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, 2001 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, SUITE 100
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, 2002, was $5,052,000. The number of shares of the
registrant's common stock outstanding as of March 15, 2002, was 4,820,832 (not
including 3,266,755 shares held in treasury).
SAFEGUARD HEALTH ENTERPRISES, INC.
INDEX TO FORM 10-K
PAGE
----
PART I:
Item 1. Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Item 2. Properties. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
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 . . . . . . . . 17
Item 6. Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 19
Item 7A. Quantitative and Qualitative Disclosures About Market Risk. . . . . . . . . . . . . . 26
Item 8. Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . 27
Item 9. Changes in and Disagreements with Independent Accountants on Accounting and
Financial Disclosure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
PART III:
Item 10. Directors and Executive Officers of the Registrant. . . . . . . . . . . . . . . . . . 27
Item 11. Executive Compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Item 12. Security Ownership of Certain Beneficial Owners and Management. . . . . . . . . . . . 30
Item 13. Certain Relationships and Related Transactions. . . . . . . . . . . . . . . . . . . . 32
PART IV:
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. . . . . . . . . . . 33
SIGNATURES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
(i)
PART I
ITEM 1. BUSINESS
- ------------------
In addition to historical information, the description of business below
includes certain forward-looking statements regarding SafeGuard Health
Enterprises, Inc. and its subsidiaries (the "Company"), including statements
about growth plans, business strategies, future operating results, future
financial position, and general economic and market events and trends. The
Company's actual future operating results 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 contract with an adequate number of participating
providers, 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 owed to the Company, natural disasters, loss
of key management, 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 provides a wide range of dental benefit plans, including HMO plan
designs and preferred provider organization ("PPO")/indemnity plan designs. The
Company also provides vision benefit plans, administrative services, and
preferred provider organization services. The Company conducts its business
through several subsidiaries, one of which is an insurance company that is
licensed in a number of states, and several of which are dental HMO 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. SafeGuard Health Enterprises, Inc.
(the "Parent") was incorporated in California in November 1982 and acquired the
California Plan in December 1982. In August 1987 the Parent 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 last ten (10) 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 plan designs to its
customers. In August 1996, the Company acquired a dental HMO 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 dental HMO 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 indemnity 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 is currently licensed
as a dental HMO in nine states, and as an indemnity insurance company in 20
states. However, substantially all of its revenue is generated in California,
Florida and Texas.
The Company sold all of its general dental practices in 1996 and 1997, and sold
all of its orthodontic practices in 1998. Certain of the general dental
practices and all of the orthodontic practices were sold to a single purchaser
(the "Purchaser"), in exchange for $23.0 million of long-term promissory notes.
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, notwithstanding the fact
that these transactions were legally structured as sales. The Purchaser
ultimately defaulted on its obligations to the Company, 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"). All of the revenues and expenses related to the general dental and
orthodontic practices are reflected in the accompanying consolidated financial
statements under "discontinued operations" in all applicable periods. See Note 2
to the accompanying consolidated financial statements for more information about
these transactions, including the accounting treatment applied to the
transactions with the Purchaser.
1
The Company's executive offices are located at 95 Enterprise, Suite 100, Aliso
Viejo, California 92656-2605. Its telephone number is 949.425.4300 and its fax
number is 949.425.4586.
DENTAL CARE MARKETPLACE
The total market for dental care services and for dental benefit plans has grown
rapidly in recent years. The United States Health Care Financing Administration
("HCFA") reported that total expenditures for dental care in the United States
increased from approximately $44.5 billion in 1995 to an estimated $60.0 billion
in 2000. The National Association of Dental Plans (the "NADP") estimated that
the number of people in the United States that were enrolled in some type of
dental benefit plan increased from 113 million in 1995 to 159 million in 2000.
The cost of dental services has increased in recent years at a rate higher than
that for consumer goods as a whole. The United States Bureau of Labor Statistics
(the "BLS) reported that the consumer price index ("CPI") for dental services
for all urban consumers increased by 25.0% from 1995 to 2000, while the CPI for
all items for all urban consumers increased by 13.0% during the same period.
HCFA reported that expenditures for dental services accounted for approximately
4.6% of total national health care expenditures during 2000. 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.
As noted above, the NADP estimated that approximately 159 million people, or
approximately 57% of the total population of the United States, were enrolled in
some type of dental benefit plan in 2000. The United States Census Bureau
estimated that approximately 238 million people, or approximately 86% of the
total population of the United States, were covered by some type of medical
benefit plan in 2000. The Company believes the number of people without dental
coverage represents an opportunity for dental benefits companies to increase
their enrollments.
The NADP estimated that enrollment in dental HMO plans increased from
approximately 19.8 million people in 1995 to approximately 26.6 million people
in 2000. However, the NADP also estimated that enrollment in dental HMOs
decreased slightly during the latter part of that period, from 27.2 million
people in 1997 to 26.6 million people in 2000. The Company believes the primary
reason that total enrollment in dental HMOs has not increased in recent years is
that most purchasers desire greater flexibility in the choice of providers than
is generally afforded by dental HMOs, and the size of dental HMO provider
networks has not kept pace with the growth in the dental benefits market.
The dental HMO business 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 plans in
the United States in 2000.
In recent years, there has been a significant increase in the enrollment in
dental insurance plans that include PPO networks, which typically provide
greater flexibility in the member's choice of providers than a dental HMO. 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" panel 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 expense 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 8.8 million people in 1995 to approximately 25.2 million
people in 2000. 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 average monthly cost of dental insurance coverage is much lower than 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 when or whether to obtain 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
2
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. In addition, co-payments and co-insurance payments made by patients
under dental plans typically represent a larger share of the total cost of
dental care, compared to the share of the total cost of medical care that is
paid by patients under medical coverage plans.
Common features of dental PPO and indemnity plans include annual deductibles of
varying amounts, maximum annual benefits of $2,000 or less per person and
significant patient cost-sharing. Patient cost-sharing typically varies by the
type of dental procedure, ranging from little or no cost-sharing for preventive
procedures to 50% or more 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 dental PPO and indemnity
plans, compared to the underwriting risk of a medical insurance plan, which
typically covers catastrophic illnesses and injuries.
Under a dental PPO or indemnity plan, dentists have little incentive to deliver
cost-effective treatments because they are compensated on a unit-of-service
basis. In contrast, under a dental HMO 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). In some cases, the general dentist also receives supplemental payments
from the dental HMO for performing certain procedures, in addition to the
capitation payments. Under a dental HMO plan, each dentist also typically
receives co-payments from the patient for certain dental services, in addition
to the capitation and supplemental payments from the dental HMO. The co-payments
and supplemental payments 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 dental HMO plan's underwriting
risk associated with varying utilization of dental services.
(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 3,000 employer
or association groups and delivers dental or vision services to approximately
625,000 covered individuals. Dental care is provided to the covered individuals
through its HMO network of approximately 4,400 dentists, and through a PPO
network of approximately 10,200 dentists.
Under the Company's dental benefit plans that have an HMO plan design, its
customers pay a monthly premium for each subscriber enrolled in the plan, which
is fixed for a period of one to 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 HMO 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. The approval by the Company confirms that the referral is for a
service covered by the member's benefit plan. Under HMO plan designs,
subscribers and dependents are not required to pay deductibles or file claim
forms, and are not subject to a maximum annual benefit.
Under the Company's dental benefit plans that have a PPO/indemnity plan design,
its customers also pay a monthly premium for each subscriber enrolled in the
plan, which 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, the geographic
location of the group, and the number of dependents enrolled by each subscriber.
3
Under PPO/indemnity plan designs, 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 plan designs, subscribers and
dependents can choose to receive dental services from any dentist of their
choice. If the subscriber or dependent chooses to receive services from a
dentist in the PPO network, the services will typically cost less than if the
services were delivered by a dentist not contracted with the Company's PPO
network.
The Company's goal is to be a leading dental benefits provider in its primary
markets of California, Florida and Texas, but it also provides dental benefit
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. Additionally,
for large clients, the Company has the information technology and flexibility to
deliver highly customized benefit plans.
Under the Company's vision benefit plans, customers pay a monthly premium for
each subscriber enrolled in the plan, which is fixed for a period of one to two
years. The monthly premium varies depending on the vision services covered, the
member co-payments required for certain vision services, and the number of
dependents enrolled by each subscriber. Under the Company's vision plans,
subscribers and dependents can choose to receive vision services from any
licensed provider of their choice. If the subscriber or dependent chooses to
receive services from a provider in the PPO network, the amount paid by the
subscriber or dependent at the time of service is typically less than it would
be if the services were delivered by a provider outside of the PPO network
The Company uses multiple distribution channels to sell its products. The large
employer market is targeted by developing relationships with benefits consulting
firms that are often engaged by large employers to assist them in selecting the
best dental plans. The Company utilizes its senior management, outside
consultants, and its internal sales force to develop relationships with benefits
consulting firms and with potential large customers. The Company primarily uses
its internal sales force to sell the Company's products to mid-size employer
groups, by developing relationships with independent brokers, and to a lesser
extent, by contacting potential customers directly. The Company recently
established a telephonic small group sales and service function in each of its
three primary markets, which focuses on developing the small group market and
providing quality service to existing customers in a cost-effective manner. In
addition, the Company has recently developed new products and new distribution
channels for the individual dental benefit plan market, which the Company
believes has growth potential. The Company's dental plans are also offered to
medical HMOs, which include the Company's dental plans in comprehensive medical
plans offered by those medical HMOs. In some cases, the Company utilizes general
agency relationships, 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 a wide range of dental
benefit plan designs, including HMO and PPO/indemnity plan designs, 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
offers stand-alone administrative services and PPO access products to its
customers, which deliver additional patient volume to its contracted providers.
The Company has provider relations representatives who maintain the network of
providers in each of the Company's significant geographic markets. The local
knowledge and expertise of these representatives enables the Company to develop
and maintain competitive provider networks, which is an important factor to
employers in selecting a dental benefit plan.
GEOGRAPHIC MARKETS
The Company operates primarily in California, Florida and Texas and its
marketing activities are currently focused on these states. It also maintains
dental HMO and dental 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, Florida and Texas.
The Company started its business in California, and expanded to Texas and
Florida primarily through the acquisition of two dental HMO companies located in
those two states. It is possible that the Company could expand its operations to
additional states as a result of future acquisitions or new or expanded customer
contracts, although the Company has no current plans to do so.
4
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 dental benefit plans with a restricted choice of providers,
through its HMO plans, plans with financial incentives to use network providers,
through its PPO plans, and benefit plans with an unrestricted choice of
providers, through its 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.
Dental HMO Plan Designs. The Company offers a comprehensive range of dental HMO
plan designs, which 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. Dental HMO 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 contracted with the
Company, 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
dental HMO 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 dental HMO plan, each subscriber and dependent selects a general dentist
from the Company's HMO 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 HMO 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 may
receive 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.
Dental PPO/Indemnity Plan Designs. The Company offers a comprehensive range of
dental PPO/indemnity plan designs, subject to regulatory restrictions.
PPO/indemnity dental plan designs typically cover the same dental procedures as
dental HMO plan designs. Under the Company's PPO/indemnity dental plan designs,
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
dental HMO plan design. In addition, the benefits covered under the Company's
PPO/indemnity dental plan designs are subject to annual deductibles and annual
benefit maximums, which is not the case under the Company's dental HMO plan
designs.
Under PPO/indemnity dental plan designs, subscribers and dependents can choose
to receive covered services from any licensed dentist. In the case of a benefit
plan that includes a PPO component, the co-insurance amounts paid by the covered
individual are reduced if he or she chooses to receive services from a dentist
in the Company's preferred provider network. In addition, the covered
individual's annual deductible is typically waived if he or she chooses to
receive all dental services from 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, which together with any
coinsurance payment due from the patient, constitutes payment in full for the
services delivered (i.e., there is no "balance billing" by the provider). The
Company pays for services delivered by non-contracted providers based on usual
and customary dental fees in each geographic area, and the provider may bill the
patient for any difference between his or her standard fee and the amount paid
by the Company. The Company believes that offering an indemnity dental plan with
a PPO network is an attractive way to enter geographic areas where few dentists
5
have agreed to participate in HMO 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 an HMO network. PPO/indemnity dental plan designs subject the
Company to more significant underwriting risks than dental HMO plan designs,
because the Company assumes all the risk related to varying utilization rates.
