations (0.53) (0.92) (0.51) (1.45) 0.17
Cumulative effect of change
in accounting principle -- -- -- -- 0.17
-------- --------- --------- -------- --------
Net income (loss) per diluted share $ (1.89) $ (10.96) $ (2.09) $ (1.12) $ 0.62
======== ========= ========= ======== ========
Weighted average diluted shares outstanding 4,747 4,747 4,747 4,899 4,940
BALANCE SHEET DATA PRO FORMA
(IN THOUSANDS): 2000 (5)
-----------
Cash and short-term investments $ 16,702 $16,702 $ 6,281 $ 4,142 $12,906 $ 9,807
Current assets 21,268 21,268 10,380 12,618 25,800 27,622
Total assets 33,095 33,095 28,577 77,956 84,085 68,116
Current liabilities (6) 19,660 72,195 18,129 24,521 20,193 11,633
Long-term debt 250 250 39,545 32,500 33,894 19,086
Stockholders' equity (deficit) 12,106 (40,429) (31,614) 19,766 29,615 35,200
See note explanations on the following page.
-19-
(1) Represents reductions in the carrying value of notes receivable in 2000,
intangible assets in 1999, and notes receivable and real estate in 1998, to
their estimated realizable values. See Note 5 to the accompanying
consolidated financial statements.
(2) The 1999 amount primarily represents a charge to establish a valuation
allowance against net deferred tax assets. See Note 9 to the accompanying
consolidated financial statements.
(3) Represents reductions in the carrying value of assets transferred under
contractual arrangements to their estimated realizable value. See Note 5 to
the accompanying consolidated financial statements.
(4) Represents operating losses related to discontinued operations prior to the
date they were sold, and subsequent expenses related to those operations.
See Note 2 to the accompanying consolidated financial statements.
(5) Pro forma balance sheet as though the conversion of debt and accrued
interest to convertible preferred stock had occurred as of December 31,
2000. See Note 14 to the accompanying consolidated financial statements.
(6) The increase in current liabilities in 2000 is primarily due to debt and
accrued interest that was converted to convertible preferred stock in 2001.
See the accompanying consolidated balance sheets.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
- --------------------------------------------------------------------------------
OF OPERATIONS
- --------------
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor"
for forward-looking statements, as long as those statements are identified as
forward-looking and are accompanied by meaningful cautionary statements
identifying important factors that could cause actual results to differ
materially from those discussed in the statements. The Company desires to take
advantage of these safe harbor provisions.
The statements contained in this Management's Discussion and Analysis of
Financial Condition and Results of Operations concerning expected growth, the
outcome of business strategies, future operating results and financial position,
economic and market events and trends, future premium revenue, future health
care expenses, the Company's ability to control health care, selling, general
and administrative expenses, and all other statements that are not historical
facts, are forward-looking statements. Words such as expects, projects,
anticipates, intends, plans, believes, seeks or estimates, or variations of such
words and similar expressions, are also intended to identify forward-looking
statements. These forward-looking statements are subject to significant risks,
uncertainties and contingencies, many of which are beyond the control of the
Company. Actual results may differ materially from those projected in the
forward-looking statements, which statements involve risks and uncertainties.
The Company's ability to expand its business is affected by competition from a
large number of other entities, many of which are much larger and have greater
financial resources than the Company, that offer dental plans in the markets in
which the Company operates. There is a risk that the Company will not be able to
increase revenues in the future as employer groups and other purchasers of
dental coverage continue to resist premium rate increases, while demanding a
wide choice of dental care providers and a high level of customer service.
Securing cost-effective contracts with dentists may become more difficult due to
increased competition among dental plans for contracts with dental providers,
and a possible decrease in the number of dentists in practice in the markets in
which the Company operates.
There are risks associated with changes in the Company's operating and expansion
strategies, and the possible inability to realize all of the proceeds from the
recent resale of certain dental office assets to a third party. There is a risk
that the Company will be unable to continue to improve its earnings before
interest, taxes, depreciation and amortization ("EBITDA"), as any such
improvement is dependent upon a multitude of factors including, but not limited
to, the ability of the Company to identify additional opportunities to reduce
costs.
There is a risk that the purchaser of certain resold dental office assets will
not comply with its agreement to make rental payments on the related office
lease agreements, for which the Company remains contingently liable, and there
is a risk that other dentists who previously purchased dental practices from the
Company will not make the required payments on their assigned or sublet lease
agreements, for which the Company remains contingently liable.
There is a risk that the Company may incur additional expenses in connection
with the delivery of the dental office assets resold to the Purchaser, and there
are risks associated with additional health care expenses that may be incurred
by the Company for the cost of the completion of orthodontic and dental
treatment that may be required to be paid in connection with the transfer of the
recently resold dental office assets. There is a risk that the dentists who
purchased a number of dental practices from the Company and issued promissory
notes to the Company, will not make payments on such promissory notes.
-20-
All of these risks and uncertainties could have a negative impact on the
estimated net proceeds from the resale of the dental office assets by the
Company.
The Company's profitability depends, in part, on its ability to maintain
effective control over its health care costs, while providing members with
quality dental care. A variety of factors, such as utilization rates of dental
services, changes in the value of the Company's assets, new technologies, the
cost of dental services delivered by referral specialists, the amount of claims
incurred by patients insured by the Company, and numerous other external
influences could affect the Company's operating results.
All of the risks set forth herein could negatively impact the earnings of the
Company in the future. The Company's expectations for the future are based on
current information and its evaluation of external influences. Changes in any
one factor could materially impact the Company's expectations related to premium
rates, benefits plans offered, membership enrollment, the amount of health care
expenses incurred, and profitability, and therefore, affect the forward-looking
statements which may be included in this report. In addition, past financial
performance is not necessarily a reliable indicator of future performance. An
investor should not use historical performance alone to anticipate future
results or future period trends.
SUMMARY OF RESULTS OF OPERATIONS
The following table shows the Company's results of operations as a percentage of
revenue, and is used in the year-to-year comparisons discussed below.
YEARS ENDED DECEMBER 31,
------------------------
2000 1999 1998
------ ------- -------
Premium revenue 100.0% 100.0% 100.0%
Health care services expense 69.5 71.5 67.7
Selling, general and administrative expense 33.1 37.2 37.2
Loss on impairment of assets 0.5 25.5 2.5
------ ------- -------
Operating income (loss) (3.1) (34.2) (7.4)
Investment and other income 1.5 2.1 0.6
Interest expense (5.0) (6.1) (4.4)
------ ------- -------
Income (loss) before income taxes and discontinued operations (6.6) (38.2) (11.2)
Income tax expense (benefit) -- 11.4 (3.5)
------ ------- -------
Income (loss) before discontinued operations (6.6) (49.6) (7.7)
Loss from discontinued operations (2.6) (4.5) (2.5)
------ ------- -------
Net income (loss) (9.2)% (54.1)% (10.2)%
====== ======= =======
2000 COMPARED TO 1999
Premium revenue increased by $1.0 million, or 1.1%, from $96.2 million in 1999
to $97.3 million in 2000. The average membership for which the Company provided
dental coverage decreased by approximately 78,000 members, or 8.8%, from 883,000
members during 1999 to 805,000 during 2000. The decrease in the average number
of members is primarily due to the loss of several customers during 2000.
Premium revenue increased by 1.1% even though average membership decreased by
8.8%. This was primarily due to a shift in the product mix toward preferred
provider ("PPO")/indemnity plans, which have higher premium rates than managed
care plans, increases in premium rates, and a shift in the managed care product
mix toward managed care plans with higher benefit levels and higher premium
rates.
-21-
Health care services expense decreased by $1.2 million, or 1.8%, from $68.8
million in 1999 to $67.6 million in 2000. Health care services expense as a
percentage of premium revenue (the "loss ratio") decreased from 71.5% in 1999 to
69.5% in 2000. This decrease is primarily due to a decrease in the loss ratio
for managed care products, which is primarily due to a reduction in certain
types of non-standard payment arrangements to managed care providers during the
first quarter of 2000. The decrease in the loss ratio for managed care products
was partially offset by a shift in the product mix toward PPO/indemnity plans,
which have a higher loss ratio than managed care plans. However, PPO/indemnity
plans also have a higher amount of gross margin (premium revenue less health
care services expense) per insured individual, and the Company believes they
have significantly lower general and administrative expenses than managed care
plans, as a percentage of premium revenue.
Selling, general and administrative ("SG&A") expenses decreased by $3.6 million,
or 10.1%, from $35.8 million in 1999 to $32.2 million in 2000. SG&A expenses as
a percentage of premium revenue decreased from 37.2% in 1999 to 33.1% in 2000.
The decrease in SG&A expenses is primarily due to the following reasons.
Salaries and benefits decreased due to a reduction in the number of employees
during the first quarter of 2000, in connection with a consolidation of the
Company's administrative services into a single location. The decrease is also
partially due to a decrease in computer programming expenses, as the Company has
completed several enhancements to its proprietary management information system
that were in process during 1999. Part of the decrease is due to a decrease in
amortization expense related to intangible assets. During the third quarter of
1999, the Company recorded a $24.6 million impairment loss to reduce the
carrying values of its intangible assets to their estimated realizable values,
which caused a decrease in amortization expense in 2000.
Loss on impairment of assets decreased from $24.6 million in 1999 to $450,000 in
2000. The loss on impairment in 1999 is primarily due to a reduction in the
carrying value of the goodwill and non-compete covenants related to the
acquisition of First American Dental Benefits, Inc. in 1996, and the acquisition
of Advantage Dental HealthPlans in 1997. The amount of the impairment loss was
determined in accordance with Accounting Principles Board Opinion No. 17, as
discussed in Note 5 to the accompanying consolidated financial statements. The
loss on impairment in 2000 is due to an increase in the reserve related to notes
receivable, as discussed in Note 5 to the accompanying financial statements.
Investment and other income decreased by $0.6 million, or 30.8%, from $2.0
million in 1999 to $1.4 million in 2000. This decrease was primarily due to net
realized gains on the sale of investments of $1.2 million in 1999, compared to
nearly zero in 2000. This was partially offset by an increase in interest income
in 2000, primarily due to investment of the proceeds of the $8.0 million
borrowing on March 1, 2000, as discussed in Note 7 to the accompanying financial
statements.
Total interest expense decreased by $1.0 million, or 16.1%, from $5.9 million in
1999 to $4.9 million in 2000. This decrease is primarily due to $1.9 million of
deferred loan costs that were charged to expense during 1999. This decrease was
partially offset by interest expense and amortization of deferred loan costs in
2000, related to the $8.0 million borrowing on March 1, 2000, as discussed in
Note 7 to the accompanying financial statements.
The loss before income taxes and discontinued operations decreased from $36.7
million, or 38.2% of premium revenue, in 1999, to $6.5 million, or 6.6% of
premium revenue, in 2000. This decrease in the loss was primarily due to a $24.6
million loss on impairment of assets in 1999, a $3.6 million decrease in SG&A
expenses, and a decrease in the loss ratio from 71.5% in 1999 to 69.5% in 2000,
which is equal to a $1.9 million decrease in health care services expense.
Income tax expense decreased from $10.9 million in 1999 to zero in 2000. Income
tax expense in 1999 primarily represents a charge to earnings to establish a
deferred tax asset valuation allowance that was equal to the entire balance of
the Company's net deferred tax assets. The Company recorded no income tax
expense or benefit in 2000 due to the valuation allowance against its deferred
tax assets. This valuation allowance was established due to uncertainty about
whether the deferred tax assets will be realized in the future, primarily due to
operating losses incurred by the Company in 1998, 1999 and 2000 and the
existence of significant net operating loss carry-forwards. See Note 9 to the
accompanying financial statements for more information.
-22-
The loss from discontinued operations decreased from $4.4 million in 1999 to
$2.5 million in 2000. The losses in both 1999 and 2000 represent reductions in
the carrying value of the net assets related to certain discontinued operations,
which were reflected under the caption "Assets of discontinued operations
transferred under contractual arrangements" on the accompanying consolidated
balance sheet. These assets were resold in October 2000, as discussed in Note 2
to the accompanying financial statements.
1999 COMPARED TO 1998
Premium revenue decreased by $1.2 million, or 1.3%, from $97.4 million in 1998
to $96.2 million in 1999. The average membership for which the Company provided
dental coverage decreased by approximately 60,000 members, or 6.4%, from 943,000
members during 1998 to 883,000 during 1999. Premium revenue decreased by only
1.3% even though average membership decreased by 6.4%. This was primarily due to
a shift in the product mix toward PPO/indemnity plans, which have higher premium
rates than managed care plans, increases in premium rates, and a shift in the
managed care product mix toward plans with higher benefit levels and higher
premium rates.
Health care services expense increased by $2.8 million, or 4.2%, from $66.0
million in 1998 to $68.8 million in 1999. Health care services expense as a
percentage of premium revenue (the "loss ratio") increased from 67.7% in 1998 to
71.5% in 1999. This increase is primarily due to an increase in the loss ratio
for managed care products, which is due to an increase in specialist referral
claims and an increase in supplemental payments to capitated providers, both as
a percentage of managed care premium revenue. The increase in specialist
referral claims is primarily due to a shift in the managed care product mix
toward richer benefit plans that include coverage of more specialist services.
The increase in supplemental payments is due to the fact that the richer benefit
plans also cover more services for which general dentists receive supplemental
payments from the Company, in addition to the monthly capitation payments.
SG&A expenses decreased by $456,000, or 1.3%, from $36.3 million in 1998 to
$35.8 million in 1999. SG&A expenses as a percentage of premium revenue was
37.2% in both 1998 and 1999. There was not a significant change in SG&A expenses
from 1998 to 1999.
Loss on impairment of assets increased from $2.4 million in 1998 to $24.6
million in 1999. The loss on impairment in 1999 is primarily due to a reduction
in the carrying value of the goodwill and non-compete covenants related to the
acquisition of First American Dental Benefits, Inc. in 1996, and the acquisition
of Advantage Dental HealthPlans in 1997. The amount of the impairment loss was
determined in accordance with Accounting Principles Board Opinion No. 17, as
discussed in Note 5 to the accompanying financial statements.