The Company believes that PPO/indemnity plan designs 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 dental HMO plan designs.
Defined Benefit Dental Plans. The Company offers a series of defined benefit
dental insurance plans. Under these plans, subscribers and dependents are
reimbursed a fixed amount for each procedure performed, regardless of which
provider performs the procedure. One innovative feature of this product is that
certain plan designs include coverage for dental implants, which are typically
excluded from other types of dental benefit plans. This product is also sold
with or without orthodontic coverage. Defined benefit plans are designed for
customers who want to avoid the restrictions of a network-based plan, while
paying a monthly premium that is significantly less than that of a typical
PPO/indemnity plan. Because this product is not dependent on a provider network,
it can be marketed to potential customers who are located outside of the areas
covered by the Company's HMO and PPO provider networks.
Dual Option Product. The Company frequently combines one of its dental HMO plan
designs with one of its PPO/indemnity plan designs to create a "dual option"
product for its groups. As a result, each subscriber can choose whether to
enroll in the dental HMO plan design or the PPO/indemnity plan design. By
offering a dual option product, the Company can offer its subscribers more
flexibility, and can capture a larger portion of the total dental benefits
expenditures by each of its groups. This product also allows the Company to
offer a dental HMO plan design to cost-conscious customers, while also providing
a PPO/indemnity plan design for coverage to employees who are located outside
the geographic area served by the Company's HMO provider network, or are willing
to pay for greater flexibility. Certain states, including Nevada and Oklahoma,
require that dental HMO plan designs 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.
In addition to routine optometric care, vision plans offered by the Company
generally cover a portion of the cost of glasses or contact lenses. The vision
plans generally cover only frames, lenses and contact lenses if the covered
individual has separate medical coverage for the cost of routine eye exams.
Under the vision plan, subscribers can choose to receive services from any
licensed optometrist or ophthalmologist of their choice. Alternatively, they can
choose to receive services from an optometrist or ophthalmologist 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 customers, the Company offers
claims administration under an administrative services only ("ASO") arrangement,
under which the Company does not assume the underwriting risk. The Company
receives an administrative fee to process claims and the underwriting risk is
retained by the customer sponsoring the self-insured plan. The Company also
provides access to its PPO network for a fixed monthly fee based on the number
of subscribers 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 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. Large
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
6
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.
The Company has an internal sales force that is paid through a combination of
salary and incentive compensation based on the revenue 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.
A small portion of the Company's sales are generated directly by its internal
sales force. The Company generally 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
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. 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 promoting retention of the clients and
subscribers 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 a salary plus incentive
compensation for selling additional products to existing customers.
RATING AND UNDERWRITING
The Company develops the premium rates for each of its benefit plans, including
rate adjustments that depend on various group-specific underwriting variables,
based on past experience with similar products, and based on actuarial analysis
using industry claims cost information.
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 this information 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, or the lack of compatibility between the
Company's provider network and the location of the potential client's employees.
CLIENTS AND CUSTOMER CONTRACTS
The Company currently provides services to an aggregate of approximately 625,000
individuals, who participate in the Company's benefit plans primarily through
group contracts with over 3,000 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, 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
dental HMO plans purchased from the Company. No single customer accounts for
five percent (5%) 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 4,400 dentists in its HMO network, and
has approximately 10,200 dentists in its PPO network. The Company believes that
a key element in the success of a dental benefits company is an extensive
network of participating dentists in convenient locations. The Company believes
that dentists who participate in its HMO 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 HMO and PPO networks in order to
supplement the patients for which they are paid usual and customary fees.
The Company requires that all dentists in its HMO network meet certain quality
assessment program standards. Those standards include current professional
license verification, adequate liability insurance coverage, a risk management
review of the dental office facility to ensure that Occupational Safety and
Health Act ("OSHA") requirements and other 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 HMO network primarily
through monthly capitation payments. Each general dentist receives a fixed
monthly payment for each subscriber or dependent that selects that dentist as
his or her primary dentist. The amount of the capitation payment related to each
member varies based on the plan design in which the 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 may 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 enrolled in certain plans, who
have selected that dentist as their general dentist. The amount of the
supplemental payment varies depending on the specific procedure performed, and
the amount of the co-payment collected from the member, which varies with the
benefit plan design. Supplemental payments are 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. Supplemental payments are low enough to avoid providing an incentive
for the dentist to deliver services that are not cost-effective. The Company
believes the use of supplemental payments provides for a higher level of member
and provider satisfaction with the Company's dental HMO plans. The general
dentist also receives co-payments from the members for certain types of
services, which vary based on the plan design under which each member is
covered. No individual dental office provides services to five percent (5%) or
more of the members enrolled in the Company's managed care plans.
The Company's dental HMO 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 under which each member is covered.
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 plans are compensated
based on usual and customary fees in each geographic area, and may bill the
subscriber or dependent for any remaining balance.
The Company employs provider relations representatives who are based in the
geographic markets served by the Company. These representatives are responsible
for developing and maintaining the Company's network of HMO and PPO dentists.
They negotiate contracts with 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 HMO 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 HMO and PPO networks
require the dentists to maintain professional liability insurance with a minimum
coverage of $200,000 per claim, and $600,000 in the 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 dental
HMO business 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, addressing member complaints and
grievances, and assessment of other qualifications of dentists to participate in
the Company's HMO 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 review
treatment outcomes.
The Company uses an independent outside service to conduct regular 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 and availability of appointments within the Company's network, the
benefits covered by the Company's benefit plans, and the customer service
provided by the Company. The results are used by the Company to determine how it
can improve its provider network and 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 HMO network, as well as the frequency of
specialist referrals initiated by those dentists, based on paid claim
information and encounter data submitted by the dentists. 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 from 5:00 a.m. to 6:00 p.m. Pacific Time. Automated service is
available 24 hours a day for inquiries such as selection of a network dentist,
requests for identification cards, and eligibility verification. The Company
uses an automated call distribution ("ACD") system for its management of
customer service calls.
9
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
dental HMO 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,
improve its customer service, and 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, monthly billings, claims processing, commission payments, utilization
management, and provider network activities, one for its dental HMO business and
one for its PPO/indemnity dental business. As part of the Company's long-term
information systems strategic plan, the Company is 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, premium rates, claims processing
activities, provider payment arrangements, and broker commissions. 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
dental HMO 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 vendor,
which generally meets the needs of the Company's PPO/indemnity business.
During 2001, the Company implemented an enhanced accounts receivable application
that is currently used for its dental HMO business. This application was
purchased from a software vendor, and has been integrated with the Company's
proprietary dental HMO system. The Company believes this new accounts receivable
system provides greater assurance that the Company is collecting appropriate
amounts from its customers, has improved the efficiency of the billing and
collections process, and improves 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 recently implemented a Customer Relationship Management
system, also as part of its long-term information systems strategic plan, which
it uses 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 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 satisfactorily serve the Company's
needs for at least the next two to three years.
RISK MANAGEMENT
Dentists in the Company's HMO and PPO networks generally indemnify the Company
against professional liability claims and are 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.
10
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
in the future at a reasonable cost.
COMPETITION
The Company operates in a highly competitive environment and faces numerous
competitors in each of its geographic markets with respect to all products
offered by the Company. The Company's competitors include large insurance
companies that offer dental HMO benefit plans and PPO/indemnity dental benefit
plans, medical HMOs that offer dental benefit plans, self-insured dental plans
provided by employers, union trust funds and other group purchasers, 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 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
flexible array of benefit plan designs, and by maintaining a high level of
customer service with respect to its employer groups, members, dental service
providers, and brokers. 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 their
customers.
Other than the minimum net worth requirements imposed by state regulators, and
the need to obtain a license from the applicable state regulator, which could
take a substantial period of time, there are no 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.
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
dental HMO subsidiaries are subject to regulation by the California Department
of Managed Health Care, the Florida Department of Insurance and the Texas
Department of Insurance. In addition, several other subsidiaries of the Company
are dental HMO plans that are licensed in the states in which they operate. The
Company's dental insurance subsidiary is primarily regulated by the California
Department of Insurance, and is also subject to regulation by state insurance
regulatory agencies in all of the states in which it is licensed.
The Company's dental HMO plans are subject to regulations that vary from state
to state, and generally include regulations with respect to the scope of
benefits provided to members, the content of all contracts with customers,
dental service providers and others, advertising, the maintenance of a minimum
amount of net worth, the maintenance of restricted deposits, procedures related
to quality assurance, enrollment procedures, the maximum percentage of premium
11
revenue that may be spent on general and administrative expenses, minimum loss
ratios, 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 premium rates.
The Company's PPO/indemnity dental plans are subject to state regulations with
respect to the maintenance of a minimum amount of net worth, the maintenance of
restricted deposits for the benefit of certain state regulators, the nature of
investments held by the Company, insurance policy forms, advertising, and claims
processing procedures. Insurance companies in general are subject to extensive
regulation and are typically required to have significantly greater financial
resources than dental HMOs.
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 from
six to twenty-four months, and must be satisfactorily completed before the
Company could commence operations in the applicable state.
Since some states will only license full service health plans, the Company
cannot offer its dental HMO 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 dental HMO 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. 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.
The Company is subject to the Health Insurance Portability and Accountability
Act of 1996 ("HIPAA"). HIPAA imposes responsibilities on the Company, including
but not limited to, privacy notice requirements to members of the Company's
benefit plans, the security and privacy of individually identifiable health
information, the use of unique identifiers for all of the contractual
relationships the Company has with members, providers and group and individual
contract holders, the adoption of standardized electronic transaction code sets,
and prevention of unauthorized use or disclosure of personal data maintained by
the Company. The Company is in the process of developing policies and procedures
to comply with these requirements and has provided privacy notices as required
by HIPAA and the Gramm-Leach-Bliley Act.
There is currently no other regulation of the Company's business at the federal
level.
TRADEMARKS, SERVICEMARKS AND TRADENAMES
The Company currently markets all of its products under the brand name
"SafeGuard." 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 all the products offered by the Company;
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 dental HMO plans
offered by the Company; and
o SafeHealth Life(R) used with a descriptive logo depicting a modified smile
used by the Company to describe its PPO/indemnity dental plans.
Collectively, these trademarks, service marks and tradenames were first used in
interstate commerce in 1984 and have been continuously used thereafter. In
addition, the Company has received 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.
12
EMPLOYEES
At March 15, 2002, the Company had approximately 200 employees, of which 37 were
represented by a labor union. The Company considers its relations with its
employees to be satisfactory. The Company provides typical employee benefits,
including paid vacation, holiday and sick time, a portion of the cost of health
insurance, dental and vision coverage for the employee's family, life insurance,
a 401(k) plan that includes a matching contribution consisting of the Company's
common stock, and the opportunity to take advantage of 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 three months of service
with the Company. Under the 401(k) plan, an employee is allowed to contribute up
to 20% of his total compensation to the plan each pay period, subject to the
annual limit prescribed by the Internal Revenue Code. Effective July 1, 2001,
the Company adopted a matching contribution program, under which the Company
makes a contribution equal to a specified percentage of each employee's
contribution, in the form of common stock of the Company. The matching
contribution percentage, which was 25% for 2001, is set in advance of each
fiscal year by the Company's board of directors, and has been set at 25% for
2002. The Company contributed 33,000 shares of its common stock to the 401(k)
plan for the year ended December 31, 2001. The Company made no contributions to
the plan during the years ended December 31, 2000 and 1999. Employees become
vested in the Company's contributions to the 401(k) plan at the rate of 20% per
year during the first five years of employment with the Company. 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 its 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.