Investment and other income increased by $1.4 million, or 231.3%, from $624,000
in 1998 to $2.1 million in 1999. This increase was primarily due to net realized
gains on the sale of investments of $1.2 million in 1999, compared to net
realized losses of $618,000 in 1998.
Interest expense increased by $1.6 million, or 35.8%, from $4.3 million in 1998
to $5.9 million in 1999. This increase was primarily due to expenses incurred in
connection with restructuring the credit agreements related to the senior notes
payable and the revolving line of credit in May 1999. Those expenses consisted
of $1.0 million of consulting and legal fees and the issuance of stock warrants
with an estimated value of $320,000 to the holder of the senior notes payable.
In addition, approximately $600,000 of other deferred loan costs were charged to
expense in the third quarter of 1999, due to acceleration of the maturity dates
of the senior notes payable and revolving line of credit.
The loss before income taxes and discontinued operations increased from $10.9
million, or 11.2% of premium revenue, in 1998, to $36.7 million, or 38.2% of
premium revenue, in 1999. This increase in the loss was primarily due to the
$24.6 million loss on impairment of assets, and an increase in the loss ratio
from 67.7% in 1998 to 71.5% in 1999. These factors were partially offset by an
increase in investment and other income from $624,000 in 1998 to $2.1 million in
1999.
Income tax expense was $10.9 million in 1999, compared to an income tax benefit
of $3.4 million in 1998. The income tax expense in 1999 primarily represents a
charge to earnings to establish a deferred tax asset valuation allowance that is
equal to the entire balance of the Company's net deferred tax assets. This
valuation allowance was established due to uncertainty about whether the
deferred tax assets will be realized in the future, primarily due to operating
losses incurred by the Company in 1999 and 1998 and the existence of significant
net operating loss carry-forwards. See Note 9 to the accompanying financial
statements for more information.
-23-
The loss from discontinued operations to be disposed of increased from $2.4
million in 1998 to $4.4 million in 1999. The loss in 1999 is due to a $6.5
million reduction, before income tax effect of $2.1 million, in the carrying
value of the net assets related to certain discontinued operations, which are
reflected under the caption "Assets of discontinued operations transferred under
contractual arrangements" on the consolidated balance sheet. During the second
quarter of 1999, the Company recorded a $6.5 million charge to earnings to
reduce the carrying value of these assets to their estimated realizable value.
LIQUIDITY AND CAPITAL RESOURCES
Net cash used by operating activities decreased by $0.4 million, from $1.8
million in 1999 to $1.4 million in 2000. This improvement was due to several
reasons, the largest of which are described below. Net cash used by the net
loss, including the adjustments to reconcile net loss to net cash provided by
(used in) operating activities, decreased from $6.7 million in 1999 to $3.0
million in 2000, primarily due to a $3.6 million decrease in SG&A expenses, as
discussed above. The increase in accrued expenses was $3.3 million in 2000,
compared to a decrease of $461,000 in 1999. The increase in 2000 was primarily
due to liabilities related to the sale of "Assets transferred under contractual
arrangements" in October 2000, as discussed in Note 2 to the accompanying
financial statements. These factors were partially offset by a net $668,000
decrease in accounts payable and claims payable in 2000, compared to a combined
increase of $3.7 million in those liabilities in 1999. The increases in these
liability accounts in 1999 were primarily due to increases in the processing
time for both accounts payable and dental claim payments during 1999. The
processing time for both accounts payable and claims payable decreased
significantly during 2000. However, in the case of claims payable, this decrease
was offset by an increase in the amount of claims payable, due to a shift in the
product mix toward PPO/indemnity plans, for which the health care expenses are
reimbursed based on claims submitted, instead of capitation payments. In
addition, deferred revenue decreased by $562,000 in 2000, compared to a $953,000
increase in 1999. The decrease in 2000 was primarily due to a decrease in the
enrollment of individual subscribers who pay an annual premium in advance. The
increase in 1999 was primarily due to earlier payment by employer groups due to
an advance in the Company's billing cycle.
Net cash used by investing activities was $10.1 million during 2000, compared to
$1.9 million of net cash provided in 1999. The net cash used in 2000 consisted
primarily of the purchase of investments using the proceeds from the $8.0
million loan in March 2000, and the proceeds from $1.3 million of payments on
notes receivable. Net cash provided by financing activities was $11.3 million in
2000, compared to $1.4 million of net cash used in 1999. The net cash provided
by financing activities in 2000 consisted primarily of the proceeds from the
$8.0 million loan in March 2000, and the increase in accrued interest that was
converted to convertible preferred stock in 2001, as discussed below.
The Company's total debt increased from $39.8 million at December 31, 1999, to
$48.0 million at December 31, 2000. This increase was primarily due to the $8.0
million borrowing in March 2000, as discussed below. See Note 7 to the
accompanying financial statements for a description of all the debt outstanding
as of December 31, 2000.
On March 1, 2000, the Company entered into a recapitalization transaction with
an investor group (the "Investors"), the revolving credit facility lender (the
"Bank"), and the holder of the senior notes payable (the "Senior Note Holder").
In this transaction, the Investors loaned $8.0 million to the Company in the
form of an investor senior loan, which was due April 30, 2001, and had an
interest rate of 10% annually. The Investors, the Bank, and the Senior Note
Holder agreed to convert the $8.0 million investor senior loan, the outstanding
balance of $7.0 million under the revolving credit facility, and the $32.5
million of senior notes payable to convertible preferred stock, subject to
regulatory and stockholder approval.
In connection with the recapitalization transaction, both the Bank and the
Senior Note Holder agreed not to demand or accept any payment of principal or
interest under their respective credit agreements, and not to take any
enforcement actions of any kind under those agreements until April 30, 2001. As
of December 31, 2000, the Company was subject to various financial covenant
requirements under the credit agreements with the Bank and the Senior Note
Holder. The Company was not in compliance with those requirements as of December
31, 2000. Accordingly, these outstanding balances are reflected as short-term
debt on the accompanying balance sheet as of December 31, 2000.
-24-
Effective as of January 31, 2001, the Company completed the conversion of the
investor senior loan ($8.0 million), the outstanding balance under the revolving
credit facility ($7.0 million), the senior notes payable ($32.5 million), and
the accrued interest on the revolving credit facility and the senior notes
payable ($5.0 million as of December 31, 2000) into 300,000 shares of
convertible preferred stock. The estimated value of the convertible preferred
stock as of January 31, 2001, was $137.50 per share, which is based on the
closing price of the Company's common stock on January 31, 2001, which was
$1.375 per share, and the fact that each share of convertible preferred stock is
convertible into 100 shares of common stock. Based on this estimated value, the
conversion transaction resulted in a gain of $11.3 million. It is expected that
there will be no income tax effect related to this transaction, due to the
Company's net operating loss carry-forwards for tax purposes, as discussed in
Note 10 to the accompanying financial statements.
The convertible preferred stock does not accrue dividends of any kind. Each
share of convertible preferred stock is convertible into 100 shares of common
stock at the option of the holder. The convertible preferred stock entitles the
holder to one vote for each share of common stock into which the preferred stock
is convertible, with respect to all matters voted on by the common stockholders
of the Company, except for the election of directors. The holders of the
convertible preferred stock have the right to elect a total of five members of
the board of directors, and the holders of the common stock have the right to
elect the remaining two directors. The convertible preferred stock has a
liquidation preference over the common stock of the Company.
As a result of the conversion transaction, the previously existing common
stockholders of the Company now own approximately 14% of the common stock
interests of the Company. In March 2000, in connection with the conversion
transaction, the Company agreed to place four new directors, who represent the
Investors, the Bank, and the Senior Note Holder, on its board of directors.
Three of those directors were placed on the board in March 2000, and the fourth
director was placed on the board as of January 31, 2001. These new directors
constitute a majority of the board of directors, which currently has a total of
seven members.
In 1999, in connection with a transaction in which the Company restructured its
credit agreement with the Senior Note Holder, the Company issued warrants to
purchase 382,000 shares of common stock for $4.51 per share to the Senior Note
Holder. The warrants were exercisable at any time from January 1, 2000 to
December 31, 2003. In connection with the recapitalization transaction, the
Senior Note Holder agreed to cancel the warrants upon conversion of the
Company's outstanding debt into convertible preferred stock. The warrants were
cancelled as of January 31, 2001, in connection with the conversion of the
Senior Notes Payable to convertible preferred stock.
Under the credit agreements related to both the revolving credit facility and
the senior notes payable, the Company is subject to various loan covenant
requirements. The Company was not in compliance with those requirements as of
December 31, 2000, and, therefore, the balances outstanding under these
agreements are classified as short-term debt as of December 31, 2000. However,
as noted above, the outstanding balances under these agreements were converted
into convertible preferred stock in January 2001.
The Company believes it has adequate financial resources to continue its current
operations for the foreseeable future. However, there can be no assurance that
there will not be any unforeseen events that could have a material adverse
impact on the Company's financial position and the adequacy of its cash
balances.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for
Derivative Instruments and Hedging Activities." SFAS No. 133 was amended by SFAS
No. 137, "Accounting for Derivative Instruments and Hedging Activities -
Deferral of the Effective Date of SFAS No. 133" in June 1999, and by SFAS No.
138, "Accounting for Certain Derivative Instruments and Certain Hedging
Activities" in June 2000. SFAS No. 133, as amended, establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. SFAS 133,
as amended, requires derivatives to be reported on the balance sheet at fair
value, and was adopted on January 1, 2001. The adoption of SFAS 133, as amended,
had no significant effect on the Company's financial statements.
-25-
In December 1999, the United States Securities and Exchange Commission issued
Staff Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial
Statements." SAB 101 provides guidance on applying generally accepted accounting
principles to revenue recognition issues in financial statements. SAB 101 was
effective for the Company beginning in the fourth quarter of the year ending
December 31, 2000. The adoption of SAB 101 had no significant effect on the
Company's financial statements.
In March 2000, the FASB issued FASB Interpretation No. 44 ("FIN 44"),
"Accounting for Certain Transactions Involving Stock Compensation." FIN 44 is
effective July 1, 2000 with respect to certain provisions applicable to new
awards, exchanges of awards in a business combination, modifications to
outstanding awards, and changes in grantee status that occur on or after that
date. FIN 44 addresses certain issues related to the application of Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." The
adoption of FIN 44 had no significant effect on the Company's financial
statements.
IMPACT OF INFLATION
The Company's operations are potentially impacted by inflation, which can affect
premium rates, health care services expense, and selling, general and
administrative expenses. The Company expects that its earnings will be
positively impacted by inflation in premium rates, because premium rates for
dental benefit plans in general have been increasing due to inflation in recent
years. The Company expects that its earnings will be negatively impacted by
inflation in health care costs, because fees charged by dentists and other
dental providers have been increasing due to inflation in recent years. The
impact of inflation on the Company's health care expenses is mitigated in the
short-term by the fact that approximately 40% of total health care services
expense consists of capitation payments to providers. In addition, most of the
Company's selling, general and administrative expenses are impacted by general
inflation in the economy.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- ---------------------------------------------------------------------------
The Company is not subject to a material amount of risk related to changes in
interest rates or foreign currency exchange rates.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
- ---------------------------------------------------------
The Consolidated Financial Statements and the related Notes and Schedules
thereto filed as part of this 2000 Annual Report on Form 10-K are listed on the
accompanying Index to Financial Statements on page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT ACCOUNTANTS ON ACCOUNTING
- --------------------------------------------------------------------------------
AND FINANCIAL DISCLOSURE
--------------------------
During the two most recent fiscal years, there have been no changes in the
Company's independent auditors or disagreements with such auditors on accounting
principles or financial statement disclosures.
-26-
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
- -------------------------------------------------------------------
The current directors and executive officers of the Company are as follows:
NAME AGE POSITION
- ---------------------------- ---- --------------------------------------------------------------
James E. Buncher 64 President, Chief Executive Officer and Director
Ronald I. Brendzel, JD 51 Senior Vice President, General Counsel, Secretary and Director
Dennis L. Gates, CPA 45 Senior Vice President, Chief Financial Officer and Director
Carlos Ferrera 37 Vice President, Operations
Kenneth E. Keating 37 Vice President, Sales and Marketing
Barbara Lucci 41 Vice President, Corporate Services
John F. Steen 46 Vice President, Development and Provider Relations
Mik L. Summers 42 Chief Information Officer
Michael B. Sutherland, DDS 54 Vice President and Dental Director
Steven J. Baileys, DDS 47 Chairman of the Board of Directors
Jack R. Anderson 76 Director (1)
Stephen J. Blewitt 41 Director
Leslie B. Daniels 53 Director (1)
_______________________________
(1) Member of Compensation and Stock Option Committee, and Audit Committee.
Mr. Buncher, Mr. Anderson and Mr. Daniels became directors of the Company on
March 1, 2000, in connection with the recapitalization transaction that occurred
on March 1, 2000 (see Key Developments for more discussion of this transaction).
Mr. Blewitt became a director of the Company on February 8, 2001, in connection
with the completion of the recapitalization transaction. All directors of the
Company are elected annually. Officers of the Company serve at the pleasure of
the board of directors, subject to certain contracts of employment. See Item 11.
- - Executive Compensation below for a description of employment agreements with
the Named Executive Officers.
Mr. Buncher has been President and Chief Executive Officer of the Company, and a
director of the Company, since March 2000. From July 1998 to February 2000, he
was a private investor. Mr. Buncher was President and Chief Executive Officer
of Community Dental Services, Inc., a corporation operating dental practices in
California, from October 1997 until July 1998. Mr. Buncher was President of the
Health Plans Group of Value Health, Inc., a national specialty managed care
company, from September 1995 to September 1997. He served as Chairman, President
and Chief Executive Officer of Community Care Network, Inc., a Value Health
subsidiary, from August 1992 to September 1997, when Value Health was acquired
by a third party and Mr. Buncher resigned his positions with that company. Mr.
Buncher currently serves on the board of directors of Horizon Health Corporation
and two other non-public health care companies.
Mr. Brendzel has been Senior Vice President, General Counsel, Secretary and a
director of the Company since 1989. He was Chief Financial Officer from April
1988 to May 1996, Vice President - Corporate Development from August 1980 until
April 1986, and held various executive and administrative positions from 1978
until 1980. Mr. Brendzel is a member of the California State Bar and is licensed
to practice law in the state of California. From 1987 to 2000, he was a member
of the Knox-Keene Health Care Service Plan Advisory Committee, which assisted
the California Department of Corporations, the predecessor of the California
Department of Managed Health Care, in regulating managed care health plans. Mr.
Brendzel is also a former member of the Texas Health Maintenance Organization
Solvency Surveillance Committee, which assists the Texas Department of Insurance
in regulating health maintenance organizations. Mr. Brendzel is the
brother-in-law of Dr. Baileys.
Mr. Gates has been Senior Vice President and Chief Financial Officer since
November 1999, and has been a director of the Company since March 2000. From
June 1995 to February 1999, he served as Chief Financial Officer, then
Treasurer, of Sheridan Healthcare, Inc., a physician practice management
company. From June 1994 to May 1995, he served as Vice President - Finance of
the California Health Plan Division of FHP International, Inc. From November
1988 to June 1994, he served as Vice President - Finance, Secretary and
Treasurer of TakeCare, Inc., a health maintenance organization company.
-27-
Mr. Ferrera has been Vice President, Operations since February 2000. He served
as Vice President - Information Technologies from October 1997 to February 2000.
Mr. Ferrera served as Vice President - SafeHealth Life Insurance Operations from
October 1995, when he joined the Company, to October 1997. From March 1988 to
October 1995, Mr. Ferrera was Director of Provider Relations and Product
Consultant for CIGNA Dental Health. Prior to that, he was a Staff Sergeant in
the United States Air Force.
Mr. Keating has been Vice President, Sales and Marketing since February 2000.
He was Western Regional Vice President of the Company from October 1997 to
February 2000. He was Vice President-Imprimis and Guards Office Operations for
the Company from October 1995 until October 1997. He was Vice
President-SafeHealth Life Insurance Operations from August 1995, when he joined
the Company, until October 1995. From March 1987 to July 1995, Mr. Keating
served in various executive capacities for CIGNA Dental Health, including
Director of Sales and Account Services, Director of Network Development and
Director of Staff Model Operations.
Ms. Lucci has been Vice President, Corporate Services since February 2000. She
served as Director of Corporate Services and Human Resources from January 1996
to February 2000. From March 1994, when she joined the Company, to January
1996, Ms. Lucci was a Broker Specialist and Sales and Marketing Administrator.
From February 1988 to March 1994, Ms. Lucci served as Vice President -
Franchise Real Estate Administration of Conroy's, Inc. From March 1985 to
February 1988, Ms. Lucci was Vice President - Administration and Assistant
Operations Officer for Dr. Howard M. Stein Dental Groups.
Mr. Steen has been Vice President, Development and Provider Relations since
November 2000, when he joined the Company. He served as President, Chief
Executive Officer and a Director of American Home Services from May 1998 to
November 2000. From January 1995 to May 1998, Mr. Steen served as President and
Chief Executive Officer of Caregivers Home Health, Inc. Mr. Steen was one of the
original founders of United Dental Care, Inc. and served as Executive Vice
President, Chief Financial Officer and Secretary from October 1985 through
January 1995.
Mr. Summers has been Chief Information Officer since November 2000. He served as
Director of Information Services from July 1999 to November 2000. From November
1998, when he joined the Company, to July 1999, Mr. Summers served as Database
Administrator and Director of Computer Operations. From April 1994 to October
1998, he served as Manager of Application Implementation with the U.S. Treasury
Department. Mr. Summers also served in other information systems management
positions with the U.S. Treasury Department from February 1991 to April 1994.
From 1980 to 1991, he served in various management positions for Grief Brothers
Corporation.
Dr. Sutherland has been Vice President and Dental Director since May 2000, when
he joined the Company. He served as Vice President of Clinical Operations and
Dental Director of Community Dental Services, Inc., a corporation operating
dental practices in California, from February 1997 to March 2000. Dr.
Sutherland owned and operated a number of dental practices from 1980 to 1997.
He served in the Naval Dental Corp from 1977 to 1980. Dr. Sutherland is
licensed to practice dentistry in California, and is a member of the California
Dental Association and the American Dental Association.
Dr. Baileys has been Chairman of the Board of Directors since September 1995. He
served as President of the Company from 1981 until March 1997 and Chief
Executive Officer from May 1995 to February 2000. He was Chief Operating Officer
from 1981 to May 1995. From 1975 until 1981, Dr. Baileys served in a variety of
executive and administrative capacities with the Company. Dr. Baileys is
licensed to practice dentistry in the State of California. He is a member of the
Southern California chapter of the Young Presidents' Organization. Dr. Baileys
currently serves on the board of directors of KRUG International Corp.
Mr. Anderson has been President of Calver Corporation, a health care consulting
and investment firm, and a private investor, since 1982. Mr. Anderson currently
serves on the board of directors of Horizon Health Corporation .
-28-
Mr. Blewitt is a Managing Director in the Bond & Corporate Finance Group of John
Hancock Life Insurance Company and has been employed by John Hancock since 1982.
Mr. Blewitt is also Co-President & Portfolio Manager of Hancock Mezzanine
Investments LLC, the General Partner of Hancock Mezzanine Partners, L.P., a fund
that invests primarily in mezzanine debt securities. Mr. Blewitt received a BA
in Economics from the University of Chicago and an MBA from Boston University
Graduate School of Management. Mr. Blewitt is currently a director of John
Hancock Capital Growth Management, Inc., Learning Curve International and
Medical Resources, Inc.
Mr. Daniels was a founder of CAI Advisors & Co., an investment management firm,
in 1989 and has been a principal of that entity and its related investment fund
vehicles since then. Mr. Daniels has substantial experience investing as a
principal in the health care industry. Over the last 20 years, Mr. Daniels has
invested in numerous start-up, venture capital and buyout transactions in
various sectors across the health care spectrum, including health maintenance
organizations, hospitals, nursing homes, cancer treatment centers, psychiatric
and substance abuse services, generic drugs, pre-clinical and clinical contract
research organizations and pharmacy benefit companies. Mr. Daniels is currently
a director of Pharmakinetics Laboratories, Inc. and MIST Inc. He was a past
Chairman of Zenith Laboratories, Inc. and has been a director of several other
public and private companies.
-29-
ITEM 11. EXECUTIVE COMPENSATION
- ----------------------------------
The following table discloses compensation paid to the Company's Chief Executive
Officer as of December 31, 2000, and the other four most highly compensated
executive officers as of December 31, 2000 who received total compensation in
excess of $100,000 during the year ended December 31, 2000 (the "Named Executive
Officers"). The compensation disclosed is for the three years ended December 31,
2000.
LONG-TERM
COMPENSATION
AWARDS
ANNUAL COMPENSATION LIFE -------------
----------------------- INSURANCE STOCK OPTIONS
NAME PRINCIPAL POSITION YEAR SALARY BONUS PREMIUMS GRANTED
- --------------------------- ---------------------- ------- -------- ------ --------- ------------
James E. Buncher President and Chief 2000 $187,500 $ -- $ -- 600,000
Executive Officer (1) 1999 -- -- -- --
1998 -- -- -- --
Steven J. Baileys Chairman and Chief 2000 $166,667 $ -- $ -- 200,000
Executive Officer (2) 1999 400,000 -- 1,260 --
1998 400,000 -- 1,260 70,000
Dennis L. Gates Senior Vice President 2000 203,750 -- -- 375,000
and Chief Financial 1999 34,833 -- -- 50,000
Officer (3) 1998 -- -- -- --
Ronald I. Brendzel Senior Vice President, 2000 185,000 -- -- 120,000
General Counsel and 1999 185,000 -- 900 --
Secretary 1998 185,000 -- 900 5,000
Kenneth E. Keating Vice President, 2000 170,654 -- -- 120,000
Sales and Marketing (4) 1999 150,000 -- -- --
1998 150,000 -- -- 5,000
Carlos Ferrera Vice President, 2000 160,763 -- -- 120,000
Operations 1999 140,000 -- -- --
1998 142,885 -- -- 5,000
(1) Mr. Buncher joined the Company as President and Chief Executive Officer in
March 2000.
(2) Dr. Baileys served as the Chief Executive Officer of the Company until
March 1, 2000. He continued as an employee of the Company until June 1,
2000, when he became a consultant to the Company at an annual rate of
$200,000 for a two (2) year period through May 31, 2002. In connection
therewith, Dr. Baileys also received non-statutory options to purchase
200,000 shares of common stock at an exercise price of $1.00 per share,
which options vest at the expiration of his consulting agreement and must
be exercised not later than one (1) year thereafter or one (1) year after
he ceases to be a director of the Company, whichever occurs last.
(3) Mr. Gates joined the Company in November 1999.
(4) Mr. Keating became Vice President, Sales and Marketing in February 2000.
Prior thereto, he was Western Regional Vice President.
The Company has employment agreements with Messrs. Buncher, Gates, Brendzel,
Keating, and Ferrera, which expire on June 30, 2002. The current annual salaries
of each of these executives are $250,000, $200,000, $185,000, $180,000, and
$175,000, respectively, in addition to potential performance bonuses. The
Company may terminate any of the agreements for cause without further
compensation responsibility to the employee, or without cause by paying the
employee an amount as described below. Each executive may terminate his
employment agreement for any reason. In the event that more than fifty percent
(50%) of the Company's outstanding Common Stock is purchased by an entity that
is not an existing stockholder and there is a substantial diminution of the
employee's authority or job responsibilities, then the executive, at his option,
may terminate his employment agreement. In such event, or if the Company
terminates the employment agreement without cause, the Company is obligated to
pay the executive an amount equal to the employee's current annual salary, or
the amount due through the end of the employment agreement, whichever is less,
but in no event less than six (6) months of the employee's compensation rate
then in effect.
-30-
STOCK OPTION GRANTS DURING THE YEAR ENDED DECEMBER 31, 2000
Stock options granted to the Named Executive Officers during the year ended
December 31, 2000 were as follows.
INDIVIDUAL STOCK OPTION GRANTS
- ----------------------------------------------------------------
NUMBER OF % OF TOTAL POTENTIAL REALIZABLE VALUE
SHARES OPTIONS AT ASSUMED ANNUAL RATES
UNDERLYING GRANTED TO EXERCISE OF STOCK PRICE APPRECIATION
OPTIONS EMPLOYEES PRICE PER EXPIRATION FOR OPTION TERM(2)
NAME GRANTED IN 2000 SHARE DATE (1) 5% 10%
- ------------------ --------- ---------- ---------- ---------- ---------- -------------
James E. Buncher 600,000 28.8% $1.00 March 2010 $281,537 $752,945
Steven J. Baileys 200,000 9.6% 1.00 June 2003 93,846 250,982
Dennis L. Gates 375,000 18.0% 1.00 March 2010 175,961 470,591
Ronald I. Brendzel 120,000 5.8% 1.00 March 2010 56,307 150,589
Kenneth E. Keating 120,000 5.8% 1.00 March 2010 56,307 150,589
Carlos Ferrera 120,000 5.8% 1.00 March 2010 56,307 150,589
(1) Subject to the terms of the applicable option agreements, the exercise
price may be paid in cash or in shares of common stock owned by the
optionee, or by a combination of the foregoing.
(2) Of the options granted to Messrs. Buncher and Gates, options for 100,000
shares each per year vest and become exercisable on March 1, 2001 and March
1, 2002. All other options vest and become exercisable in three equal
annual installments. Exercisability of the options may be accelerated in
the event of a commencement of a tender offer for shares of the Company,
the signing of an agreement for certain mergers or consolidations involving
the Company, the sale of all or substantially all of the assets of the
Company, a change of control, or certain other extraordinary corporate
transactions. The options are subject to early termination in the event of
the optionee's termination of employment or cessation of service with the
Company.
(3) There is no assurance that the actual stock appreciation over the remaining
term of the options will be at the assumed five percent (5%) or ten percent
(10%) levels or at any other defined level. Unless the market price of the
common stock does in fact appreciate over the option term, no value will be
realized from the option grants.
STOCK OPTION EXERCISES AND YEAR-END STOCK OPTION VALUES
There were no stock options exercised by any of the Named Executive Officers
during the year ended December 31, 2000. Stock options held by the Named
Executive Officers at December 31, 2000 are shown in the following table. There
were no stock appreciation rights outstanding as of December 31, 2000.
STOCK OPTIONS EXERCISED NUMBER OF SECURITIES VALUE OF UNEXERCISED
----------------------- UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS
SHARES OPTIONS AT FISCAL YEAR-END AT FISCAL YEAR-END
ACQUIRED VALUE -------------------------- ---------------------------
NAME ON EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ------------------ ----------- --------- ----------- ------------- ------------ --------------
James E. Buncher -- $ -- -- 600,000 $ -- $ --
Steven J. Baileys -- -- -- 200,000 -- --
Dennis L. Gates -- -- 16,667 408,333 -- --
Ronald I. Brendzel -- -- 43,333 121,667 -- --
Kenneth E. Keating -- -- 13,333 121,667 -- --
Carlos Ferrera -- -- 8,333 121,667 -- --
-31-
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
- --------------------------------------------------------------------------------
The following table shows the number of shares of common stock beneficially
owned as of March 15, 2001, by each director, each Named Executive Officer, each
entity that, to the Company's knowledge, beneficially owned 5% or more of the
total outstanding common stock of the Company, and all current directors and
Named Executive Officers as a group. The number of shares beneficially owned
includes the number of shares of common stock into which the convertible
preferred stock held by each person is convertible. To the Company's knowledge,
the named person has sole voting and investment power with respect to all shares
of common stock listed, except where indicated otherwise.