Operating Losses. The Company incurred significant operating losses during each
of the three years ended December 31, 2000. A number of actions have been taken
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
into one location which facilitated a decrease in the number of its employees,
and decreases in various other selling, general and administrative expenses. The
Company's operating results have consistently improved during the two years
ended December 31, 2001, as shown in its quarterly results of operations
included in Note 13 to the accompanying consolidated financial statements. The
Company plans to further improve its profitability through various actions,
including the improvement of various customer service functions, further
streamlining its operations, increasing customer retention, increasing its
volume of new business, and the development of new products. However, there can
be no assurance that the Company will be successful in implementing those
actions or maintaining its profitability.
Stockholder 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 and its officers. On October 6, 2000, the
plaintiffs filed an appeal of the dismissal of the lawsuit, and the dismissal
was overturned on February 22, 2002. The case was remanded back to the District
Court with instructions to allow the plaintiff to file a second amended
complaint. The Company has directors and officers liability insurance and
intends to vigorously defend any second amended complaint that may be filed by
the plaintiff. However, there can be no assurance that the ultimate outcome of
this litigation will not have an adverse effect on the Company's consolidated
financial position or results of operations.
Government Regulation. The dental benefits industry is subject to extensive
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 dental HMO plan or a dental insurance
13
company, including the maintenance of a minimum amount of 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.
Health Insurance Portability and Accountability Act of 1996 ("HIPAA"). HIPAA
imposes various responsibilities on the Company, as described above under
"Government Regulation." The Company is in the process of developing policies
and procedures to comply with these requirements. The total cost of compliance
with HIPAA is not known at this time. There is a risk that the Company will not
be able to successfully implement all of the HIPAA requirements. There is also a
risk that the cost of compliance with HIPAA could have a material 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, the obligation to complete
orthodontic treatments for certain dental HMO patients who previously paid for
the treatments in full. The amount of these liabilities is subject to
uncertainties and 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, 2001.
Contingent Lease Obligations. As of December 31, 2001, the Company is
contingently liable for an aggregate of approximately $4.4 million of office
lease obligations related to the dental and orthodontic practices sold by the
Company. These leases have been assigned to the purchasers of those practices,
but there can be no assurance that the persons and/or entities to which these
office leases were assigned will make the lease payments, and that the Company
will not become liable for those payments.
Payments Due on Promissory Notes. In connection with the sale of certain dental
practices, the dentists who purchased those practices issued long-term
promissory notes secured by the assets purchased. Although payments on these
promissory notes are current at the present time, 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 Company's common stock. The fact that
the Company's common stock is not listed on an exchange 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 maintain its 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 maintain its
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 Maintain Revenue. The Company's total revenue decreased from $97.3
million in 2000 to $84.8 million in 2001, primarily due to the loss of a number
of its customers. 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 maintain its existing business or to
expand its business depends on a number of factors, including existing and
emerging competition, its ability to renew its relationships with existing
customers on an annual basis, 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.
Utilization of Dental Care Services. Under the Company's PPO/indemnity dental
plan designs, the Company assumes the underwriting risk related to the cost and
rate at which dental care services are utilized by subscribers and dependents.
If the Company does not accurately assess these underwriting risks, the premium
rates charged may not be sufficient to cover the cost of the dental services
delivered. This could have a material adverse effect on the Company's operating
results.
14
Under the Company's dental HMO plan designs, the Company also assumes
underwriting risk related to the cost and rate at which specialist services are
utilized by subscribers and dependents, to the cost of supplemental payments
made to general dentists, and to the cost of dental services provided by general
dentists with whom the Company does not have standard capitation arrangements.
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, recession or
terrorist activities 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. The Company has entered into
employment agreements with nine members of senior management, of which eight
agreements expire during 2002.
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, due April 30, 2001. As part of this
transaction, 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 the Company's common stock.
Effective as of January 31, 2001, the Company completed the conversion of this
debt into 300,000 shares of convertible preferred stock. 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 pre-tax gain of $11.3
million, which is net of approximately $350,000 of transaction costs. There was
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 consolidated 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 $30
million liquidation preference over the Company's common stock.
As a result of the conversion transaction, the ownership interest of the
previously existing common stockholders of the Company was reduced to
15
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 represented 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, at which time the Bank sold its interest in the Company to
other existing stockholders. These four new directors constitute a majority of
the board of directors, which currently has a total of seven members.
In 1999, in connection with a restructuring of the senior notes payable, 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 cancelled without being
exercised, in connection with the conversion of the senior notes payable into
convertible preferred stock effective January 31, 2001.
The Company sold all of its general dental practices in 1996 and 1997, and sold
all of its orthodontic practices in 1998. Certain of the general dental
practices and all of the orthodontic practices were sold to a single purchaser
(the "Purchaser"), in exchange for long-term promissory notes. The Purchaser
ultimately defaulted on its obligations to the Company, and in October 2000, the
Company completed a transaction with the Purchaser and another third party (the
"New Purchaser"), in which the practices originally sold to the Purchaser were
sold to 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 dental HMO 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 could have been 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 reflected on the Company's consolidated
balance sheet based on the Company's best estimates, but these amounts are
subject to various uncertainties. See Note 5 to the accompanying consolidated
financial statements for a discussion of impairment charges that were recognized
in 2000 and 1999 in connection with this transaction.
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 unrelated third parties. 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, and for its California
regional office. In addition, the Company leases office space in Walnut Creek,
California; Coral Springs and Tampa, Florida; and Dallas and Houston, Texas. The
Company leased all of the office space used by its previously owned dental and
orthodontic practices. The Company remains contingently liable for 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 arising 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 have a material adverse effect on the
Company's consolidated 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 and its officers. On October 6, 2000, the plaintiffs filed an appeal of
the dismissal of the lawsuit, and the dismissal was overturned on February 22,
2002. The case was remanded back to the District Court with instructions to
allow the plaintiff to file a second amended complaint. The Company has
directors and officers liability insurance and intends to vigorously defend any
second amended complaint that may be filed by the plaintiff. In the opinion of
16
management, the ultimate outcome of this matter will not have a material adverse
effect on the Company's consolidated financial position or results of
operations, although there can be no assurance that this will be the case.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- ---------------------------------------------------------------------
None.
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. 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, 2002:
First Quarter, through March 15, 2002. $ 1.95 $ 1.19
Year ended December 31, 2001:
First Quarter. . . . . . . . . . . . . $ 2.75 $ 0.88
Second Quarter . . . . . . . . . . . . 1.80 1.25
Third Quarter. . . . . . . . . . . . . 2.00 1.15
Fourth Quarter . . . . . . . . . . . . 2.40 1.17
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
(b) HOLDERS
As of March 15, 2002, there were approximately 500 holders of the Company's
common stock, including approximately 400 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 Rights
become exercisable upon the occurrence of certain defined events related to a
possible change of control of the Company. 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. The Rights Agreement may be amended by the Company's board of
directors without the approval of the Rights holders, at any time prior to the
Rights becoming exercisable. The Rights Agreement was amended in March 2000 to
specify that the recapitalization transaction initiated in March 2000 would not
cause the Rights to become exercisable.
17
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 consolidated 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 2001 2000 1999 1998 1997
-------- --------- --------- --------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA):
Premium revenue, net $84,822 $ 97,251 $ 96,225 $ 97,449 $95,350
Health care services expense 58,692 68,568 69,528 66,020 65,702
Selling, general and administrative expense 25,391 31,203 35,072 36,259 25,103
Loss on impairment of assets (1) -- 450 24,576 2,397 --
-------- --------- --------- --------- --------
Operating income (loss) 739 (2,970) (32,951) (7,227) 4,545
Investment and other income 1,060 1,431 2,067 624 1,316
Interest expense (504) (4,913) (5,855) (4,311) (2,871)
-------- --------- --------- --------- --------
Income (loss) before income taxes, discontinued
operations and extraordinary item 1,295 (6,452) (36,739) (10,914) 2,990
Income tax expense (benefit) (2) -- -- 10,934 (3,406) 1,371
-------- --------- --------- --------- --------
Income (loss) before discontinued
operations and extraordinary item 1,295 (6,452) (47,673) (7,508) 1,619
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)
Gain on sale of general dental practices -- -- -- -- 296
Extraordinary item: Conversion of
debt to convertible preferred stock (5) 11,251 -- -- -- --
-------- --------- --------- --------- --------
Net income (loss) $12,546 $ (8,952) $(52,036) $ (9,938) $(5,493)
======== ========= ========= ========= ========
Basic net income (loss) per share:
Income (loss) before discontinued
operations and extraordinary item $ 0.04 $ (1.36) $ (10.04) $ (1.58) $ 0.34
Loss from discontinued operations -- (0.53) (0.92) (0.51) (1.50)
Extraordinary item 0.35 -- -- -- --
-------- --------- --------- --------- --------
Net income (loss) per basic share $ 0.39 $ (1.89) $ (10.96) $ (2.09) $ (1.16)
======== ========= ========= ========= ========
Weighted average basic shares outstanding (6) 32,253 4,747 4,747 4,747 4,723
Diluted net income (loss) per share:
Income (loss) before discontinued
operations and extraordinary item $ 0.04 $ (1.36) $ (10.04) $ (1.58) $ 0.33
Loss from discontinued operations -- (0.53) (0.92) (0.51) (1.45)
Extraordinary item 0.34 -- -- -- --
-------- --------- --------- --------- --------
Net income (loss) per diluted share $ 0.38 $ (1.89) $ (10.96) $ (2.09) $ (1.12)
======== ========= ========= ========= ========
Weighted average diluted shares outstanding 33,009 4,747 4,747 4,747 4,899
BALANCE SHEET DATA, AS OF DECEMBER 31 (IN THOUSANDS):
Cash and short-term investments $15,453 $ 16,702 $ 6,281 $ 4,935 $12,906
Current assets 19,195 21,268 10,380 13,411 25,800
Total assets 29,325 33,095 28,577 78,749 84,085
Current liabilities (5) 14,988 72,180 18,129 25,314 20,193
Long-term debt -- 265 39,545 32,500 33,894
Stockholders' equity (deficit) 13,366 (40,429) (31,614) 19,766 29,615
See note explanations on the following page.
18
NOTE EXPLANATIONS TO SELECTED FINANCIAL DATA:
(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 the net assets related to
the dental practices sold to the Purchaser 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) Effective January 31, 2001, the Company completed the conversion of $47.5
million of debt and $5.3 million of accrued interest (which includes
$321,000 of interest incurred in January 2001) into 300,000 shares of
convertible preferred stock, resulting in an extraordinary gain of $11.3
million, net of transaction expenses.
(6) Includes the common share equivalents of the convertible preferred stock,
because the Company believes the convertible preferred stock is essentially
equivalent to common stock, based on all the rights and preferences of both
types of stock.
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 information in the "Risk Factors"
section of Item 1 of this Form 10-K should be read in conjunction with this
Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A").
The statements contained in this MD&A 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.
All of the risks set forth in the "Risk Factors" section of this Form 10-K 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 revenue, premium rates, benefit 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 for the Company.
SIGNIFICANT ACCOUNTING POLICIES
The Company's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America.
Application of those accounting principles includes the use of estimates and
assumptions that have been made by the management, and which the Company
believes are reasonable based on the information available. These estimates and
assumptions affect the reported amounts of assets, liabilities, revenues and
expenses in the accompanying consolidated financial statements. The Company
believes the most significant accounting policies used to prepare the
accompanying consolidated financial statements are the following:
19
INVESTMENTS
The Company has classified all of its investments as "available-for-sale."
Accordingly, investments 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. In the event there was
an unrealized loss on an investment that the Company believed to be a permanent
loss, the loss would be reported in the statement of operations, instead of in a
separate caption of stockholders' equity. As of December 31, 2001, there were no
unrealized losses that the Company believed to be permanent losses.
ACCOUNTS RECEIVABLE
Accounts receivable represent uncollected premiums related to coverage periods
prior to the balance sheet date, and are stated at the estimated collectible
amounts, net of an allowance for bad debts. The Company continuously monitors
the timing and amount of its premium collections, and maintains a reserve for
estimated bad debt losses. The amount of the reserve is based primarily on the
Company's historical experience and any customer-specific collection issues that
are identified. The Company believes its reserve for bad debt losses is adequate
as of December 31, 2001. However, there can be no assurance that future bad debt
losses will not exceed the currently estimated bad debt losses or those
experienced by the Company in the past.