NUMBER OF SHARES
BENEFICIALLY % OF TOTAL SHARES
OFFICER OR DIRECTOR OWNED (1) OUTSTANDING (2)
- ------------------------------------------------------------------- ----------------- -----------------
John Hancock Life Insurance Company (3) 15,000,000 43.2
CAI Capital Partners & Company II, Limited Partnership (4) 8,467,244 24.4
Leslie B. Daniels (5) 37,155 *
Jack R. Anderson (6) 3,167,615 9.1
Steven J. Baileys (7) 2,711,267 7.8
The Burton Partnership (8) 2,199,185 6.3
James E. Buncher (9) 460,333 1.3
Ronald I. Brendzel (10) 296,573 *
Dennis L. Gates (11) 275,000 *
Kenneth E. Keating (12) 55,000 *
Carlos Ferrera (13) 50,000 *
Stephen J. Blewitt (3) -- *
All directors and Named Executive Officers as a group (9 persons) 30,483,032 86.3
All principal stockholders in total 32,682,217 92.5
* Indicates less than one percent (1%).
_______________________________________
(1) Includes the number of shares of common stock into which the convertible
preferred stock held by each person is convertible. Also includes shares
issuable pursuant to stock options that are exercisable within 60 days of
March 15, 2001. Some of the stockholders included in this table reside in
states having community property laws under which the spouse of a
stockholder in whose name securities are registered may be entitled to
share in the management of their community property, which may include the
right to vote or dispose of such shares.
(2) For purposes of computing all the percentages above, the total shares
outstanding includes the shares of common stock into which all outstanding
convertible preferred stock is convertible. For purposes of computing the
percentage for each individual, the total shares outstanding includes the
shares issuable to that person pursuant to stock options that are
exercisable within 60 days of March 15, 2001. For purposes of computing the
percentages for all directors and officers as a group, and for all
principal stockholders as a group, the total shares outstanding includes
all the shares issuable pursuant to stock options that are included in the
above table.
(3) Mr. Blewitt is employed by an affiliate of John Hancock Life Insurance
Company, which has beneficial ownership of 15,000,000 shares issuable upon
conversion of shares of convertible preferred stock, as to which Mr.
Blewitt disclaims beneficial ownership. The address of Mr. Blewitt and John
Hancock Life Insurance Company is John Hancock Place, P.O. Box 111, Boston,
Massachusetts 02117.
(4) Includes 37,155 shares of common stock owned directly by Mr. Daniels,
2,780,796 shares issuable upon conversion of shares of convertible
preferred stock owned by CAI Partners & Company II, Limited Partnership,
and 5,649,293 shares issuable upon conversion of shares of convertible
preferred stock owned by CAI Capital Partners & Company II, Limited
Partnership (collectively "CAI"). Mr. Daniels is a principal of both
entities. The address of CAI and Mr. Daniels is 767 Fifth Avenue, 5th
Floor, New York, New York 10153.
-32-
(5) Represents 37,155 shares of common stock owned directly by Mr. Daniels.
Does not include 2,780,796 shares issuable upon conversion of shares of
convertible preferred stock owned by CAI Partners & Company II, Limited
Partnership, and 5,649,293 shares issuable upon conversion of shares of
convertible preferred stock owned by CAI Capital Partners & Company II,
Limited Partnership (collectively "CAI"). Mr. Daniels is a principal of
both entities. The address of Mr. Daniels is 767 Fifth Avenue, 5th Floor,
New York, New York 10153.
(6) Includes 1,802,885 shares issuable upon conversion of shares of convertible
preferred stock and 183,000 shares of common stock held by Mr. Anderson.
Also includes 1,081,730 shares issuable upon conversion of shares of
convertible preferred stock and 100,000 shares of common stock owned by Mr.
Anderson's spouse as separate property, as to which Mr. Anderson disclaims
beneficial ownership. The address of Mr. Anderson is 16475 Dallas Parkway,
Suite 735, Addison, Texas 77001.
(7) Includes 645,000 shares of common stock held by Dr. Baileys directly,
912,500 shares issuable upon conversion of shares of convertible preferred
stock held by the Baileys Family Trust and affiliated trusts for the
benefit of various relatives of Dr. Baileys, 700,767 shares of common stock
owned by the Baileys Family Trust, 303,000 shares of common stock held in
various trusts for relatives of Dr. Baileys, as to all of which Dr. Baileys
is trustee and for which Dr. Baileys has sole power to vote the securities,
and 150,000 shares of common stock held by the Alvin and Geraldine Baileys
Foundation, for which Dr. Baileys is an officer and director and for which
Dr. Baileys has shared power to vote the securities. Dr. Baileys disclaims
beneficial ownership of any of the shares in the trusts or the foundation
referenced above. The address of Dr. Baileys is 95 Enterprise, Aliso Viejo,
California 92656-2605.
(8) Includes 130,325 shares of common stock and 419,470 shares issuable upon
conversion of shares of convertible preferred stock owned by the Burton
Partnership, Limited Partnership ("BPLP"), and 390,975 shares of common
stock and 1,258,415 shares issuable upon conversion of shares of
convertible preferred stock owned by the Burton Partnership (QP), Limited
Partnership ("QP"). Mr. Donald W. Burton is a principal of both entities.
The address of BPLP, QP and Mr. Burton is P.O. Box 4643, Jackson, Wyoming
83001.
(9) Includes 200,000 shares issuable upon conversion of shares of convertible
preferred stock, and options to purchase 233,333 shares of common stock .
(10) Includes 100,000 shares issuable upon conversion of shares of convertible
preferred stock, and options to purchase 85,000 shares of common stock.
(11) Includes 100,000 shares issuable upon conversion of shares of convertible
preferred stock, and options to purchase 175,000 shares of common stock.
(12) Represents options to purchase 55,000 shares of common stock.
(13) Represents options to purchase 50,000 shares of common stock.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
- -------------------------------------------------------------
Please see the discussion under "Recent Developments" in Part I, Item 1 of this
Form 10-K.
-33-
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
- --------------------------------------------------------------------------------
(a) FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, AND EXHIBITS
The consolidated financial statements and financial statement schedule of
SafeGuard Health Enterprises, Inc. filed as part of this 2000 Annual Report on
Form 10-K are listed in the accompanying Index to Financial Statements on Page
F-1. An "Exhibit Index" is included in this 2000 Annual Report on Form 10-K
beginning on Page E-1. All Exhibits are either attached hereto or are on file
with the Securities and Exchange Commission.
(b) REPORTS ON FORM 8-K
A Current Report on Form 8-K dated as of March 6, 2001 was filed with the SEC,
reporting that the Company completed the conversion of the $8 million investor
senior loan, the outstanding balance of $7.0 million under the revolving credit
facility, the $32.5 million senior notes payable, and the accrued interest on
the revolving credit facility and the senior notes payable, to 300,000 shares of
convertible preferred stock. As a result of the conversion transaction, the
previously existing common stockholders of the Company now own approximately 14%
of the common stock interests of the Company. The above-described report on Form
8-K also reported the sale of the convertible preferred stock that would have
been issuable to the holder of the revolving credit facility, to certain
officers and directors of the Company, and to another stockholder of the
Company.
The above-described report on Form 8-K dated as of March 6, 2001, is hereby
incorporated by reference in this 2000 Annual Report on Form 10-K for the year
ended December 31, 2000.
-34-
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.
SAFEGUARD HEALTH ENTERPRISES, INC.
By: /s/ James E. Buncher Date: March 29, 2001
- -------------------------------------------------- -----------------------------
James E. Buncher
President, Chief Executive Officer and Director
(Principal Executive Officer)
By: /s/ Dennis L. Gates Date: March 29, 2001
- -------------------------------------------------- -----------------------------
Dennis L. Gates
Senior Vice President, Chief Financial Officer
and Director (Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
By: /s/ James E. Buncher Date: March 29, 2001
- -------------------------------------------------- -----------------------------
James E. Buncher
President, Chief Executive Officer and Director
By: /s/ Steven J. Baileys Date: March 29, 2001
- -------------------------------------------------- -----------------------------
Steven J. Baileys, D.D.S.
Chairman of the Board of Directors
By: /s/ Ronald I. Brendzel Date: March 29, 2001
- -------------------------------------------------- -----------------------------
Ronald I. Brendzel, J.D.
Senior Vice President, General Counsel,
Secretary and Director
By: /s/ Dennis L. Gates Date: March 29, 2001
- -------------------------------------------------- -----------------------------
Dennis L. Gates
Senior Vice President, Chief Financial
Officer and Director
By: /s/ Jack R. Anderson Date: March 29, 2001
- -------------------------------------------------- -----------------------------
Jack R. Anderson
Director
By: /s/ Stephen J. Blewitt Date: March 29, 2001
- -------------------------------------------------- -----------------------------
Stephen J. Blewitt
Director
By: /s/ Leslie B. Daniels Date: March 29, 2001
- -------------------------------------------------- -----------------------------
Leslie B. Daniels
Director
-35-
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------ -----------------------------------------------------------------------
2.1 Plans of Acquisition (6)
3.1 Articles of Incorporation (4)
3.1.1 Amended and Restated Certificate of Incorporation (12)
3.1.2 Certificate of Designation of Preferred Stock (12)
3.2 Bylaws (3)
10.1 1984 Stock Option Plan (2)
10.2 Stock Option Plan Amendment (1)
10.3 Stock Option Plan Amendment (4)
10.4 Stock Option Plan Amendment (5)
10.5 2000 Stock Option Plan Amendment
10.6 Form of Employment Agreement between the Company and the Named
Executive Officers
10.7 Form of Rights Agreement, dated as of March 22, 1996, between the
Company and American Stock Transfer and Trust Company, as Rights
Agent (6)
10.8 Default Forbearance Agreement and Irrevocable Power of Attorney (7)
10.9 First Waiver and Amendment to Note Purchase Agreement (8)
10.10 Amended and Restated Loan and Security Agreement (8)
10.11 Debenture and Note Purchase Agreement (9)
10.12 Stockholder Agreement (9)
10.13 First Amendment to Debenture and Note Purchase Agreement (10)
10.14 Second Amendment to Debenture and Note Purchase Agreement (10)
10.15 Term Sheet Agreement dated as of March 1, 2000 (11)
10.16 Loan Document and Purchase Agreement (12)
10.17 Agreement among Stockholders and the Company (12)
10.18 Registration Rights Agreement between certain Stockholders and the
Company (12)
10.19 Consulting Agreement between the Company and Steven J. Baileys
21.1 Subsidiaries of the Company
23.1 Independent Auditor's Consent
_________________________________________
(1) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Registration Statement on Form S- 1 filed as of September 12,
1983 (File No. 2-86472).
(2) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Registration Statement on Form S-1 filed as of July 3, 1984
(File No. 2-92013).
(3) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Annual Report of Form 10-K for the year ended December 31,
1987.
(4) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Annual Report of Form 10-K for the year ended December 31,
1989.
(5) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Annual Report of Form 10-K for the year ended December 31,
1992.
(6) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Report on Form 8-K dated as of September 27, 1996.
(7) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Annual Report on Form 10-K for the year ended December 31,
1998.
(8) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Report on Form 8-K dated as of June 4, 1999.
(9) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Report on Form 8-K dated as of June 30, 1999.
(10) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Report on Form 8-K dated as of October 5, 1999.
(11) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Report on Form 8-K dated as of March 16, 2000.
(12) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Report on Form 8-K dated as of March 6, 2001.
E-1
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
PAGE
----
Independent Auditors' Report. . . . . . . . . . . . . . . . . . . . . . . F-2
Financial Statements:
Consolidated Balance Sheets. . . . . . . . . . . . . . . . . . . . . F-3
Consolidated Statements of Operations . . . . . . . . . . . . . . . F-4
Consolidated Statements of Stockholders' Equity (deficit). . . . . F-5
Consolidated Statements of Cash Flows. . . . . . . . . . . . . . . F-6
Notes to Consolidated Financial Statements . . . . . . . . F-7 to F-24
Financial Statement Schedule:
Schedule II - Valuation and Qualifying Accounts. . . . . . . . F-25
F-1
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of SafeGuard Health Enterprises,
Inc.:
We have audited the accompanying consolidated balance sheets of SafeGuard Health
Enterprises, Inc. and subsidiaries (the "Company") as of December 31, 2000 and
1999, and the related consolidated statements of operations, stockholders'
equity (deficit), and cash flows for each of the three years in the period ended
December 31, 2000. Our audits also included the financial statement schedule for
the years ended December 31, 2000, 1999, and 1998, included in the Index at Item
14(a)(2). These consolidated financial statements and financial statement
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on the financial statements and financial statement
schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of SafeGuard Health Enterprises, Inc.
and subsidiaries as of December 31, 2000 and 1999, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2000, in conformity with accounting principles generally accepted
in the United States of America. Also, in our opinion, such consolidated
financial statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly, in all
material respects, the information set forth therein.
DELOITTE & TOUCHE LLP
Costa Mesa, California
March 21, 2001
F-2
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2000 AND 1999
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
PRO FORMA
2000 2000 1999
-------------- --------- ---------
(unaudited)
ASSETS (see Note 14)
Current assets:
Cash and cash equivalents $ 1,381 $ 1,381 $ 1,639
Investments available-for-sale, at fair value 15,321 15,321 4,642
Accounts receivable, net of allowances of
$868 in 2000 and $1,054 in 1999 2,778 2,778 2,978
Other current assets 1,788 1,788 1,121
-------------- --------- ---------
Total current assets 21,268 21,268 10,380
Property and equipment, net of accumulated depreciation 2,843 2,843 4,816
Restricted cash (none in 2000 and $360 in 1999) and
investments available-for-sale, at fair value 2,700 2,700 2,688
Notes receivable, net of allowances of
$2,806 in 2000 and $3,839 in 1999 1,750 1,750 3,505
Assets of discontinued operations transferred
under contractual arrangements -- -- 2,500
Intangible assets, net of accumulated amortization of
$342 in 2000 and $58 in 1999 4,154 4,154 4,437
Other assets 380 380 251
-------------- --------- ---------
Total assets $ 33,095 $ 33,095 $ 28,577
============== ========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable $ 4,664 $ 4,664 $ 5,771
Accrued interest, subject to conversion to equity (Notes 7 and 14) -- 4,990 --
Other accrued expenses 6,457 6,457 3,691
Short-term debt, subject to conversion to equity (Notes 7 and 14) -- 47,545 --
Other short-term debt 250 250 255
Claims payable and claims incurred but not reported 6,876 6,876 6,437
Deferred revenue 1,413 1,413 1,975
-------------- --------- ---------
Total current liabilities 19,660 72,195 18,129
Long-term debt 250 250 39,545
Accrued interest -- -- 1,207
Other long-term liabilities (Note 8) 1,079 1,079 1,310
Commitments and contingencies (Note 10)
Stockholders' equity (deficit):
Convertible preferred stock - $.01 par value; 1,000,000 shares
authorized; no shares issued or outstanding in 2000 or 1999 41,250 -- --
Common stock - $.01 par value; 40,000,000 shares authorized;
4,747,000 shares issued and outstanding in 2000 and 1999 21,829 21,829 21,829
Retained earnings (accumulated deficit) (32,969) (44,254) (35,302)
Accumulated other comprehensive income (loss) 119 119 (18)
Treasury stock, at cost (18,123) (18,123) (18,123)
-------------- --------- ---------
Total stockholders' equity (deficit) 12,106 (40,429) (31,614)
-------------- --------- ---------
Total liabilities and stockholders' equity (deficit) $ 33,095 $ 33,095 $ 28,577
============== ========= =========
See accompanying Notes to Consolidated Financial Statements.
F-3
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2000, 1999, AND 1998
(IN THOUSANDS, EXCEPT PER SHARE DATA)
2000 1999 1998
-------- --------- ---------
Premium revenue, net $97,251 $ 96,225 $ 97,449
Health care services expense 67,589 68,797 66,020
Selling, general and administrative expense 32,182 35,803 36,259
Loss on impairment of assets 450 24,576 2,397
-------- --------- ---------
Operating income (loss) (2,970) (32,951) (7,227)
Investment and other income 1,431 2,067 624
Interest expense on debt that became subject to
conversion to equity in 2000 (Notes 7 and 14) (4,801) (5,610) (3,197)
Other interest expense (112) (245) (1,114)
-------- --------- ---------
Income (loss) before income taxes and discontinued operations (6,452) (36,739) (10,914)
Income tax expense (benefit) -- 10,934 (3,406)
-------- --------- ---------
Income (loss) before discontinued operations (6,452) (47,673) (7,508)
Discontinued operations:
Loss from assets transferred under contractual arrangements
(net of income tax benefit of $2,087 in 1999) (2,500) (4,363) --
Loss from operations to be disposed of
(net of income tax benefit of $1,554 in 1998) -- -- (2,430)
-------- --------- ---------
Loss from discontinued operations (2,500) (4,363) (2,430)
-------- --------- ---------
Net income (loss) $(8,952) $(52,036) $ (9,938)
======== ========= =========
Basic and diluted net income (loss) per share:
Income (loss) from continuing operations $ (1.36) $ (10.04) $ (1.58)
Income (loss) from discontinued operations (0.53) (0.92) (0.51)
-------- --------- ---------
Net income (loss) $ (1.89) $ (10.96) $ (2.09)
======== ========= =========
Weighted average basic and diluted shares outstanding 4,747 4,747 4,747
See accompanying Notes to Consolidated Financial Statements.
F-4
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
(IN THOUSANDS)
ACCUMULATED
RETAINED OTHER
NUMBER OF SHARES EARNINGS COMPREHENSIVE
------------------- COMMON (ACCUMULATED INCOME TREASURY
COMMON TREASURY STOCK DEFICIT) (LOSS) STOCK TOTAL
-------- --------- ------- --------- ------- --------- ---------
Balances, January 1, 1998 8,022 (3,275) $21,509 $ 26,672 $ (443) $(18,123) $ 29,615
Net loss -- -- -- (9,938) -- -- (9,938)
Other comprehensive income:
Net unrealized gains on
investments available-for-sale,
net of tax of $57 89 89
---------
Total comprehensive income (loss) (9,849)
-------- --------- ------- --------- ------- --------- ---------
Balances, December 31, 1998 8,022 (3,275) 21,509 16,734 (354) (18,123) 19,766
Net loss -- -- -- (52,036) -- -- (52,036)
Other comprehensive income:
Net unrealized gains on
investments available-for-sale,
net of tax of $226 336 336
---------
Total comprehensive income (loss) (51,700)
Issuance of stock warrants (1) -- -- 320 -- -- -- 320
-------- --------- ------- --------- ------- --------- ---------
Balances, December 31, 1999 8,022 (3,275) 21,829 (35,302) (18) (18,123) (31,614)
Net loss -- -- -- (8,952) -- -- (8,952)
Other comprehensive income:
Net unrealized gains on
investments available-for-sale 137 137
---------
Total comprehensive income (loss) (8,815)
-------- --------- ------- --------- ------- --------- ---------
Balances, December 31, 2000 8,022 (3,275) $21,829 $(44,254) $ 119 $(18,123) $(40,429)
======== ========= ======= ========= ======= ========= =========
See accompanying Notes to Consolidated Financial Statements.
(1) These warrants were cancelled without being exercised as of January 31, 2001, in connection with
the conversion of the Senior Notes Payable to convertible preferred stock, as discussed in Notes 7 and 4.
F-5
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
(IN THOUSANDS)
2000 1999 1998
--------- --------- ---------
Cash flows from operating activities:
Net income (loss) $ (8,952) $(52,036) $ (9,938)
Adjustments to reconcile net loss to net
cash provided by (used in) operating activities:
Loss from discontinued operations 2,500 4,363 2,430
Loss on impairment of assets 450 24,576 2,397
Bad debt expense 300 481 1,733
Depreciation and amortization 2,767 3,832 3,399
Write-off and amortization of deferred loan costs 339 1,954 106
Gains on sale of property and equipment and investments (101) -- --
Deferred income taxes -- 10,569 (2,349)
Changes in operating assets and liabilities:
Accounts receivable (100) (114) (821)
Other current assets (667) 370 96
Accounts payable (1,107) 853 3,461
Accrued expenses 3,266 (461) 542
Claims payable and claims incurred but not reported 439 2,879 (73)
Deferred revenue (562) 953 (155)
--------- --------- ---------
Net cash (used in) provided by continuing operations (1,428) (1,781) 828
Net cash used in discontinued operations -- -- (2,779)
--------- --------- ---------
Net cash used in operating activities (1,428) (1,781) (1,951)
Cash flows from investing activities:
Purchase of investments available-for-sale (42,477) (13,267) (10,169)
Proceeds from sale/maturity of investments available-for-sale 31,941 13,815 11,319
Proceeds from maturity of investments held-to-maturity -- -- 4,906
Purchase of property and equipment (646) (1,220) (2,357)
Proceeds from sale of property and equipment 218 3,500 --
Payments received on notes receivable 1,305 518 92
Issuance of notes receivable -- (500) (750)
Additions to other assets (468) (969) --
--------- --------- ---------
Net cash (used in) provided by investing activities (10,127) 1,877 3,041
Cash flows from financing activities:
Borrowings on debt 8,000 -- 8,000
Increase in accrued interest, subject to conversion to equity 3,783 1,207 --
Payments on debt (255) (2,594) (9,692)
Payments on other long-term liabilities (231) (48) (72)
--------- --------- ---------
Net cash provided by (used in) financing activities 11,297 (1,435) (1,764)
--------- --------- ---------
Net increase (decrease) in cash (258) (1,339) (674)
Cash and cash equivalents at beginning of year 1,639 2,978 3,652
--------- --------- ---------
Cash and cash equivalents at end of year $ 1,381 $ 1,639 $ 2,978
========= ========= =========
Supplementary information:
Cash paid during the year for interest $ 720 $ 4,189 $ 4,008
Supplementary disclosure of non-cash activities:
Issuance of debt in exchange for cancellation of lease 500 -- --
See accompanying Notes to Consolidated Financial Statements.
F-6
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
- ------------------------------------------------------------
SafeGuard Health Enterprises, Inc., a Delaware corporation (the "Company"),
provides managed care dental benefit plans, preferred provider ("PPO")/indemnity
dental insurance plans, and other related products. The Company's operations are
primarily in California, Texas and Florida, but it also operates in several
other states. The Company conducts its operations through several subsidiaries,
one of which is an insurance company that is licensed in several states, and
several of which are licensed as managed care dental plans in the states in
which they operate. The Company provides dental benefits to approximately
750,000 individuals through a managed care network of contracted dentists and a
preferred provider organization of contracted dentists. The Company was founded
as a not-for-profit entity in California in 1974, and was converted to a
for-profit entity in 1982.
The Company incurred significant net losses in each of the three years ended
December 31, 2000. During 2000, management took certain actions to improve the
Company's operating results and financial position. In March 2000, the Company
obtained $8.0 million of financing, and entered into a transaction under which
substantially all of the Company's debt was converted into equity, as discussed
in Notes 7 and 14, which will substantially reduce the Company's interest
expense. During the first quarter of 2000, the Company consolidated all of its
administrative activities into its National Service Center in California, which
resulted in a significant reduction in the number of employees at the Company
and the amount of office space used by the Company. Also during the first
quarter of 2000, the Company reduced its health care services expense by
eliminating non-standard payments to certain dental service providers. These
actions, along with reductions in various other selling, general and
administrative expenses, have had a significant positive impact on the Company's
results of operations and financial position, beginning in the second quarter of
2000. Management intends to further improve the Company's results of operations
by increasing revenue through improved customer service and customer retention
programs, decreasing health care services expense by expanding its provider
networks, and making further reductions in various selling, general and
administrative expenses. The Company believes these actions and its improved
financial position will provide adequate financial resources to support its
operations for the foreseeable future.
BASIS OF PRESENTATION
The consolidated financial statements include all the accounts of the Company
and its subsidiaries. Significant intercompany accounts and transactions have
been eliminated in consolidation. The Company's financial statements were
prepared in accordance with accounting principles generally accepted in the
United States of America.
BUSINESS SEGMENT INFORMATION
Management measures operating results on a geographic basis and, therefore,
views certain geographic areas as separate operating segments. The Company
provides essentially the same services in all of the geographic areas in which
it operates. For financial reporting purposes, all the Company's operating
segments are aggregated into one reporting segment, which provides dental
benefit plans to employers, individuals and other purchasers.
CASH AND CASH EQUIVALENTS
Investments with an original maturity of three months or less are included in
cash equivalents.
RESTRICTED DEPOSITS AND MINIMUM NET WORTH REQUIREMENTS
Several of the Company's subsidiaries are subject to state regulations that
require them to maintain restricted deposits in the form of cash or investments.
The Company had total restricted deposits of $2.7 million as of December 31,
2000 and 1999. In addition, some of those subsidiaries are required to maintain
minimum amounts of tangible net worth. A substantial portion of the Company's
cash and investments as of December 31, 2000 were required to meet those minimum
net worth requirements.
F-7
INVESTMENTS
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 115,
"Accounting for Certain Investments in Debt and Equity Securities," the Company
has determined that all of its investments are properly classified as
"available-for-sale." Investments classified as available-for-sale are carried
at fair value, based on quoted market prices, and unrealized gains and losses,
net of applicable income taxes, are reported in a separate caption of
stockholders' equity.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The accompanying consolidated balance sheets include the following financial
instruments as of December 31, 2000: cash and cash equivalents, investments,
accounts receivable, notes receivable, accounts payable, accrued expenses,
short-term and long-term debt, and other long-term liabilities. All of these
financial instruments, except for notes receivable, long-term debt, and other
long-term liabilities, are current assets or current liabilities. The current
assets are expected to be realized, and the current liabilities, except for
those subject to conversion to equity (see Note 14) are expected to be paid,
within a short period of time. Therefore, the carrying amount of these financial
instruments approximates fair value. Notes receivable, which are long-term, have
been written down to the Company's estimate of their net realizable value, which
approximates fair value. Long-term debt and other long-term liabilities are
stated at the present value of the expected future payments, which approximates
fair value.
PROPERTY AND EQUIPMENT
Property and equipment is recorded at cost. Depreciation and amortization are
calculated using the straight-line method over the estimated useful lives of the
assets as follows: leasehold improvements - the length of the related lease,
which ranges from 5 to 10 years; furniture, fixtures and other equipment - 3 to
7 years. The cost of maintenance and repairs is expensed as incurred, while
significant improvements that extend the estimated useful life of an asset are
capitalized. Upon the sale or other retirement of assets, the cost of any such
assets and the related accumulated depreciation are removed from the books and
any resulting gain or loss is recognized.
INTANGIBLE ASSETS
Intangible assets at December 31, 2000 consist of goodwill and a non-competition
agreement related to the acquisition of a managed care dental company in 1996.
Goodwill represents the excess of the purchase price of the acquired company
over the fair value of the net assets acquired, and is being amortized on a
straight-line basis over 40 years. The Company's accounting policy is to
amortize intangible assets over their estimated useful lives. The Company
estimates that its goodwill has a useful life of 40 years from the date of
acquisition of the related entity. See Note 5 for the Company's policy for
assessing recoverability of goodwill and a discussion of a charge to earnings
during 1999 for impairment of goodwill.
LONG-LIVED ASSETS
In accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of,"long-lived assets are
reviewed for events or changes in circumstances that indicate that their
carrying value may not be recoverable. See Note 5 for a discussion of impairment
charges with respect to certain long-lived assets.
RECOGNITION OF PREMIUM REVENUE AND HEALTH CARE SERVICES EXPENSE
Premium revenue is recognized in the period during which dental coverage is
provided to the covered individuals. Payments received from customers in advance
of the related period of coverage are reflected on the accompanying balance
sheet as deferred revenue. Health care services expense is recognized in the
period in which the services are delivered. The estimated liability for claims
incurred but not reported is based primarily on the average historical lag time
between the date of service and the date the related claim is submitted to the
Company, as well as the recent trend in the aggregate amount of incurred claims
per covered individual. Since the liability for incurred but not reported claims
is necessarily an actuarial estimate, the amount of claims eventually submitted
for services provided prior to the balance sheet date could differ from the
estimated liability. Any such differences are included in the consolidated
statement of operations for the period in which the differences are identified.