NOTES RECEIVABLE
Notes receivable are stated at the estimated collectible amounts, net of an
allowance for bad debts. The Company continuously monitors its collection of
payments on the notes receivable, and maintains a reserve for estimated bad debt
losses. The amount of the reserve is based primarily on the Company's historical
experience in collecting similar notes receivable that are no longer
outstanding, and any available information about the financial condition of the
note issuers, although the Company has access to very little such information.
The Company believes its reserve for bad debt losses is adequate as of December
31, 2001. However, there can be no assurance that the Company will realize the
carrying amount of its notes receivable.
INTANGIBLE ASSETS
Intangible assets at December 31, 2001 consist entirely of goodwill related to
the acquisition of a Texas-based dental HMO company in 1996. This goodwill
represents the excess of the purchase price of the acquired company over the
fair value of the net assets acquired. The Company estimates that this goodwill
has a useful life of 40 years from the date of acquisition of the related
entity, and amortized the goodwill over that period during the three years ended
December 31, 2001. In accordance with SFAS No. 142, "Goodwill and Other
Intangible Assets," the Company's goodwill will not be amortized after December
31, 2001, but will be evaluated for possible impairment on an ongoing basis. See
Note 5 to the accompanying consolidated financial statements for the Company's
policy for assessing recoverability of goodwill and a discussion of a charge to
earnings during 1999 for impairment of goodwill.
LIABILITIES RELATED TO SALE OF DENTAL OFFICES
The Company completed the sale of its interest in certain dental and orthodontic
practices in October 2000, as described in Note 2 to the accompanying
consolidated financial statements. In connection with this transaction, 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
dental HMO patients who previously paid for the treatments in full. These
obligations had to be paid in order to complete the transaction, were
obligations of the Company as the member's dental HMO plan, or were obligations
for which the Company could have been contingently liable in any event. As of
December 31, 2001, the Company has satisfied a substantial portion of the
obligations described above. However, the ultimate cost of the obligations
assumed by the Company are subject to various uncertainties, and are reflected
on the accompanying consolidated balance sheet based on the Company's best
estimates.
20
CLAIMS PAYABLE AND CLAIMS INCURRED BUT NOT REPORTED
The estimated liability for claims payable and 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 paid by the Company, as well as the
recent trend in the aggregate amount of incurred claims per covered individual.
Since the liability for claims payable and claims incurred but not reported is
necessarily an actuarial estimate, the amount of claims eventually paid for
services provided prior to the balance sheet date could differ from the
estimated liability, which could have a material adverse effect on the Company's
financial statements. Any such differences are included in the consolidated
statement of operations for the period in which the differences are identified.
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.
The Company's net deferred tax assets have been fully reserved since September
30, 1999, due to uncertainty about whether those net assets will be realized in
the future. The uncertainty is primarily due to operating losses incurred by the
Company during each of the three years ended December 31, 2000, and the
existence of significant net operating loss carryforwards. The Company's
deferred tax assets remain fully reserved as of December 31, 2001 for the same
reasons.
The Company had a net loss for tax purposes for the year ended December 31,
2001, and its net deferred tax assets remain fully reserved, as discussed above.
Accordingly, the Company recorded no income tax expense for the year ended
December 31, 2001.
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, including the common shares into which the
convertible preferred stock is convertible, but excluding the effect of other
potentially dilutive securities. The number of basic common shares outstanding
includes the common share equivalents of the convertible preferred stock,
because the Company believes the convertible preferred stock is essentially
equivalent to common stock, based on all the rights and preferences of both
types of stock.
21
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,
-----------------------
2001 2000 1999
------ ------ -------
Premium revenue, net 100.0% 100.0% 100.0%
Health care services expense 69.2 70.5 72.3
Selling, general and administrative expense 29.9 32.1 36.4
Loss on impairment of assets -- 0.5 25.5
------ ------ -------
Operating income (loss) 0.9 (3.1) (34.2)
Investment and other income 1.2 1.5 2.1
Interest expense (0.6) (5.0) (6.1)
------ ------ -------
Income (loss) before income taxes, discontinued
operations and extraordinary item 1.5 (6.6) (38.2)
Income tax expense (benefit) -- -- 11.4
------ ------ -------
Income (loss) before discontinued
operations and extraordinary item 1.5 (6.6) (49.6)
Loss from discontinued operations -- (2.6) (4.5)
Extraordinary item 13.3 -- --
------ ------ -------
Net income (loss) 14.8% (9.2)% (54.1)%
====== ====== =======
2001 COMPARED TO 2000
Premium revenue decreased by $12.4 million, or 12.8%, from $97.3 million in 2000
to $84.8 million in 2001. The average membership for which the Company provided
dental coverage decreased by approximately 190,000 members, or 23.6%, from
805,000 members during 2000 to 615,000 during 2001. The decrease in the average
number of members is primarily due to the loss of a number of customers during
2000 and at the beginning of 2001. The Company believes the loss of these
customers was primarily due to the Company's poor financial condition in late
1999 and early 2000, large premium increases necessary for clients with high
loss ratios, and customer service problems during 1999 and 2000. The Company
believes it significantly improved its financial condition by completing the
recapitalization transaction that was initiated in March 2000 (see Liquidity and
Capital Resources below), and by implementing various cost reduction strategies
during 2000 and 2001. The Company also implemented various operational
improvements during 2000 and 2001, which it believes addressed and improved
customer service. As a result, the Company believes its financial condition and
level of customer service are no longer significant factors in its ability to
retain its existing customers or to generate new customers. Premium revenue
decreased by only 12.8% even though average membership decreased by 23.6%. This
was primarily due to increases in premium rates, and a shift in the type of plan
designs toward preferred provider ("PPO")/indemnity plan designs, which have
higher premium rates than HMO plan designs. Substantially all of the Company's
premium revenue was derived from dental benefit plans in 2001 and 2000. Premium
revenue from vision benefit plans and other products was not material in 2001 or
2000.
Health care services expense decreased by $9.9 million, or 14.4%, from $68.6
million in 2000 to $58.7 million in 2001. Health care services expense as a
percentage of premium revenue (the "loss ratio") decreased from 70.5% in 2000 to
69.2% in 2001. This decrease is primarily due to an increase in premium rates,
and a reduction in certain types of non-standard payment arrangements to dental
HMO providers. Those non-standard payment arrangements consisted primarily of
discounted fee-for-service arrangements for dental services that are typically
delivered through capitation arrangements, and minimum monthly capitation
payments, regardless of the number of members enrolled with the provider. The
Company reduced its expenses related to these non-standard arrangements by
either negotiating a different arrangement with the providers, or terminating
the arrangements and contracting with other providers. These factors were
22
partially offset by a shift in the type of plan designs toward PPO/indemnity
plan designs, which have a higher loss ratio than HMO plan designs. However,
PPO/indemnity plan designs 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 HMO plan designs, as a percentage of premium revenue.
Selling, general and administrative ("SG&A") expenses decreased by $5.8 million,
or 18.6%, from $31.2 million in 2000 to $25.4 million in 2001. SG&A expenses as
a percentage of premium revenue decreased from 32.1% in 2000 to 29.9% in 2001.
The decrease in SG&A expenses as a percentage of premium revenue is due to cost
reductions implemented in several categories, including equipment rent,
depreciation expense, telecommunications, property rent, and others. A portion
of the decrease in SG&A expenses is due to decreases in broker commissions,
internal commissions, and premium taxes, which are all related to the 12.8%
decrease in premium revenue in 2001.
Loss on impairment of assets decreased from $450,000 in 2000 to zero in 2001.
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 consolidated
financial statements.
Investment and other income decreased by $0.4 million, or 25.9%, from $1.4
million in 2000 to $1.1 million in 2001. This decrease is primarily due to a
decrease in interest income from notes receivable, due to the liquidation of a
majority of the Company's notes receivable during the past year, and a decrease
in interest rates on fixed income investments. These factors were partially
offset by realized gains on the sale of investments in the first quarter of
2001.
Total interest expense decreased by $4.4 million, or 89.7%, from $4.9 million in
2000 to $0.5 million in 2001. This decrease is primarily due to the
recapitalization transaction that was completed effective January 31, 2001,
which converted substantially all of the Company's debt to convertible preferred
stock. See Note 7 to the accompanying consolidated financial statements for more
information on this transaction.
The income (loss) before income taxes, discontinued operations and extraordinary
item improved from a loss of $6.5 million, or 6.6% of premium revenue, in 2000,
to income of $1.3 million, or 1.5% of premium revenue, in 2001. This improvement
was primarily due to a $4.4 million decrease in interest expense, a $5.8 million
decrease in SG&A expenses, and a decrease in the loss ratio from 70.5% in 2000
to 69.2% in 2001, which is equal to a $1.1 million decrease in health care
services expense.
There was no income tax expense in 2001, and no income tax benefit in 2000. The
Company had no current income tax expense in 2001 due to temporary differences
between income before income taxes for accounting purposes and taxable income
for tax purposes, which resulted in a net loss for tax purposes. There was also
no deferred income tax expense or benefit in 2001, due to the valuation
allowance against the Company's net deferred tax assets, as discussed in Note 9
to the accompanying consolidated financial statements. There was no income tax
benefit in 2000 because the Company had previously used its loss carryback
opportunities, and because of the valuation allowance against its net deferred
tax assets.
The loss from discontinued operations decreased from $2.5 million in 2000 to
zero in 2001. The loss in 2000 represents a reduction in the carrying value of
the net assets related to certain dental and orthodontic practices, which the
Company originally sold to an unrelated party in 1997 and 1998. These assets
were resold to another unrelated party in October 2000, as discussed in Note 2
to the accompanying consolidated financial statements.
There was an $11.3 million extraordinary gain on the conversion of the Company's
debt to convertible preferred stock in 2001. See Note 7 to the accompanying
consolidated financial statements for more discussion of the extraordinary gain.
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 increases in premium rates, and a shift in the
23
type of plan designs toward PPO/indemnity plan designs, which have higher
premium rates than HMO plan designs, and HMO plan designs with higher benefit
levels and higher premium rates. Substantially all of the Company's premium
revenue was derived from dental benefit plans in 2000 and 1999. Premium revenue
from vision benefit plans and other products was not material in 2000 or 1999.
Health care services expense decreased by $0.9 million, or 1.4%, from $69.5
million in 1999 to $68.6 million in 2000. The loss ratio decreased from 72.3% in
1999 to 70.5% in 2000. This decrease is primarily due to a decrease in the loss
ratio in the dental benefit plans with HMO plan designs, which is primarily due
to a reduction in certain types of non-standard payment arrangements to dental
HMO providers during the first quarter of 2000. The decrease in the loss ratio
related to HMO plan designs was partially offset by a shift in the type of plan
designs toward PPO/indemnity plan designs, which have a higher loss ratio than
HMO plan designs. However, PPO/indemnity plan designs 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 HMO plan designs, as a percentage of premium
revenue.
SG&A expenses decreased by $3.9 million, or 11.0%, from $35.1 million in 1999 to
$31.2 million in 2000. SG&A expenses as a percentage of premium revenue
decreased from 36.4% in 1999 to 32.1% 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 a Texas-based dental HMO company in 1996, and the acquisition of
a Florida-based dental HMO company 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 consolidated 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
consolidated 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 consolidated 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 $3.9 million decrease in SG&A
expenses, and a decrease in the loss ratio from 72.3% in 1999 to 70.5% in 2000,
which is equal to a $1.8 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
24
existence of significant net operating loss carry-forwards. See Note 9 to the
accompanying consolidated financial statements for more information.
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 dental and orthodontic
practices, which the Company originally sold to an unrelated party in 1997 and
1998. These assets were resold to another unrelated party in October 2000, as
discussed in Note 2 to the accompanying consolidated financial statements.