F-8
STOCK-BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation," provides a choice of
two different methods of accounting for stock options granted to employees. SFAS
No. 123 encourages, but does not require, entities to recognize compensation
expense equal to the fair value of employee stock options granted. Under this
method of accounting, the fair value of a stock option is measured at the grant
date, and compensation expense is recognized over the period in which the stock
option becomes exercisable. Alternatively, an entity may choose to use the
accounting method described in Accounting Principles Board Opinion ("APB") No.
25, "Accounting for Stock Issued to Employees." Under APB No. 25, no
compensation expense is generally recognized as long as the exercise price of
each stock option is at least equal to the market price of the underlying stock
at the time of the grant. If an entity chooses to use the accounting method
described in APB No. 25, SFAS No. 123 requires that the pro forma effect of
using the fair value method of accounting on its net income be disclosed in a
note to the financial statements. The Company has chosen to use the accounting
method described in APB No. 25.
INCOME TAXES
The Company's accounting for income taxes is in accordance with SFAS No. 109,
"Accounting for Income Taxes." SFAS No. 109 requires the recognition of deferred
tax liabilities and assets for the expected future tax consequences of events
that are recognized in the Company's financial statements in different periods
than those in which the events are recognized in the Company's tax returns. The
measurement of deferred tax liabilities and assets is based on current tax laws
as of the balance sheet date. The Company records a valuation allowance related
to deferred tax assets in the event that available evidence indicates that the
future tax benefits related to the deferred tax assets may not be realized. A
valuation allowance is required when it is more likely than not that the
deferred tax assets will not be realized.
USE OF ESTIMATES IN FINANCIAL STATEMENTS
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities, and the
reported amounts of revenues and expenses. Actual results could differ from
those estimates.
INCOME (LOSS) PER SHARE
Income (loss) per share is presented in accordance with SFAS No. 128, "Earnings
Per Share." Basic earnings (loss) per share is based on the weighted average
common shares outstanding, excluding the effect of any potentially dilutive
securities. Diluted earnings (loss) per share is based on the weighted average
common shares outstanding, including the effect of all potentially dilutive
securities. During the three years ended December 31, 2000, the potentially
dilutive securities of the Company that were outstanding consisted entirely of
stock options and warrants. Due to net losses incurred in the three years ended
December 31, 2000, the outstanding stock options and warrants would have an
anti-dilutive effect on diluted loss per share in each year. Accordingly, stock
options and warrants are excluded from the calculation of diluted loss per share
for each of these years. Therefore, the Company's diluted loss per share is the
same as its basic loss per share for the three years ended December 31, 2000.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No.
133 was amended by SFAS No. 137, "Accounting for Derivative Instruments and
Hedging Activities - Deferral of the Effective Date of SFAS No. 133" in June
1999, and by SFAS No. 138, "Accounting for Certain Derivative Instruments and
Certain Hedging Activities" in June 2000. SFAS No. 133, as amended, establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging activities.
SFAS 133, as amended, requires derivatives to be reported on the balance sheet
at fair value, and was adopted effective on January 1, 2001. The adoption of
SFAS 133, as amended, had no significant effect on the Company's financial
statements.
F-9
In December 1999, the United States Securities and Exchange Commission issued
Staff Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial
Statements." SAB 101 provides guidance on applying generally accepted accounting
principles to revenue recognition issues in financial statements. SAB 101 was
effective for the Company beginning in the fourth quarter of the year ending
December 31, 2000. The adoption of SAB 101 had no significant effect on the
Company's financial statements.
In March 2000, the FASB issued FASB Interpretation No. 44 ("FIN 44"),
"Accounting for Certain Transactions Involving Stock Compensation." FIN 44 is
effective July 1, 2000 with respect to certain provisions applicable to new
awards, exchanges of awards in a business combination, modifications to
outstanding awards, and changes in grantee status that occur on or after that
date. FIN 44 addresses certain issues related to the application of Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." The
adoption of FIN 44 had no significant effect on the Company's financial
statements.
RECLASSIFICATION
Certain amounts in the financial statements for prior years have been
reclassified to conform to the current year presentation.
NOTE 2. DISCONTINUED OPERATIONS
- ----------------------------------
SALE OF DISCONTINUED OPERATIONS
In February 1998 the Company announced the discontinuance of its orthodontic
practices. In April 1998 the Company sold all of its orthodontic practices in a
single transaction for consideration consisting of $15.0 million of 30-year
promissory notes, which were secured by all the assets of the purchasers,
including the assets sold in the transaction. The assets of the orthodontic
practices sold consisted primarily of accounts receivable, supply inventory,
leasehold improvements and dental equipment.
The operating results of the discontinued orthodontic practices are included in
the accompanying consolidated statement of operations under the caption "Loss
from operations to be disposed of." Net revenue of the discontinued operations,
which is reflected under the caption "Loss from operations to be disposed of,"
was $1.9 million during the year ended December 31, 1998.
ACCOUNTING TREATMENT OF CERTAIN SALE TRANSACTIONS
In 1996 the Company announced the discontinuance of its general dental
practices, all of which were sold in 1996 and 1997. A number of the general
dental practices sold in 1997 were sold to a single purchaser (the "Purchaser")
in exchange for $8.0 million of long-term promissory notes. In April 1998 the
Company also sold all of its orthodontic practices to the Purchaser in exchange
for $15.0 million of long-term promissory notes. During 1997 and 1998, other
entities that purchased four other general dental practices from the Company
conveyed those practices to the Purchaser in exchange for the assumption of the
related promissory notes payable to the Company. At the time of the conveyances
of these practices to the Purchaser, the related promissory notes had an
aggregate outstanding principal balance of $1.9 million. During 1997 and 1998,
the Company loaned a total of $1.6 million to the Purchaser, which was used for
working capital purposes by the Purchaser.
Because management concluded that the Purchaser would not be able to repay the
promissory notes from sources other than the operations of the purchased
practices, the Company did not treat the transactions with the Purchaser as
sales for accounting purposes. Accordingly, the related promissory notes and the
working capital loans have not been reflected in the Company's financial
statements. Instead, the historical cost of the net assets of the related
general dental and orthodontic practices, less the interest payments received
from the Purchaser, has been reflected on the Company's balance sheet under the
caption "Assets of discontinued operations transferred under contractual
arrangements," which was stated at estimated realizable value. The Company's
financial statements do not reflect any gains on these sale transactions, and do
not reflect any interest income on the related promissory notes. In addition,
the carrying values of the promissory notes related to the four general dental
practices that were transferred to the Purchaser in 1997 and 1998 were reduced
to the historical cost of the net assets of the related practices. These
reductions are included in the accompanying statement of operations under the
caption "Loss from operations to be disposed of." These assets have also been
reflected on the Company's balance sheet under the caption "Assets of
F-10
discontinued operations transferred under contractual arrangements." The working
capital loans were treated as expenses at the time the loans were made, which
are included the accompanying statement of operations under the caption "Loss
from operations to be disposed of." In the opinion of management, this
accounting treatment appropriately reflects the economic substance of the
transactions, as distinct from the legal form of the transactions. The Company
recorded impairment charges with respect to the "Assets of discontinued
operations transferred under contractual arrangements" in both 2000 and 1999
(see Note 5).
SALE OF DISCONTINUED OPERATIONS TO NEW PURCHASER
In October 2000, the Company completed a transaction with the Purchaser and
another third party (the "New Purchaser"), in which the assets reflected on the
Company's balance sheet under the caption "Assets of discontinued operations
transferred under contractual arrangements" were sold. In this transaction, the
Purchaser transferred its interest in the dental and orthodontic practices to
the New Purchaser, the New Purchaser paid $2.4 million to the Company and placed
an additional $1.5 million in an escrow account for the benefit of the Company,
and the Company agreed to pay certain obligations related to these practices.
These obligations consisted primarily of payroll, dental office lease
obligations, patient refunds, and the obligation to complete the orthodontic
treatments for managed care patients who previously paid for the treatments in
full. These obligations either had to be paid in order to complete the
transaction, or were obligations for which the Company may be contingently
liable in any event. The amount of the escrow account that may be realized by
the Company, and the ultimate cost of the obligations assumed by the Company,
are subject to uncertainties. Based on the Company's estimates of the outcome of
these uncertainties, the Company estimates that it will realize no net proceeds
from this transaction, after satisfaction of all the obligations assumed from
the Purchaser. However, the Company believes that by completing this
transaction, it may avoid being responsible for a significant amount of
contingent lease obligations related to the dental and orthodontic practices
sold to the New Purchaser, which are described in Note 10. This transaction
resulted in a $2.5 million charge to earnings during 2000 to reduce the carrying
value of "Assets of discontinued operations transferred under contractual
arrangements" to their estimated realizable value. See Note 5 for a discussion
of impairment charges that were recognized in 2000 and 1999 in connection with
this transaction.
NOTE 3. INVESTMENTS
- ---------------------
Gross realized gains on sales of investments were $19,000, $2,051,000, and
$815,000 for the years ended December 31, 2000, 1999, and 1998, respectively.
Gross realized losses on sales of investments were $1,000, $851,000, and
$1,225,000 for the years ended December 31, 2000, 1999, and 1998, respectively.
The historical cost of specific securities sold is used to compute the gain or
loss on the sale of investments. At December 31, 2000, the Company had net
unrealized gains of $119,000, which is included in stockholders' equity under
the caption "Accumulated other comprehensive income (loss)."
The Company's investments as of December 31, 2000 are summarized below (in
thousands).
COST/ ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
----------- ----------- ------------ ---------
Classified as available-for-sale:
U.S. government and its agencies $ 14,472 $ 80 $ (1) $ 14,551
State and municipal obligations 996 41 -- 1,037
Other marketable securities 2,434 -- (1) 2,433
----------- ----------- ------------ ---------
Total available-for-sale $ 17,902 $ 121 $ (2) $ 18,021
=========== =========== ============ =========
F-11
The maturity dates of the Company's investments as of December 31, 2000, are
summarized below (in thousands):
COST/ ESTIMATED
AMORTIZED FAIR
COST VALUE
------------ ----------
Classified as available-for-sale:
Due in 2001 $ 13,683 $ 13,719
Due in 2002 through 2005 3,277 3,305
Due in 2006 through 2010 844 886
Due after 2010 98 111
----------- -----------
Total available-for-sale $ 17,902 $ 18,021
=========== ===========
The Company's investments as of December 31, 1999 are summarized below (in
thousands).
COST/ ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
----------- ----------- ------------ ----------
Classified as available-for-sale:
U.S. government and its agencies $ 5,489 $ -- $ (31) $ 5,458
State and municipal obligations 989 12 -- 1,001
Other marketable securities 510 1 -- 511
----------- ----------- ------------ ----------
Total available-for-sale $ 6,988 $ 13 $ (31) $ 6,970
=========== =========== ============ ==========
NOTE 4. PROPERTY AND EQUIPMENT
- ----------------------------------
The Company's property and equipment consists of the following (in thousands):
DECEMBER 31,
------------------
2000 1999
-------- --------
Buildings and improvements $ -- $ 165
Leasehold improvements 811 860
Furniture, fixtures and other equipment 10,082 10,000
-------- --------
Total, at cost 10,893 11,025
Less - accumulated depreciation and amortization (8,050) (6,209)
-------- --------
Total, net of accumulated depreciation and amortization $ 2,843 $ 4,816
======== ========
NOTE 5. IMPAIRMENT OF ASSETS
- --------------------------------
ASSETS OF DISCONTINUED OPERATIONS TRANSFERRED UNDER CONTRACTUAL ARRANGEMENTS
"Assets of discontinued operations transferred under contractual arrangements"
consists of the historical cost of the net assets of certain general dental
practices and certain orthodontic practices that were sold by the Company in
1998 and 1997 (see Note 2). During 1999, the Company reached an oral agreement
with the purchaser of those practices (the "Purchaser") and another third party
(the "New Purchaser"), under which the related promissory notes payable to the
Company (the "Notes") would be liquidated. Under this agreement, the Purchaser
would convey the dental and orthodontic practices that comprised the collateral
for the Notes to the New Purchaser, in exchange for proceeds that would be paid
to the Company in satisfaction of the Notes. Based on this oral agreement, the
Company recorded a $4.4 million charge to earnings (net of income tax benefit of
$2.1 million) during 1999 to reduce the carrying value of "Assets of
discontinued operations transferred under contractual arrangements" to their
estimated realizable value. This charge is reflected on the Company's statement
of operations under the caption "Loss from assets transferred under contractual
arrangements."
F-12
In March 2000 the Company entered into a definitive agreement with respect to
the transaction described above. In September 2000, the Company entered into a
restructured agreement with respect to this transaction, which superseded the
previous agreement. Based on the terms of the restructured agreement, the
Company recorded a $2.5 million charge to earnings during 2000 to reduce the
carrying value of "Assets of discontinued operations transferred under
contractual arrangements" to their revised estimated realizable value. This
charge is reflected on the Company's statement of operations under the caption
"Loss from assets transferred under contractual arrangements."
Notes Receivable
The Company's notes receivable consist of several notes issued by the purchasers
of a number of general dental practices sold by the Company in 1996 and 1997,
and are related to dental practices other than those sold to the Purchaser, as
discussed in Note 2. The Company reviews the carrying amount of its notes
receivable for possible impairment on an ongoing basis, based on the estimated
collectibility of the notes. During 2000, the Company increased the reserve on
its notes receivable by recording an impairment loss of $450,000, based on the
recent payment history of the notes, its estimate of the ability of the issuers
to repay the notes, its estimate of the financial condition of the dental
practices that comprise the collateral for the notes, and its estimate of the
value of the assets of those practices.
In 1998, in an effort to liquidate assets, the Company made offers to the
issuers of these notes receivable to reduce the outstanding principal amount of
the notes in exchange for current cash payment in satisfaction of the notes.
Accordingly, the Company provided a $1.8 million reserve against its notes
receivable as of December 31, 1998, to reflect the impact of its decision to
actively pursue liquidation of the notes.
INTANGIBLE ASSETS
Management reviews for impairment of intangible assets that are used in the
Company's operations on a periodic basis in accordance with APB No. 17.