LIQUIDITY AND CAPITAL RESOURCES
The Company's net working capital improved from negative $50.9 million as of
December 31, 2000, to positive $4.2 million as of December 31, 2001, primarily
due to the conversion of $52.5 million of debt and accrued interest into
convertible preferred stock, as discussed below. Excluding the obligations that
were converted to equity, the Company's net working capital increased from $1.6
million as of December 31, 2000, to $4.2 million as of December 31, 2001. This
improvement is primarily due to $3.1 million of income before depreciation and
amortization, and before the extraordinary item, during the year ended December
31, 2001.
Net cash used by operating activities was $1.4 million in 2001, which was the
result of $3.5 million of net cash provided by net income, as adjusted for
non-cash items, as reflected on the accompanying consolidated statement of cash
flows, which was partially offset by net cash used to reduce certain
liabilities. In contrast, net cash used by operating activities in 2000 was also
$1.4 million, but this was the result of $2.6 million of net cash used by the
net loss in 2000, as adjusted for non-cash items, as reflected on the
accompanying consolidated statement of cash flows, which was partially offset by
net cash provided by increases in certain liabilities. The $3.5 million of net
cash provided by net income in 2001 was more than offset by $2.0 million of net
cash used to reduce accrued expenses, $1.6 million used to reduce claims payable
and claims incurred but not reported ("IBNR"), and $0.8 million used to reduce
accounts payable. The significant improvement in the Company's operating results
is discussed above under Results of Operations.
The reduction in accrued expenses in 2001 was primarily due to payments made to
reduce the obligations assumed in connection with the re-sale of certain dental
practices, as discussed in Note 2 to the accompanying consolidated financial
statements. The reduction was also partially due to decreases in accrued premium
taxes, accrued provider fees, and accruals for outside services, all of which
are due to normal variations in the timing of payments. The reduction in claims
payable and claims IBNR during 2001 was primarily due to a decrease in the
Company's enrollment. The reduction in accounts payable in 2001 was primarily
due to normal variations in the timing of disbursements by the Company.
Net cash provided by investing activities was $1.5 million during 2001, compared
to $10.1 million of net cash used by investing activities in 2000. The net cash
provided in 2001 consisted primarily of the proceeds from $1.3 million of
payments received on notes receivable, which resulted from the Company's
liquidation of its notes receivable in order to reduce collection risks. 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. There was no significant cash
provided by financing activities in 2001, compared to $11.3 million provided in
2000. 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 short-term and long-term debt decreased from $48.0 million
at December 31, 2000, to $265,000 at December 31, 2001, primarily due to the
conversion of $47.5 million of debt into convertible preferred stock effective
January 31, 2001. See Note 7 to the accompanying consolidated financial
statements for information on the conversion of substantially all of the
Company's debt into convertible preferred stock.
25
A summary of the Company's future commitments is as follows (in thousands):
DUE IN DUE IN DUE 2004 DUE
2002 2003 TO 2006 THEREAFTER TOTAL
------- ------- --------- ----------- -------
CONTRACTUAL OBLIGATIONS:
Debt $ 265 $ -- $ -- $ -- $ 265
Other long-term liabilities -- 199 592 180 971
Operating lease commitments, net 2,552 2,025 5,679 3,064 13,320
------- ------- --------- ----------- -------
Total contractual obligations $ 2,817 $ 2,224 $ 6,271 $ 3,244 $14,556
======= ======= ========= =========== =======
OTHER COMMITMENTS:
Contingent liability for dental office
leases assigned to other entities $ 1,418 $ 1,280 $ 1,679 $ 24 $ 4,401
Contingent liability for subleased
office space 278 130 43 -- 451
------- ------- --------- ----------- -------
Total other commitments $ 1,696 $ 1,410 $ 1,722 $ 24 $ 4,852
======= ======= ========= =========== =======
If the entities to which the dental office leases have been assigned fail to
make a significant amount of the lease payments, this could have a material
adverse affect on the Company. See Note 8 to the accompanying consolidated
financial statements for more information on other long-term liabilities, and
see Note 10 for more information on operating lease commitments and contingent
lease obligations.
The Company's primary source of funds is cash flows from operations and
investment income. The Company believes that cash flows from operations and
investment income will be adequate to meet the Company's cash requirements for
at least the next twelve months, except for financing that may be required to
complete potential acquisitions. The Company does not expect any significant
changes in its cash requirements in the foreseeable future, except in connection
with potential acquisitions. 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 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
See Note 1 to the accompanying consolidated financial statements for a
discussion of recent accounting pronouncements.
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 35% of total health care services
expense consists of capitation (fixed) 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 subject to risk related to changes in short-term interest rates,
due to its investments in interest-bearing securities. As of December 31, 2001,
the Company's total investments were approximately $16.8 million. Therefore, a
one percentage-point change in short-term interest rates would have a $168,000
impact on the Company's annual investment income. The Company is not subject to
a material amount of risk related to changes in foreign currency exchange rates.
26
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
- ---------------------------------------------------------
The Consolidated Financial Statements and the related Notes and Schedules
thereto filed as part of this 2001 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.
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 65 President, Chief Executive Officer and Director
Stephen J. Baker 44 Executive Vice President and Chief Operating Officer
Ronald I. Brendzel, JD 52 Senior Vice President, General Counsel, Secretary and Director
Dennis L. Gates, CPA 46 Senior Vice President, Chief Financial Officer and Director
Kenneth E. Keating 38 Vice President, Marketing and Chief Marketing Officer
Barbara Lucci 42 Vice President, Service Center Operations
John F. Steen 47 Vice President, Development and Chief Development Officer
Mik L. Summers 43 Vice President, Information Services and Chief Information Officer
Michael B. Sutherland, DDS 55 Vice President, Provider Relations and Dental Director
Steven J. Baileys, DDS 48 Chairman of the Board of Directors
Jack R. Anderson 77 Director (1)
Stephen J. Blewitt 42 Director (1)
Leslie B. Daniels 54 Director (1)
___________________
(1) Member, 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 was
initiated on March 1, 2000 (see Recent 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 certain executive officers.
Mr. Buncher has been President and Chief Executive Officer, 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. Baker has been Executive Vice President and Chief Operating Officer since
April 2001, when he joined the Company. Prior to joining the Company, he was a
consultant to the senior management of the Company from September 2000 to March
2001. Mr. Baker was Vice President, Chief Operating Officer and Chief
27
Information Officer for Novaeon, Inc., a national health and disability
management company, from September 1999 to August 2000. He was an independent
management consultant from September 1997 to August 1999. Mr. Baker was Vice
President, Developing Businesses for Community Care Network, Inc., a group
health and workers' compensation managed care company from January 1997 to
August 1997.
Mr. Brendzel has been Senior Vice President, General Counsel, Secretary and a
director of the Company since 1989. He joined the Company in 1978 and was Chief
Financial Officer from April 1988 to May 1996. Mr. Brendzel is licensed to
practice law in the state of California. Mr. Brendzel is the brother-in-law of
Dr. Baileys.
Mr. Gates has been Senior Vice President and Chief Financial Officer since
November 1999, when he joined the Company, and has been a director of the
Company since March 2000. From June 1995 to February 1999, he was Chief
Financial Officer, then Treasurer, of Sheridan Healthcare, Inc., a physician
practice management company.
Mr. Keating has been Vice President, Marketing and Chief Marketing Officer since
May 2001, and was Vice President, Sales and Marketing from February 2000 to May
2001. He was Western Regional Vice President of the Company from October 1997
to February 2000. He joined the Company in 1995 and was Vice President-Imprimis
and Guards Office Operations for the Company from October 1995 until October
1997.
Ms. Lucci has been Vice President, Service Center Operations since June 2001,
and was Vice President, Corporate Services from February 2000 to May 2001. She
joined the Company in 1994 and served as Director of Corporate Services and
Human Resources from January 1996 to February 2000.
Mr. Steen has been Vice President, Development and Chief Development Officer
since May 2001, and was Vice President, Development and Provider Relations from
November 2000, when he joined the Company, to May 2001. 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. Summers has been Vice President, Information Services since May 2001, and
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.
Dr. Sutherland has been Vice President, Provider Relations since July 2001, and
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. Dr. Sutherland is licensed to
practice dentistry in the state of California.
Dr. Baileys has been Chairman of the Board of Directors since September 1995. He
joined the Company in 1975 and served as President of the Company from 1981 to
March 1997, and Chief Executive Officer from May 1995 to February 2000. Dr.
Baileys is licensed to practice dentistry in the state of California. Dr.
Baileys currently serves on the board of directors of SunLink Health Systems,
Inc.
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.
Mr. Blewitt is a Senior 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 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 is
currently a director of John Hancock Capital Growth Management, Inc., Learning
Curve International, NSP Holdings L.L.C., 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 is currently a director of Pharmakinetics
28
Laboratories, Inc. and Mylan Laboratories, Inc. He was a past Chairman of Zenith
Laboratories, Inc. and has been a director of several other public and private
companies.
ITEM 11. EXECUTIVE COMPENSATION
- ----------------------------------
The following table shows the compensation paid to the Company's Chief Executive
Officer as of December 31, 2001, and the other four most highly compensated
executive officers as of December 31, 2001 who received total compensation in
excess of $100,000 during the year ended December 31, 2001 (the "Named Executive
Officers"). The compensation disclosed is for the three years ended December 31,
2001.
LONG-TERM
COMPENSATION
AWARDS
ANNUAL COMPENSATION -------------
---------------------- OTHER COM- STOCK OPTIONS
NAME PRINCIPAL POSITION YEAR SALARY BONUS PENSATION(1) GRANTED
- ------------------ ------------------------- ---- -------- ------ ------------- -------------
James E. Buncher President and Chief 2001 $246,000 $ -- $ 928 100,000
Executive Officer (2) 2000 187,500 -- -- 600,000
1999 -- -- -- --
Stephen J. Baker Executive Vice President 2001 152,000 -- -- 300,000
and Chief Operating 2000 -- -- -- --
Officer (3) 1999 -- -- -- --
Dennis L. Gates Senior Vice President 2001 197,000 -- -- --
and Chief Financial 2000 203,750 -- -- 375,000
Officer (4) 1999 34,833 -- -- 50,000
Ronald I. Brendzel Senior Vice President, 2001 193,000 -- -- --
General Counsel and 2000 185,000 -- -- 120,000
Secretary 1999 185,000 -- 900 --
Kenneth E. Keating Vice President, 2001 180,000 -- 938 --
Marketing and Chief 2000 170,654 -- -- 120,000
Marketing Officer (5) 1999 150,000 -- -- --
________________________________
(1) Other compensation consists of matching contributions to the Company's
401(k) plan in 2001, and life insurance premiums in 1999.
(2) Mr. Buncher joined the Company as President and Chief Executive Officer in
March 2000.
(3) Mr. Baker joined the Company as Executive Vice President and Chief
Operating Officer in April 2001.
(4) Mr. Gates joined the Company as Senior Vice President and Chief Financial
Officer in November 1999.
(5) Mr. Keating became Vice President, Marketing and Chief Marketing Officer in
May 2001. He was Vice President, Sales and Marketing from February 2000 to
May 2001, and was Western Regional Vice President prior to February 2000.
The Company has employment agreements with Messrs. Buncher, Baker, Gates,
Brendzel, and Keating, all of which expire on June 30, 2002, except for the
agreement with Mr. Baker, which expires on April 30, 2004. The current annual
salaries of each of these executives are $250,000, $220,000, $200,000, $185,000,
and $180,000, 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 annual salary then in
effect.
29
STOCK OPTION GRANTS DURING THE YEAR ENDED DECEMBER 31, 2001
Stock options granted to the Named Executive Officers during the year ended
December 31, 2001 were as follows.
INDIVIDUAL STOCK OPTION GRANTS POTENTIAL REALIZABLE VALUE
- ---------------------------------------------------------------------- AT ASSUMED ANNUAL RATES
NUMBER OF % OF TOTAL OF STOCK
SHARES OPTIONS PRICE APPRECIATION
UNDERLYIN GRANTED TO EXERCISE FOR OPTION TERM (3)
OPTIONS EMPLOYEES PRICE PER EXPIRATION -----------------------
NAME GRANTED IN 2001 SHARE(1) DATE(2) 5% 10%
- ------------------ ---------- ----------- ----------- ------------ ------------ ---------
James E. Buncher 100,000 12.4% $ 1.20 August 2010 $ 75,467 $191,249
Stephen J. Baker 250,000 31.1% 1.25 April 2010 196,530 498,045
Stephen J. Baker 50,000 6.2% 1.20 August 2010 37,734 95,625
Dennis L. Gates -- -- -- -- -- --
Ronald I. Brendzel -- -- -- -- -- --
Kenneth E. Keating -- -- -- -- -- --
______________________
(1) The exercise price per share of each of the options is equal to or greater
than the market price of the Company's common stock on the date of the
grant. Subject to the terms of each option agreement, the exercise price
may be paid in cash or in shares of common stock owned by the option
holder, or by a combination of the foregoing.
(2) Each of the options becomes 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 the option holder's
employment is terminated.
(3) There is no assurance that the actual stock appreciation over the 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, 2001. Stock options held by the Named
Executive Officers at December 31, 2001 are shown in the following table. There
were no stock appreciation rights outstanding as of December 31, 2001.
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 -- $ -- 233,333 466,667 $ 198,333 $ 376,667
Stephen J. Baker -- -- -- 300,000 -- 182,500
Dennis L. Gates -- -- 158,333 216,667 134,583 184,167
Ronald I. Brendzel -- -- 40,000 80,000 34,000 68,000
Kenneth E. Keating -- -- 40,000 80,000 34,000 68,000
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, 2002, 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 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
30
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. The total number of shares of common
stock outstanding as of March 15, 2002 was 4,820,832 and the total number of
shares of preferred stock outstanding as of that date was 300,000, which is
convertible into 30,000,000 shares of common stock. The following table includes
the common share equivalents of the convertible preferred stock, because the
Company believes the convertible preferred stock is essentially equivalent to
common stock, based on all the rights and preferences of both types of stock.
NUMBER OF SHARES
BENEFICIALLY % OF TOTAL SHARES
OFFICER OR DIRECTOR OWNED(1) OUTSTANDING(2)
- ------------------------------------------------------------------- ----------------- -----------------
John Hancock Life Insurance Company (3) 15,000,000 43.1
CAI Capital Partners & Company II, Limited Partnership (4) 8,514,579 24.5
Leslie B. Daniels (5) 84,500 *
Jack R. Anderson (6) 3,210,615 9.2
Steven J. Baileys (7) 2,711,267 7.8
The Burton Partnership (8) 2,199,185 6.3
James E. Buncher (9) 725,667 2.1
Dennis L. Gates (10) 416,667 1.2
Ronald I. Brendzel (11) 310,673 *
Stephen J. Baker (12) 104,533 *
Kenneth E. Keating (13) 86,000 *
Stephen J. Blewitt (3) -- *
All directors and Named Executive Officers as a group (9 persons) 31,080,001 86.7
All principal stockholders in total 33,279,186 92.8
* 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, 2002. 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 shown, the total shares
outstanding includes the shares of common stock into which all outstanding
shares of convertible preferred stock are 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, 2002. 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 84,500 shares of common stock owned directly by Mr. Daniels,
2,780,786 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.
31
(5) Represents 84,500 shares of common stock owned directly by Mr. Daniels.
Does not include 2,780,786 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 226,000 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, Suite 100,
Aliso Viejo, California 92656.
(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 59,000 shares of common stock, 200,000 shares issuable upon
conversion of shares of convertible preferred stock, and options to
purchase 466,667 shares of common stock.
(10) Includes 100,000 shares issuable upon conversion of shares of convertible
preferred stock, and options to purchase 316,667 shares of common stock.
(11) Includes 130,673 shares of common stock, 100,000 shares issuable upon
conversion of shares of convertible preferred stock, and options to
purchase 80,000 shares of common stock.
(12) Includes 21,200 shares of common stock and options to purchase 83,333
shares of common stock.
(13) Includes 6,000 shares of common stock and options to purchase 80,000 shares
of common stock.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
- -------------------------------------------------------------
The Company paid $200,000 and $117,000 of consulting fees to the chairman of its
board of directors during the years ended December 31, 2001 and 2000,
respectively. In addition, please see the discussion of the Company's
recapitalization transaction under "Recent Developments" in Part I, Item 1 of
this Form 10-K.
32
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 2001 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 2001 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
None.
33
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 28, 2002
------------------------------- ---------------------
James E. Buncher
President, Chief Executive Officer and Director
(Principal Executive Officer)
By: /s/ Dennis L. Gates Date: March 28, 2002
------------------------------- ---------------------
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 28, 2002
------------------------------- ---------------------
James E. Buncher
President, Chief Executive Officer and Director
By: /s/ Steven J. Baileys Date: March 28, 2002
------------------------------- ---------------------
Steven J. Baileys, DDS
Chairman of the Board of Directors
By: /s/ Ronald I. Brendzel Date: March 28, 2002
------------------------------- ---------------------
Ronald I. Brendzel, JD
Senior Vice President, General Counsel, Secretary and Director
By: /s/ Dennis L. Gates Date: March 28, 2002
------------------------------- ---------------------
Dennis L. Gates
Senior Vice President, Chief Financial Officer and Director
By: /s/ Jack R. Anderson Date: March 28, 2002
------------------------------- ---------------------
Jack R. Anderson
Director
By: /s/ Stephen J. Blewitt Date: March 28, 2002
------------------------------- ---------------------
Stephen J. Blewitt
Director
By: /s/ Leslie B. Daniels Date: March 28, 2002
------------------------------- ---------------------
Leslie B. Daniels
Director
34
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------ ----------------------------------------------------------------------
2.1 Plans of Acquisition (5)
3.1 Articles of Incorporation (3)
3.1.1 Amended and Restated Certificate of Incorporation (11)
3.1.2 Certificate of Designation of Preferred Stock (11)
3.2 Amended and Restated Bylaws
10.1 1984 Stock Option Plan (2)
10.2 Stock Option Plan Amendment (1)
10.3 Stock Option Plan Amendment (3)
10.4 Stock Option Plan Amendment (4)
10.5 2000 Stock Option Plan Amendment (12)
10.6 Form of Employment Agreement between the Company and the Named
Executive Officers (12)
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
(5)
10.8 Default Forbearance Agreement and Irrevocable Power of Attorney (6)
10.9 First Waiver and Amendment to Note Purchase Agreement (7)
10.10 Amended and Restated Loan and Security Agreement (7)
10.11 Debenture and Note Purchase Agreement (8)
10.12 Stockholder Agreement (8)
10.13 First Amendment to Debenture and Note Purchase Agreement (9)
10.14 Second Amendment to Debenture and Note Purchase Agreement (9)
10.15 Term Sheet Agreement dated as of March 1, 2000 (10)
10.16 Loan Document and Purchase Agreement (11)
10.17 Agreement among Stockholders and the Company (11)
10.18 Registration Rights Agreement between certain Stockholders and the
Company (11)
10.19 Consulting Agreement between the Company and Steven J. Baileys (12)
10.20 Asset Purchase Agreement between the Company and Total Dental
Administrators Health Plan, Inc.
10.21 Administrative Services Agreement between the Company and Total
Dental Administrators Health Plan, Inc.
10.22 Stock Purchase Agreement between the Company and Total Dental
Administrators, Inc.
10.23 Promissory Note and Security Interest given by Total Dental
Administrators, Inc. to the Company
10.24 Administrative Services Agreement between the Company and Total
Dental Administrators, Inc.
10.25 Stock Purchase Agreement between the Company and Dental Source of
Missouri and Kansas, Inc.
10.26 First Amendment to Stock Purchase Agreement between the Company and
Dental Source of Missouri and Kansas, Inc.
10.27 Administrative Services Agreement between the Company and Dental
Source of Missouri and Kansas, Inc.
10.28 Amended and Restated 401(k) Plan
10.29 First Amendment to Amended and Restated 401(k) Plan
21.1 Subsidiaries of the Company
23.1 Independent Auditors' 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,
1989.
(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,
1992.
E-1
(5) 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.
(6) 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.
(7) 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.
(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 30, 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 October 5, 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 March 16, 2000.
(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 6, 2001.
(12) 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,
2000.
E-2
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED 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-25
Financial Statement Schedule:
Schedule II - Valuation and Qualifying Accounts. . . . . . . . . F-26
F-1
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders 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, 2001 and
2000, 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, 2001. Our audits also included the consolidated financial statement
schedule for the years ended December 31, 2001, 2000, and 1999, included in the
Index at Item 14(a)(2). These consolidated financial statements and consolidated
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on the consolidated financial
statements and consolidated 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 consolidated financial position of SafeGuard Health
Enterprises, Inc. and subsidiaries as of December 31, 2001 and 2000, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2001, 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 7, 2002
F-2
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2001 AND 2000
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
2001 2000
--------- ---------
ASSETS
Current assets:
Cash and cash equivalents $ 1,497 $ 1,381
Investments available-for-sale, at fair value 13,956 15,321
Accounts receivable, net of allowances of $508 in 2001 and $868 in 2000 2,839 2,778
Other current assets 903 1,788
--------- ---------
Total current assets 19,195 21,268
Property and equipment, net of accumulated depreciation and amortization 2,348 2,843
Restricted investments available-for-sale, at fair value 2,831 2,700
Notes receivable, net of allowances of $467 in 2001 and $2,806 in 2000 805 1,750
Intangible assets, net of accumulated amortization of $254 in 2001 and $342 in 2000 3,920 4,154
Other assets 226 380
--------- ---------
Total assets $ 29,325 $ 33,095
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable $ 3,168 $ 3,986
Accrued interest, subject to conversion to equity -- 4,990
Other accrued expenses 4,827 6,457
Short-term debt, subject to conversion to equity -- 47,545
Other short-term debt 265 235
Claims payable and claims incurred but not reported 5,905 7,554
Deferred revenue 823 1,413
--------- ---------
Total current liabilities 14,988 72,180
Long-term debt -- 265
Other long-term liabilities 971 1,079
Commitments and contingencies (Note 10)
Stockholders' equity (deficit):
Convertible preferred stock and additional paid-in capital - $.01 par value;
1,000,000 shares authorized; 300,000 shares issued and outstanding in 2001,
and none issued or outstanding in 2000; liquidation preference of $30 million 41,250 --
Common stock and additional paid-in capital - $.01 par value;
40,000,000 shares authorized; 8,065,000 shares and 8,022,000 shares
issued in 2001 and 2000; 4,798,000 shares and 4,747,000 shares
outstanding in 2001 and 2000 21,552 21,829
Retained earnings (accumulated deficit) (31,447) (44,254)
Accumulated other comprehensive income 63 119
Treasury stock, at cost (18,052) (18,123)
--------- ---------
Total stockholders' equity (deficit) 13,366 (40,429)
--------- ---------
Total liabilities and stockholders' equity (deficit) $ 29,325 $ 33,095
========= =========
See accompanying Notes to Consolidated Financial Statements.