Management deems a group of assets to be impaired if estimated discounted future
cash flows are less than the carrying amount of the assets. Estimates of future
cash flows are based on management's best estimates of anticipated operating
results over the remaining useful life of the assets.
During 1999, the Company recognized impairment losses of $24.6 million based on
estimated discounted cash flows to be generated by each of the Company's
intangible assets. The impairment was recognized for the goodwill and
non-compete covenant related to the acquisition of First American Dental
Benefits, Inc. in September 1996 ($14.7 million), the goodwill and non-compete
covenant related to the acquisition of Advantage Dental HealthPlans in May 1997
($9.3 million), and the insurance license acquisition costs related to the
acquisitions of two insurance companies in 1997 and 1992 ($0.6 million).
REAL ESTATE
During 1998 the Company moved its corporate office from a building owned by the
Company in Anaheim, California to leased office space in Aliso Viejo,
California. During the first quarter of 1999, the Company received a written
offer to purchase the building in Anaheim and other related assets. Based on
this offer, the Company recorded an impairment loss of $569,000 in 1998 to
reduce the carrying value of the building to the estimated net proceeds from the
expected sale, which were $3.6 million. This accounting treatment is in
accordance with SFAS No. 121, "Accounting for Impairment of Long-lived Assets
and for Long-lived Assets to be Disposed of." In May 1999, the Company sold the
building for $3.5 million, including $3.0 million in cash and a promissory note
for $500,000, which was paid in full in 2000.
NOTE 6. CLAIMS PAYABLE AND CLAIMS INCURRED BUT NOT REPORTED
- --------------------------------------------------------------------
The Company is responsible for paying claims submitted by dentists for services
provided to patients who have purchased dental coverage from the Company. Claims
payable are claims submitted by the dentists but not yet paid by the Company.
Claims incurred but not reported is an estimate of the claims for services
delivered prior to the balance sheet date, but which have not yet been submitted
to the Company as of the balance sheet date. The estimate of claims incurred but
not reported is based primarily on the average historical lag time between the
date of service and the date the related claim is submitted to the Company, as
well as the recent trend in the aggregate amount of incurred claims per covered
individual. Since the liability for incurred but not reported claims is
necessarily an actuarial estimate, the amount of claims eventually submitted for
services provided prior to the balance sheet date could differ from the
estimated liability. Any such differences are included in the consolidated
statement of operations for the period in which the differences are identified.
F-13
PPO/indemnity claims are related to services delivered to individuals covered by
the Company's indemnity insurance plans, some of which contain a preferred
provider organization ("PPO") feature. Specialist referral claims are related to
specialist services delivered to individuals covered by the Company's managed
care plans. Supplemental claims are related to primary care dental services
delivered to individuals covered by the Company's managed care plans. A summary
of the activity in the liability for each type of claim is shown below (in
thousands). The activity in the liability for supplemental payments is not shown
for 1998 because it was not material in that year.
PPO/ SPECIALIST
INDEMNITY REFERRAL SUPPLEMENTAL
CLAIMS CLAIMS PAYMENTS TOTAL
----------- ------------ -------------- ---------
Balance at January 1, 1998 $ 2,150 $ 1,481 $ 3,631
Incurred claims related to:
Current year - 1998 16,909 7,251 24,160
Prior years 794 (338) 456
Paid claims related to:
Current year - 1998 (14,636) (5,966) (20,602)
Prior years (2,944) (1,143) (4,087)
----------- ------------ -------------- ---------
Balance at December 31, 1998 $ 2,273 $ 1,285 $ 3,558
=========== ============ ============== =========
Balance at January 1, 1999 $ 2,273 $ 1,285 $ 400 $ 3,958
Incurred claims related to:
Current year - 1999 18,722 8,292 6,730 33,744
Prior years 186 (517) 42 (289)
Paid claims related to:
Current year - 1999 (14,497) (6,932) (5,879) (27,308)
Prior years (2,459) (767) (442) (3,668)
----------- ------------ -------------- ---------
Balance at December 31, 1999 4,225 1,361 851 6,437
Incurred claims related to:
Current year - 2000 24,747 6,971 4,634 36,352
Prior years 226 (351) (122) (247)
Paid claims related to:
Current year - 2000 (19,528) (5,942) (4,006) (29,476)
Prior years (4,451) (1,010) (729) (6,190)
----------- ------------ -------------- ---------
Balance at December 31, 2000 $ 5,219 $ 1,029 $ 628 $ 6,876
=========== ============ ============== =========
The liability for claims payable and claims incurred but not reported is
adjusted each year to reflect any differences between claims actually paid and
previous estimates of the liability. During each of the years ended December 31,
2000, 1999, and 1998, the aggregate adjustments to the liability to reflect
these differences, which are reflected in the above table, were not material.
F-14
NOTE 7. NOTES PAYABLE AND LONG-TERM DEBT
- ----------------------------------------------
Notes payable and long-term debt consisted of the following (in thousands):
DECEMBER 31,
-------------------
2000 1999
--------- --------
Investor senior loan $ 8,000 $ --
Revolving credit facility 7,045 7,045
Senior notes payable 32,500 32,500
Other 500 255
--------- --------
Total debt 48,045 39,800
Less - current portion (47,795) (255)
--------- --------
Long-term debt $ 250 $39,545
========= ========
On March 1, 2000, the Company entered into a recapitalization transaction with
an investor group (the "Investors"), the revolving credit facility lender (the
"Bank"), and the holder of the senior notes payable (the "Senior Note Holder").
In this transaction, the Investors loaned $8.0 million to the Company in the
form of an investor senior loan, which was due April 30, 2001, and had an
interest rate of 10% annually. The Investors, the Bank, and the Senior Note
Holder agreed to convert the $8.0 million investor senior loan, the outstanding
balance of $7.0 million under the revolving credit facility, and the $32.5
million of senior notes payable to convertible preferred stock, subject to
regulatory and stockholder approval. This conversion to convertible preferred
stock was completed as of January 31, 2001, as discussed in Note 14.
In connection with the recapitalization transaction, both the Bank and the
Senior Note Holder agreed not to demand or accept any payment of principal or
interest under their respective credit agreements, and not to take any
enforcement actions of any kind under those agreements until April 30, 2001. As
of December 31, 2000, the Company was subject to various financial covenant
requirements under the credit agreements with the Bank and the Senior Note
Holder. The Company was not in compliance with those requirements as of December
31, 2000. Accordingly, these outstanding balances are reflected as short-term
debt on the Company's balance sheet as of December 31, 2000.
In 1999, in connection with a transaction in which the Company restructured its
credit agreement with the Senior Note Holder, the Company issued warrants to
purchase 382,000 shares of its common stock for $4.51 per share to the Senior
Note Holder. The warrants were exercisable at any time from January 1, 2000 to
December 31, 2003. The Company estimated that the fair value of these warrants
was $320,000, based on an option-pricing model. Accordingly, this amount was
charged to interest expense and credited to stockholders' equity during 1999. In
connection with the recapitalization transaction, the Senior Note Holder agreed
to cancel the warrants upon conversion of the Company's outstanding debt into
convertible preferred stock. The warrants were cancelled as of January 31, 2001,
in connection with the conversion of the Senior Notes Payable to convertible
preferred stock (see Note 14).
In 1998, the Company entered into an $8.0 million revolving credit facility with
the Bank, under which $7.0 million was outstanding at December 31, 2000. The
interest rate on the outstanding balance as of December 31, 2000, was equal to
the bank's prime rate plus 3.0 % (12.5% at December 31, 2000). The loan is
secured by all assets of the Company, including investments, accounts
receivable, notes receivable, property and equipment, and intangible assets, and
a negative pledge on the stock of all the Company's subsidiaries. The
outstanding balance under the credit facility was converted to convertible
preferred stock as of January 31, 2001, as discussed in Note 14.
In 1997, the Company issued $32.5 million of unsecured senior notes payable to
the Senior Note Holder. The senior notes are payable in annual installments of
$6.5 million on each September 30, beginning in 2001, with a final maturity date
of September 30, 2005. The interest rate on the notes was fixed at 8.91% at
December 31, 2000. The senior notes payable were converted to convertible
preferred stock as of January 31, 2001, as discussed in Note 14.
F-15
Annual maturities of debt are as follows, as of December 31, 2000 (in
thousands):
2001 $ 47,795
2002 250
------------
Total debt $ 48,045
============
NOTE 8. OTHER LONG-TERM LIABILITIES
- ---------------------------------------
Other long-term liabilities consist of accrued lease obligations related to
equipment that is no longer used by the Company, accrued rent expense related to
an office lease with monthly payments that increase over the term of the lease,
deferred compensation payments to a former employee of an entity acquired by the
Company in 1996, security deposits collected in connection with subleases, and
an accrued consulting obligation related to an entity acquired by the Company in
1997.
Annual maturities of other long-term liabilities are as follows, as of December
31, 2000 (in thousands):
2001 $ --
2002 457
2003 133
2004 192
2005 and thereafter 297
-----------
Total other long-term liabilities $ 1,079
===========
NOTE 9. INCOME TAXES
- -----------------------
The Company's federal and state income tax expense (benefit) is as follows (in
thousands):
YEARS ENDED DECEMBER 31,
----------------------------
2000 1999 1998
-------- -------- --------
Income tax expense (benefit) from continuing operations:
Currently payable - Federal $ -- $ 648 $ (31)
State -- 358 11
Deferred - Federal -- 6,613 (2,667)
State -- 3,315 (719)
-------- -------- --------
Income tax expense (benefit) from continuing operations -- 10,934 (3,406)
Income tax expense (benefit) from discontinued operations -- (2,087) (1,554)
-------- -------- --------
Total income tax expense (benefit) $ -- $ 8,847 $(4,960)
======== ======== ========
F-16
A reconciliation of the expected federal income tax expense (benefit) based on
the statutory rate to the actual income tax expense (benefit) on the loss from
continuing operations is as follows (in thousands):
YEARS ENDED DECEMBER 31,
--------------------------------------------------------
2000 1999 1998
----------------- ------------------ -----------------
AMOUNT % AMOUNT % AMOUNT %
-------- ------- --------- ------- -------- -------
Expected federal income tax
expense (benefit) $(2,194) (34.0)% $(12,491) (34.0)% $(3,820) (35.0)%
State income tax expense
(benefit), net of effect
on federal income tax -- -- 1,903 5.2 (497) (4.5)
Tax-exempt interest income (13) (0.2) (17) (0.1) (19) (0.2)
Goodwill amortization
and impairments 42 0.7 8,190 22.3 254 2.3
Transaction loss -- -- -- -- 670 6.1
Other items 59 0.9 468 1.3 6 0.1
Change in valuation
allowance 2,106 32.6 12,881 35.1 -- --
-------- ------- --------- ------- -------- -------
Actual income tax
expense (benefit) $ -- --% $ 10,934 29.8% $(3,406) (31.2)%
======== ======= ========= ======= ======== =======
Deferred tax assets (liabilities) are related to the following items (in
thousands):
DECEMBER 31,
--------------------
2000 1999
--------- ---------
Current deferred tax assets (liabilities):
Accrued expenses $ 1,965 $ 429
Bad debt allowance 378 1,038
State income taxes (958) (18)
Prepaid expenses (211) (188)
Other 2 279
--------- ---------
Total current deferred tax assets 1,176 1,540
Valuation allowance (1,176) (1,540)
--------- ---------
Net current deferred tax assets $ -- $ --
========= =========
Long-term deferred tax assets (liabilities):
Net operating loss carry-forward $ 13,651 $ 4,994
Depreciation and amortization 3,384 2,373
Bad debt reserves on notes receivable 1,263 1,645
Gain on sale of dental offices (898) 6,696
Other 40 18
--------- ---------
Total long-term deferred tax assets 17,440 15,726
Valuation allowance (17,440) (15,726)
--------- ---------
Net long-term deferred tax assets $ -- $ --
========= =========
During each of the years ended December 31, 2000 and 1999, the Company recorded
a charge to earnings to increase the valuation allowance against its net
deferred tax assets. As of December 31, 2000 and 1999, the valuation allowances
were equal to the total amounts of net deferred tax assets, which were $18.6
million and $17.3 million as of December 31, 2000 and 1999, respectively. The
Company's deferred tax assets have been fully reserved due to uncertainty about
whether they will be realized in the future, primarily due to operating losses
incurred by the Company during the three years ended December 31, 2000, and the
existence of significant net operating loss carry-forwards. As of December 31,
2000, the Company had net operating loss carry-forwards for federal and state
tax purposes of approximately $35.3 million and $18.6 million, which begin to
expire in 2018 and 2003, respectively. These net operating loss carry-forwards
were significantly reduced as a result of a transaction that occurred as of
January 31, 2001, as discussed in Note 14.
F-17
NOTE 10. COMMITMENTS AND CONTINGENCIES
- ------------------------------------------
LEASE COMMITMENTS
The Company leases several administrative offices and various office equipment
under operating leases. Rent expense under these operating leases was
$3,986,000, $4,289,000, and $2,306,000 in 2000, 1999, and 1998, respectively.
The Company has subleased certain of its office space to third parties, which
office space is subject to lease agreements for which the Company remains
contingently liable in the event the sublessees fail to make the lease payments.
Future minimum rental payments required under non-cancelable operating leases
are as follows, net of payments expected to be received pursuant to subleases
(in thousands):
TOTAL EXPECTED NET
LEASE SUBLEASE CONTINGENT
OBLIGATION PAYMENTS OBLIGATION
----------- ---------- -----------
2001 $ 3,066 $ (683) $ 2,383
2002 2,551 (291) 2,260
2003 1,993 -- 1,993
2004 1,938 -- 1,938
2005 1,838 -- 1,838
Thereafter 4,902 -- 4,902
----------- ---------- -----------
Total minimum payments $ 16,288 $ (974) $ 15,314
=========== ========== ===========
LITIGATION
The Company is a defendant in various lawsuits arising in the normal course of
business. In the opinion of management, the ultimate outcome of existing
litigation will not have a material effect on the Company's financial position
or results of operations.
In December 1999, a stockholder lawsuit against the Company was filed, which
alleged that the Company and certain of its officers violated certain securities
laws by issuing a series of alleged false and misleading statements concerning
the Company's publicly reported revenues and earnings during a specified class
period. On September 12, 2000, after the plaintiffs had filed a first amended
complaint, the Federal District Trial Court dismissed the lawsuit with
prejudice, stating that the plaintiffs had failed to state a claim against the
Company. On October 6, 2000, the plaintiffs filed an appeal of the dismissal of
the lawsuit, and that appeal is currently pending. The Company has directors and
officers liability insurance and intends to vigorously contest the appeal. In
the opinion of management, the ultimate outcome of this matter will not have a
material adverse effect on the Company's financial position or results of
operations.
CONTINGENT LEASE OBLIGATIONS
The Company sold its general dental practices and orthodontic practices in 1996,
1997 and 1998, as discussed in Note 2. The Company also re-sold certain of these
practices in October 2000, after the original purchaser of a number of these
practices defaulted on its obligations to the Company, as discussed in Note 2.
In connection with the sale and re-sale of those practices, all the purchasers
of the practices agreed to make the remaining lease payments related to the
dental offices used by those practices. However, the Company remains
contingently liable for the lease payments in the event the purchasers of those
practices fail to make the payments. As of December 31, 2000, the aggregate
contingent liability of the Company related to all of these leases was
approximately $5.5 million over the terms of the various lease agreements, which
expire at various dates through 2007. Management has not been notified of any
defaults that would materially affect the Company's financial position. The
aggregate contingent lease obligation of $5.5 million excludes $425,000 of
estimated lease obligations that have been accrued as of December 31, 2000, due
to failures by the entities to make the lease payments under the leases which
were assigned by the Company. This estimated lease obligation is included in the
accompanying consolidated balance sheet under the caption "Other accrued
expenses."
F-18
EMPLOYEE RETIREMENT PLAN
The Company maintains a retirement plan under Section 401(k) of the Internal
Revenue Code (the "Plan"). Under the Plan, employees are permitted to make
contributions to a retirement account through payroll deductions from pre-tax
earnings. Employees are fully vested in contributions made from payroll
deductions. In addition, the Company may, at its discretion, make additional
contributions to the Plan. The Company made no contributions to the Plan during
the three years ended December 31, 2000.
PROFESSIONAL LIABILITY INSURANCE
The Company maintains professional liability insurance that covers losses on a
claims made basis.
NOTE 11. CAPITAL STOCK
- -------------------------
STOCK REPURCHASES
As of December 31, 2000, the Company had 3,274,788 shares of treasury stock,
which were acquired by the Company for an aggregate of $18.1 million. In
December 2000, the board of directors of the Company authorized management to
repurchase up to 500,000 additional shares of the Company's outstanding common
stock.
STOCK OPTION PLAN
The Company has a stock option plan (the "Plan") that authorizes the granting of
both incentive and non-qualified stock options to purchase an aggregate of
3,000,000 shares of common stock. Either incentive or non-qualified stock
options may be granted to executive officers and other employees of the Company.
Only non-qualified stock options may be granted to non-employee directors of the
Company. Under the Plan, the exercise price of any stock option granted must be
at least equal to the market value of the Company's common stock on the date the
option is granted. The Plan is administered by the Compensation and Stock Option
Committee of the board of directors of the Company.
The following is a summary of activity in stock options:
YEARS ENDED DECEMBER 31,
---------------------------------
2000 1999 1998
----------- --------- ---------
Outstanding at beginning of year 755,300 769,800 638,017
Stock options granted 2,080,000 55,000 184,000
Stock options exercised -- -- --
Stock options canceled (619,000) (69,500) (52,217)
----------- --------- ---------
Outstanding at end of year 2,216,300 755,300 769,800
=========== ========= =========
Exercisable at end of year 105,966 551,000 455,066
Weighted average exercise price of options granted $ 1.00 $ 3.72 $ 9.11
Weighted average exercise price of options exercised -- -- --
Weighted average exercise price of options canceled 9.96 12.70 12.45
Weighted average exercise price of options outstanding 1.53 9.88 10.58
Weighted average exercise price of options exercisable 10.39 10.39 10.10
F-19
The following is a summary of stock options outstanding as of December 31, 2000:
TOTAL STOCK OPTIONS OUTSTANDING STOCK OPTIONS EXERCISABLE
------------------------------------------ ---------------------------
RANGE OF WEIGHTED WEIGHTED WEIGHTED
EXERCISE NUMBER AVERAGE AVERAGE NUMBER AVERAGE
PRICES OF SHARES REMAINING LIFE EXERCISE PRICE OF SHARES EXERCISE PRICE
- ------------- --------- -------------- --------------- ---------- ---------------
$ 1.00 2,065,000 9.26 years $ 1.00 -- $ --
3.44 - 3.75 55,000 8.83 years 3.72 18,333 3.72
9.00 - 11.88 73,900 5.12 years 10.27 65,233 10.42
15.75 22,400 5.22 years 15.75 22,400 15.75
--------- ----------
Total 2,216,300 9.07 years $ 1.53 105,966 $ 10.39
========= ==========
The weighted average fair value of stock options granted was $0.76, $2.73, and
$5.93 per share during the years ended December 31, 2000, 1999, and 1998,
respectively. In accordance with SFAS No. 123, the following table shows the pro
forma effect of using the fair value method of accounting for stock options
granted to employees (in thousands, except per share amounts):
YEARS ENDED DECEMBER 31,
------------------------------
2000 1999 1998
-------- --------- ---------
Net loss, as reported $(8,952) $(52,036) $ (9,938)
Pro forma net loss (9,733) (52,360) (10,325)
Loss per share, as reported (1.89) (10.96) (2.09)
Pro forma loss per share (2.05) (11.03) (2.18)
SFAS No. 123 requires a publicly-traded entity to estimate the fair value of
stock-based compensation by using an option-pricing model that takes into
account certain facts and assumptions. The facts and assumptions that must be
taken into account are the exercise price, the expected life of the option, the
current stock price, the expected volatility of the stock price, the expected
dividends on the stock, and the risk-free interest rate. The option-pricing
models commonly used were developed to estimate the fair value of freely
tradable, fully transferable options without vesting restrictions, which
significantly differ from the stock options granted by the Company. The Company
estimated the fair value of each stock option as of the date of grant by using
the Black-Scholes option-pricing model. The facts and assumptions used to
determine the fair value of stock options granted were an average expected life
of four years, expected volatility of 184% in 2000, 97% in 1999, and 50% in
1998, no expected dividends, and a risk-free interest rate of approximately 6%.
The assumptions regarding the expected life of the options and the expected
volatility of the stock price are subjective, and these assumptions greatly
affect the estimated fair value amounts.
NOTE 12. INVESTMENT AND OTHER INCOME
- -----------------------------------------
Investment and other income consists of the following (in thousands):
YEARS ENDED DECEMBER 31,
-----------------------
2000 1999 1998
------ ------- ------
Net realized gains (losses) on sale of investments $ 18 $1,200 $(410)
Interest income 1,330 932 268
Other, net 83 (65) 766
------ ------- ------
Total investment and other income $1,431 $2,067 $ 624
====== ======= ======
F-20
Note 3. UNAUDITED SELECTED QUARTERLY INFORMATION
- ----------------------------------------------------
QUARTERLY RESULTS OF OPERATIONS
Unaudited quarterly results of operations for the years ended December 31, 2000
and 1999 are shown below (in thousands, except per share data). The unaudited
quarterly results should be read in conjunction with the accompanying audited
financial statements.
YEAR ENDED DECEMBER 31, 2000
------------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
--------- --------- --------- ---------
Premium revenue, net $ 24,463 $ 24,173 $ 24,639 $ 23,976
Health care services expense 17,505 17,464 17,318 15,302
Selling, general and administrative expense 8,646 7,365 7,690 8,481
Loss on impairment of assets -- -- -- 450
--------- --------- --------- ---------
Operating income (loss) (1,688) (656) (369) (257)
Investment and other income 259 378 478 316
Interest expense on debt that became subject
to conversion to equity in 2000 (1,015) (1,202) (1,287) (1,297)
Other interest expense (17) (18) (53) (24)
--------- --------- --------- ---------
Income (loss) before income taxes and
discontinued operations (2,461) (1,498) (1,231) (1,262)
Income tax expense -- -- -- --
--------- --------- --------- ---------
Income (loss) before discontinued operations (2,461) (1,498) (1,231) (1,262)
Discontinued operations:
Loss from assets transferred under
contractual arrangements -- -- (1,750) (750)
--------- --------- --------- ---------
Net income (loss) $ (2,461) $ (1,498) $ (2,981) $ (2,012)
========= ========= ========= =========
Basic and diluted net income (loss) per share:
Income (loss) from continuing operations $ (0.52) $ (0.32) $ (0.26) $ (0.26)
Income (loss) from discontinued operations -- -- (0.37) (0.16)
--------- --------- --------- ---------
Net income (loss) $ (0.52) $ (0.32) $ (0.63) $ (0.42)
========= ========= ========= =========
Weighted average basic and
diluted shares outstanding 4,747 4,747 4,747 4,747
F-21
YEAR ENDED DECEMBER 31, 1999
------------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
--------- --------- --------- ---------
Premium revenue, net $ 23,863 $ 23,989 $ 24,065 $ 24,308
Health care services expense 16,789 17,015 17,402 17,591
Selling, general and administrative expense 8,840 9,035 9,816 8,112
Loss on impairment of assets -- -- 24,576 --
--------- --------- --------- ---------
Operating income (loss) (1,766) (2,061) (27,729) (1,395)
Investment and other income 1,503 437 (147) 274
Interest expense on debt that became subject
to conversion to equity in 2000 (865) (1,058) (2,759) (928)
Other interest expense (82) (44) (42) (77)
--------- --------- --------- ---------
Income (loss) before income taxes and
discontinued operations (1,210) (2,726) (30,677) (2,126)
Income tax expense (benefit) (350) (940) 12,224 --
--------- --------- --------- ---------
Income (loss) before discontinued operations (860) (1,786) (42,901) (2,126)
Discontinued operations:
Loss from assets transferred under
contractual arrangements -- (3,264) (1,099) --
--------- --------- --------- ---------
Net income (loss) $ (860) $ (5,050) $(44,000) $ (2,126)
========= ========= ========= =========
Basic and diluted net income (loss) per share:
Income (loss) from continuing operations $ (0.18) $ (0.38) $ (9.04) $ (0.45)
Income (loss) from discontinued operations -- (0.69) (0.23) --
--------- --------- --------- ---------
Net income (loss) $ (0.18) $ (1.07) $ (9.27) $ (0.45)
========= ========= ========= =========
Weighted average basic and
diluted shares outstanding 4,747 4,747 4,747 4,747
NOTE 14. SUBSEQUENT EVENT
- ----------------------------
Effective as of January 31, 2001, the Company completed the conversion of the
investor senior loan ($8.0 million), the outstanding balance under the revolving
credit facility ($7.0 million), the senior notes payable ($32.5 million), and
the accrued interest on the revolving credit facility and the senior notes
payable ($5.0 million as of December 31, 2000) into 300,000 shares of
convertible preferred stock (see Note 7). The estimated value of the convertible
preferred stock was $137.50 per share as of January 31, 2001, which is based on
the closing price of the Company's common stock on January 31, 2001, which was
$1.375 per share, and the fact that each share of convertible preferred stock is
convertible into 100 shares of common stock. Based on this estimated value, the
conversion transaction resulted in a gain of $11.3 million. It is expected that
there will be no income tax effect related to this transaction, due to the
Company's net operating loss carry-forwards for tax purposes, as discussed in
Note 8.
The accompanying financial statements include an unaudited pro forma balance
sheet as of December 31, 2000, which reflects the conversion of debt into
convertible preferred stock, as though the conversion had occurred on December
31, 2000, based on the actual gain on the conversion as of January 31, 2001, as
described above.
The convertible preferred stock does not accrue dividends of any kind. Each
share of convertible preferred stock is convertible into 100 shares of common
stock at the option of the holder. The convertible preferred stock entitles the
holder to one vote for each share of common stock into which the preferred stock
is convertible, with respect to all matters voted on by the common stockholders
of the Company, except for the election of directors. The holders of the
convertible preferred stock have the right to elect a total of five members of
the board of directors, and the holders of the common stock have the right to
elect the remaining two directors. The convertible preferred stock has a
liquidation preference over the common stock.
F-22
As a result of the conversion transaction, the previously existing common
stockholders of the Company now own approximately 14% of the common stock
interests of the Company. In March 2000, in connection with the conversion
transaction, the Company agreed to place a four new directors, who represent the
holders of the investor senior loan, the revolving credit facility, and the
senior notes payable, on its board of directors. Three of those directors were
placed on the board in March 2000, and the fourth director was placed on the
board as of January 31, 2001. These new directors constitute a majority of the
board of directors, which currently has a total of seven members.
F-23
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 2000, 1999, AND 1998
(IN THOUSANDS)
BALANCE AT CHARGED TO CHARGED TO BALANCE AT
BEGINNING COSTS AND OTHER END
OF YEAR EXPENSES ACCOUNTS WRITE-OFFS OF YEAR
-------- --------- --------- ------------ --------
YEAR ENDED DECEMBER 31, 1998:
Allowance for doubtful accounts:
Accounts receivable $ 1,061 $ 1,733 $ -- $ (851) $ 1,942
Long-term notes receivable $ 2,205 $ 833 $ -- $ (1,018) $ 2,020
YEAR ENDED DECEMBER 31, 1999:
Allowance for doubtful accounts:
Accounts receivable $ 1,942 $ 481 $ -- $ (1,369) $ 1,054
Long-term notes receivable $ 2,020 $ 1,819 $ -- $ -- $ 3,839
YEAR ENDED DECEMBER 31, 2000:
Allowance for doubtful accounts:
Accounts receivable $ 1,054 $ 300 $ -- $ (486) $ 868
Long-term notes receivable $ 3,839 $ 450 $ -- $ (1,483) $ 2,806
F-24