F-3
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2001, 2000, AND 1999
(IN THOUSANDS, EXCEPT PER SHARE DATA)
2001 2000 1999
-------- -------- ---------
Premium revenue, net $84,822 $97,251 $ 96,225
Health care services expense 58,692 68,568 69,528
Selling, general and administrative expense 25,391 31,203 35,072
Loss on impairment of assets -- 450 24,576
-------- -------- ---------
Operating income (loss) 739 (2,970) (32,951)
Investment and other income 1,060 1,431 2,067
Interest expense on debt that was converted
to equity in 2001 (402) (4,801) (5,610)
Other interest expense (102) (112) (245)
-------- -------- ---------
Income (loss) before income taxes,
discontinued operations and extraordinary item 1,295 (6,452) (36,739)
Income tax expense -- -- 10,934
-------- -------- ---------
Income (loss) before discontinued operations
and extraordinary item 1,295 (6,452) (47,673)
Discontinued operations:
Loss from assets transferred under contractual arrangements
(net of income tax benefit of $2,087 in 1999) -- (2,500) (4,363)
Extraordinary item:
Gain on conversion of debt to convertible preferred stock 11,251 -- --
-------- -------- ---------
Net income (loss) $12,546 $(8,952) $(52,036)
======== ======== =========
Basic net income (loss) per share:
Income (loss) before discontinued
operations and extraordinary item $ 0.04 $ (1.36) $ (10.04)
Loss from discontinued operations -- (0.53) (0.92)
Extraordinary item 0.35 -- --
-------- -------- ---------
Net income (loss) $ 0.39 $ (1.89) $ (10.96)
======== ======== =========
Weighted average basic shares outstanding 32,253 4,747 4,747
Diluted net income (loss) per share:
Income (loss) before discontinued
operations and extraordinary item $ 0.04 $ (1.36) $ (10.04)
Loss from discontinued operations -- (0.53) (0.92)
Extraordinary item 0.34 -- --
-------- -------- ---------
Net income (loss) $ 0.38 $ (1.89) $ (10.96)
======== ======== =========
Weighted average diluted shares outstanding 33,009 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, 2001, 2000, AND 1999
(IN THOUSANDS)
ACCUMULATED
NUMBER OF SHARES PREFERRED COMMON RETAINED OTHER
---------------------------- STOCK AND STOCK AND EARNINGS COMPRE-
COMMON ADDITIONAL ADDITIONAL (ACCUMU- HENSIVE
----------------- PAID-IN PAID-IN LATED INCOME
PREFERRED ISSUED TREASURY CAPITAL CAPITAL DEFICIT) (LOSS)
--------- ------ --------- ----------- ------------ ---------- -------------
Balances, January 31, 1999 -- 8,022 (3,275) $ -- $ 21,509 $ 16,734 $ (354)
Net loss -- -- -- -- -- (52,036) --
Other comprehensive income:
Net unrealized gains on
investments available-for-sale,
net of tax of $226 336
Total comprehensive income (loss)
Issuance of stock warrants (1) -- -- -- -- 320 -- --
--------- ------ --------- ----------- ------------ ---------- -------------
Balances, December 31, 1999 -- 8,022 (3,275) 21,829 (35,302) (18)
Net loss -- -- -- (8,952) --
Other comprehensive income:
Net unrealized gains on
investments available-for-sale 137
Total comprehensive income (loss)
--------- ------ --------- ----------- ------------ ---------- -------------
Balances, December 31, 2000 -- 8,022 (3,275) 21,829 (44,254) 119
Net income -- -- -- -- -- 12,546 --
Other comprehensive income:
Net unrealized losses on
investments available-for-sale (56)
Total comprehensive income
Issuance of preferred stock 300 -- -- 41,250 -- -- --
Cancellation of stock warrants (1) -- -- -- -- (320) 320 --
Repurchase of common stock -- -- (10) -- -- -- --
Reissuance of treasury stock in
contribution to retirement plan -- -- 18 -- -- (59) --
Exercise of stock options -- 43 -- -- 43 -- --
--------- ------ --------- ----------- ------------ ---------- -------------
Balances, December 31, 2001 300 8,065 (3,267) $ 41,250 $ 21,552 $ (31,447) $ 63
========= ====== ========= =========== ============ ========== =============
TREASURY
STOCK TOTAL
---------- ---------
Balances, January 31, 1999 $ (18,123) $ 19,766
Net loss -- (52,036)
Other comprehensive income:
Net unrealized gains on
investments available-for-sale,
net of tax of $226 336
---------
Total comprehensive income (loss) (51,700)
Issuance of stock warrants (1) -- 320
---------- ---------
Balances, December 31, 1999 (18,123) (31,614)
Net loss -- (8,952)
Other comprehensive income:
Net unrealized gains on
investments available-for-sale 137
---------
Total comprehensive income (loss) (8,815)
---------- ---------
Balances, December 31, 2000 (18,123) (40,429)
Net income -- 12,546
Other comprehensive income:
Net unrealized losses on
investments available-for-sale (56)
---------
Total comprehensive income 12,490
Issuance of preferred stock -- 41,250
Cancellation of stock warrants (1) -- --
Repurchase of common stock (10) (10)
Reissuance of treasury stock in
contribution to retirement plan 81 22
Exercise of stock options -- 43
---------- ---------
Balances, December 31, 2001 $ (18,052) $ 13,366
========== =========
(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 Note 7.
See accompanying Notes to Consolidated Financial Statements.
F-5
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2001, 2000, AND 1999
(IN THOUSANDS)
2001 2000 1999
--------- --------- ---------
Cash flows from operating activities:
Net income (loss) $ 12,546 $ (8,952) $(52,036)
Adjustments to reconcile net income (loss) to net
cash used in operating activities:
Loss from discontinued operations -- 2,500 4,363
Gain on conversion of debt to convertible preferred stock (11,251) -- --
Loss on impairment of assets -- 450 24,576
Bad debt expense 245 300 481
Depreciation and amortization 1,838 2,767 3,832
Write-off and amortization of deferred loan costs 24 339 1,954
Gain on liquidation of notes receivable (175) -- --
Gain on sale of investments (101) (18) (1,200)
Gain on sale of property and equipment -- (83) --
Deferred income taxes -- -- 10,569
Contribution to retirement plan in the form of common stock 22 -- --
Changes in operating assets and liabilities:
Accounts receivable (306) (100) (114)
Other current assets 685 (667) 370
Accounts payable (818) 424 (1,455)
Other accrued expenses (2,034) 3,266 (61)
Claims payable and claims incurred but not reported (1,649) (1,092) 3,994
Deferred revenue (469) (562) 953
--------- --------- ---------
Net cash used in operating activities (1,443) (1,428) (3,774)
Cash flows from investing activities:
Purchase of investments available-for-sale (15,599) (42,477) (13,267)
Proceeds from sale/maturity of investments available-for-sale 16,878 31,941 15,015
Purchase of property and equipment (1,109) (646) (1,220)
Proceeds from sale of property and equipment -- 218 3,500
Payments received on notes receivable 1,320 1,305 518
Issuance of notes receivable -- -- (500)
Decrease (increase) in other assets 58 (468) (969)
--------- --------- ---------
Net cash provided by (used in) investing activities 1,548 (10,127) 3,077
Cash flows from financing activities:
Borrowings on debt -- 8,000 --
Increase in accrued interest, converted to equity in 2001 321 3,783 1,207
Payments on debt (235) (255) (2,594)
Repurchase of common stock (10) -- --
Exercise of stock options 43 -- --
Payment of other long-term liabilities (108) (231) (48)
--------- --------- ---------
Net cash provided by (used in) financing activities 11 11,297 (1,435)
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents 116 (258) (2,132)
Cash and cash equivalents at beginning of year 1,381 1,639 3,771
--------- --------- ---------
Cash and cash equivalents at end of year $ 1,497 $ 1,381 $ 1,639
========= ========= =========
Supplementary information:
Cash paid during the year for interest $ 315 $ 720 $ 4,189
Supplementary disclosure of non-cash activities:
Debt converted into convertible preferred stock 41,250 -- --
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 a wide range of dental benefit plans, vision benefit plans, and other
related products. The Company's operations are primarily in California, Florida
and Texas, 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
dental health maintenance organization ("HMO") plans in the states in which they
operate. The Company provides dental benefits and other related products to
approximately 625,000 individuals. The Company was founded as a not-for-profit
entity in California in 1974, and was converted to a for-profit entity in 1982.
Under the dental HMO plan designs provided by the Company, a majority of the
total health care services expense consists of capitation payments to dental
service providers, which are fixed monthly payments for each covered individual.
These capitation arrangements limit the amount of risk assumed by the Company.
Under the dental preferred provider organization ("PPO")/indemnity plan designs
provided by the Company, all health care services expense consists of claims
that are paid each time a covered individual receives dental services. Under
this type of plan design, the Company assumes all of the utilization risk.
Capitation payments comprised 37%, 41% and 45% of the Company's total health
care services expense during the years ended December 31, 2001, 2000 and 1999,
respectively.
BASIS OF PRESENTATION
The consolidated financial statements include all the accounts of the Company
and its subsidiaries. Intercompany accounts and transactions have been
eliminated in consolidation. The Company's consolidated financial statements
were prepared in accordance with accounting principles generally accepted in the
United States of America.
BUSINESS SEGMENT INFORMATION
Management views certain geographic areas as separate operating segments, and
therefore, measures the Company's operating results separately for each of those
geographic areas. 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 and other related products 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 $2.8 million and $2.7 million as of
December 31, 2001 and 2000, respectively.
In addition, several of the Company's subsidiaries are subject to state
regulations that require them to maintain minimum amounts of statutory capital
and surplus. The aggregate minimum statutory capital and surplus that is
required with respect to all of the Company's subsidiaries that are subject to
minimum capital and surplus requirements was approximately $10.6 million as of
December 31, 2001. The aggregate statutory capital and surplus in these
subsidiaries as of December 31, 2001, was approximately $11.2 million. As a
result of these regulatory requirements, approximately $10.7 million of the
Company's consolidated stockholders' equity as of December 31, 2001, was not
available for the payment of dividends to the Company's stockholders. In
addition, the amount of consolidated stockholders' equity that is available for
dividends may be further restricted by the amount of cash and other liquid
assets in the Company's non-regulated entities.
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 classified its investments 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
stockholders' equity under the caption "Accumulated other comprehensive income."
In the event there was an unrealized loss on an investment that the Company
believed to be a permanent loss, the loss would be reported in the statement of
operations, instead of in a separate caption of stockholders' equity. As of
December 31, 2001, there were no unrealized losses that the Company believed to
be permanent losses.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The accompanying consolidated balance sheets include the following financial
instruments as of December 31, 2001: 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 Company
expects to realize the current assets, and to pay the current liabilities,
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. Depreciation of leasehold improvements is calculated based on the
shorter of the estimated useful lives of the assets, or the length of the
related lease. The Company uses the following useful lives to record
depreciation expense: leasehold improvements - 5 to 10 years; computer hardware
and software - 3 to 4 years; and furniture, fixtures and other office equipment
- - 5 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, 2001 consist entirely of goodwill related to
the acquisition of a dental HMO company in 1996. This goodwill represents the
excess of the purchase price of the acquired company over the fair value of the
net assets acquired. The Company estimates that this goodwill has a useful life
of 40 years from the date of acquisition of the related entity, and amortized
the goodwill over that period during the three years ended December 31, 2001. In
accordance with SFAS No. 142, "Goodwill and Other Intangible Assets," the
Company's goodwill will not be amortized after December 31, 2001, but will be
evaluated for possible impairment on an ongoing basis. 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 values may not be recoverable. The Company's principal long-lived asset
as of December 31, 2001 is goodwill. The Company evaluates its goodwill for
impairment on an ongoing basis, primarily by comparing the present value of
estimated future cash flows related to the goodwill to the carrying amount of
the goodwill. See Note 5 for a discussion of impairment charges with respect to
certain long-lived assets.
F-8
RECOGNITION OF PREMIUM REVENUE AND COMMISSION 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 consolidated
balance sheet as deferred revenue.
In connection with its acquisition of new customers, the Company pays broker and
consultant commissions based on a percentage of premium revenue collected. The
Company also pays internal sales commissions, some of which are based on a
percentage of premium revenue collected, and some of which consist of a one-time
payment at the beginning of a customer contract. Commissions that are based on a
percentage of premium revenue collected are recognized as expenses in the period
in which the related premium revenue is recognized. Commissions that consist of
a one-time payment at the beginning of a customer contract are recognized as
expenses at the beginning of the related customer contract. As stated in SFAS
No. 60, "Accounting and Reporting by Insurance Companies," commissions related
to insurance contracts should be capitalized and charged to expense over the
term of the customer contract, in proportion to premium revenue recognized. In
the case of the PPO/indemnity insurance policies issued by the Company, the
customers have the ability to cancel the policy at any time with 30 days advance
written notice. Because of this ability, one-time commissions paid at the
beginning of a customer contract are charged to expense at the beginning of the
related customer contract.
RECOGNITION OF HEALTH CARE SERVICES EXPENSE
Capitation payments to providers are recognized as expense in the period in
which the providers are obligated to deliver the related health care services.
Other payments for health care services are recognized as expense in the period
in which the services are delivered.
The estimated liability for claims payable and 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 paid by the Company, as well as the
recent trend in the aggregate amount of incurred claims per covered individual.
Since the liability for claims payable and claims incurred but not reported is
necessarily an actuarial estimate, the amount of claims eventually paid 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.
ADMINISTRATIVE SERVICES ARRANGEMENTS
The Company processed approximately $3.2 million, $3.2 million, and $2.0 million
of dental claims under administrative services only ("ASO") agreements during
the years ended December 31, 2001, 2000 and 1999, respectively. The revenue
recognized by the Company from ASO agreements consists only of the ASO fees
received from its clients, and the claims processed by the Company under ASO
agreements are not included in the accompanying consolidated statements of
operations.
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 during 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. See Note 11 for the pro forma effect of using
the fair value method of accounting for stock options.
F-9
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 consolidated 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.
RELATED PARTY TRANSACTIONS
The Company paid $200,000 and $117,000 of consulting fees to the chairman of its
board of directors during the years ended December 31, 2001 and 2000,
respectively. See Note 7 for information regarding the $8.0 million senior
investor loan.
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, including the common shares into which the
convertible preferred stock is convertible, but excluding the effect of other
potentially dilutive securities. The number of basic common shares outstanding
includes the common share equivalents of the convertible preferred stock,
because the Company believes the convertible preferred stock is essentially
equivalent to common stock, based on all the rights and preferences of both
types of stock. 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, 2001, the
potentially dilutive securities of the Company that were outstanding consisted
entirely of stock options and warrants. Due to net losses incurred in the two
years ended December 31, 2000, the outstanding stock options and warrants would
have an anti-dilutive effect on diluted loss per share in each of these years.
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 two years ended
December 31, 2000.
RECENT ACCOUNTING PRONOUNCEMENTS
In September 2000, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities." SFAS No. 140 replaces SFAS No. 125, which has
the same title, revises the accounting and reporting standards for
securitizations and other transfers of assets, and expands the disclosure
requirements for such transactions. Under SFAS No. 140, consistent standards are
provided for distinguishing transfers of financial assets that are sales from
transfers that are secured borrowings. The accounting requirements of SFAS No.
140 are effective for transfers and servicing of financial assets and
extinguishments of liabilities that occur after March 31, 2001, and must be
applied prospectively. The adoption of SFAS No. 140 had no significant effect on
the Company's consolidated financial statements.
In July 2001, the FASB issued SFAS No. 141, "Business Combinations." SFAS No.
141 requires the purchase method of accounting to be used for all business
combinations initiated after June 30, 2001, and eliminates the
pooling-of-interests method of accounting. The adoption of SFAS No. 141 had no
significant effect on the Company's consolidated financial statements.
F-10
In July 2001, the FASB issued SFAS No. 142, which requires that goodwill
established after June 30, 2001, not be amortized, and that amortization of
goodwill that existed as of June 30, 2001, be ceased effective January 1, 2002.
SFAS No. 142 also requires that all goodwill be evaluated for possible
impairment as of the end of each reporting period, and establishes a new method
of testing for possible impairment. SFAS No. 142 is effective on January 1,
2002, and as a result, the Company's goodwill amortization will cease effective
January 1, 2002. The Company recorded $234,000 of amortization expense related
to goodwill and identifiable intangible assets during the year ended December
31, 2001. The Company is currently evaluating whether the adoption of SFAS No.
142 will have any other significant effects on its consolidated financial
statements.
In August 2001, the FASB issued SFAS No. 143, "Accounting for Obligations
Associated with the Retirement of Long-Lived Assets." SFAS No. 143 establishes
accounting and reporting standards for the recognition and measurement of an
asset retirement obligation and the associated asset retirement cost. SFAS No.
143 is effective for fiscal years beginning after June 15, 2002. The Company
does not believe the adoption of SFAS No. 143 will have a significant effect on
its consolidated financial statements.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets." SFAS No. 144 supersedes SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of," and APB No. 30, "Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual, and Infrequently Occurring Events and Transactions." SFAS No. 144
establishes accounting and reporting standards for the impairment or disposal of
long-lived assets, and for reporting the results of discontinued operations.
SFAS No. 144 is effective for fiscal years beginning after December 15, 2001.
The Company does not believe the adoption of SFAS No. 144 will have a
significant effect on its consolidated 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
- ----------------------------------
ACCOUNTING TREATMENT OF CERTAIN SALE TRANSACTIONS
The Company sold all of its general dental practices in 1996 and 1997, and sold
all of its orthodontic practices in 1998. Certain of the general dental
practices and all of the orthodontic practices were sold to a single purchaser
(the "Purchaser"), in exchange for $23.0 million of long-term promissory notes.
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, notwithstanding the fact
that these transactions were legally structured as sales. Accordingly, the
related promissory notes were not reflected in the Company's financial
statements. Instead, the historical cost of the net assets of the related
general dental and orthodontic practices were reflected on the Company's balance
sheet, and were stated at their estimated realizable value. The Company's
financial statements did not reflect any gains on these sale transactions, and
do not reflect any interest income on the related promissory notes. 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 net
assets of these dental and orthodontic practices in both 2000 and 1999 (see Note
5).
SALE OF DISCONTINUED OPERATIONS TO NEW PURCHASER
The Purchaser ultimately defaulted on its obligations to the Company, and in
October 2000, the Company completed a transaction with the Purchaser and another
third party (the "New Purchaser"), in which the practices originally sold to the
Purchaser were sold to 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
dental HMO patients who previously paid for the treatments in full. These
F-11
obligations had to be paid in order to complete the transaction, were
obligations of the Company as the member's dental HMO plan, or were obligations
for which the Company could have been contingently liable in any event.
As of December 31, 2001, the Company has collected a substantial portion of the
escrow account, and has satisfied a substantial portion of the obligations
described above. However, the remaining 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 various uncertainties, and are reflected on the
accompanying consolidated balance sheet based on the Company's best estimates.
This transaction resulted in a $2.5 million charge to earnings during 2000 to
reduce the carrying value of the net assets of the dental and orthodontic
practices 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 $101,000, $19,000, and
$2,051,000 for the years ended December 31, 2001, 2000, and 1999, respectively.
Gross realized losses on sales of investments were zero, $1,000, and $851,000
for the years ended December 31, 2001, 2000, and 1999, respectively. The
historical cost of specific securities sold is used to compute the gain or loss
on the sale of investments. At December 31, 2001, the Company had net unrealized
gains of $63,000, which is included in stockholders' equity under the caption
"Accumulated other comprehensive income."
The Company's investments as of December 31, 2001 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 $ 2,757 $ 57 $ (2) $ 2,812
State and municipal obligations 255 8 -- 263
Other marketable debt securities 13,712 -- -- 13,712
------------ ------------ ------------ -------
Total available-for-sale $ 16,724 $ 65 $ (2) $16,787
============ ============ ============ =======
The maturity dates of the Company's investments as of December 31, 2001 are
summarized below (in thousands):
COST/ ESTIMATED
AMORTIZED FAIR
COST VALUE
------------ ------------
Classified as available-for-sale:
Due in 2002 $ 14,195 $ 14,204
Due in 2003 1,306 1,345
Due in 2004 and thereafter 1,223 1,238
------------ ------------
Total available-for-sale $ 16,724 $ 16,787
============ ============
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 debt securities 2,434 -- (1) 2,433
------------ ------------ ------------ -------
Total available-for-sale $ 17,902 $ 121 $ (2) $18,021
============ ============ ============ =======
F-12
NOTE 4. PROPERTY AND EQUIPMENT
- -------------------------------
The Company's property and equipment consists of the following (in thousands):
DECEMBER 31,
--------------------------
2001 2000
------------ ------------
Leasehold improvements $ 841 811
Furniture, fixtures and other equipment 11,161 10,082
------------ ------------
Total, at cost 12,002 10,893
Less - accumulated depreciation and amortization (9,654) (8,050)
------------ ------------
Total, net of accumulated depreciation and amortization $ 2,348 $ 2,843
============ ============
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 the net assets of the
dental and orthodontic practices to their estimated realizable value. This
charge is reflected on the Company's consolidated statement of operations under
the caption "Loss from assets transferred under contractual arrangements."
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, and on the
related transaction that was completed in October 2000, the Company recorded a
$2.5 million charge to earnings during 2000 to reduce the carrying value of the
net assets of the dental and orthodontic practices to their revised estimated
realizable value. This charge is reflected on the Company's consolidated
statement of operations under the caption "Loss from assets transferred under
contractual arrangements."
NOTES RECEIVABLE
The Company's notes receivable consist of promissory notes issued by the
purchasers of certain 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. There was no impairment loss
recorded during 2001. As of December 31, 2001, the net carrying amount of the
outstanding notes receivable was $805,000, which is based on the Company's
estimate of the net realizable value of the promissory notes.
F-13
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,
"Intangible Assets." 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 with respect to the goodwill
and non-compete covenant related to the acquisition of a Texas-based dental HMO
in September 1996 ($14.7 million), the goodwill and non-compete covenant related
to the acquisition of a Florida-based dental HMO 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). There was no impairment
loss recorded with respect to intangible assets during 2001 or 2000, and the
Company believes there is no impairment of its intangible assets as of December
31, 2001.
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. The
liability for claims payable and claims incurred but not reported is an estimate
of the claims for services delivered prior to the balance sheet date, which have
not yet been paid by the Company as of the balance sheet date. The estimate of
claims payable and 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 paid by the Company, as well as the recent trend in the aggregate
amount of incurred claims per covered individual. Since the liability for claims
payable and claims incurred but not reported is necessarily an actuarial
estimate, the amount of claims eventually paid 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.
The amounts included in the liability for claims payable and claims incurred but
not reported in the accompanying consolidated financial statements are the same
as the amounts included in the statutory financial statements that are filed
with various state regulators by the Company's subsidiaries.
F-14
PPO/indemnity claims are related to services delivered to individuals covered
under dental indemnity plan designs, some of which contain a PPO feature.
Specialist referral claims are related to specialist services delivered to
individuals covered under dental HMO plan designs. Other claims are related to
primary care dental services delivered to individuals covered under dental HMO
plan designs. A summary of the activity in the liability for each type of claim
is shown below (in thousands).
DENTAL HMO
--------------------
PPO/ SPECIALIST
INDEMNITY REFERRAL OTHER
CLAIMS CLAIMS CLAIMS TOTAL
----------- ---------- -------- ---------
Balance at January 1, 2000 $ 5,807 $ 1,988 $ 851 $ 8,646
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 (18,969) (5,823) (4,006) (28,798)
Prior years (6,033) (1,637) (729) (8,399)
----------- ---------- -------- ---------
Balance at December 31, 2000 5,778 1,148 628 7,554
Incurred claims related to:
Current year - 2001 23,582 6,047 4,161 33,790
Prior years (834) (138) (204) (1,176)
Paid claims related to:
Current year - 2001 (19,330) (4,955) (3,600) (27,885)
Prior years (4,944) (1,010) (424) (6,378)
----------- ---------- -------- ---------
Balance at December 31, 2001 $ 4,252 $ 1,092 $ 561 $ 5,905
=========== ========== ======== =========
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,
2001 and 2000, the aggregate adjustments to the liability to reflect these
differences, which are reflected in the above table, were not material.
NOTE 7. NOTES PAYABLE AND LONG-TERM DEBT
- ----------------------------------------------
Notes payable and long-term debt consisted of the following (in thousands):
DECEMBER 31,
-----------------
2001 2000
------ ---------
Investor senior loan $ -- $ 8,000
Revolving credit facility -- 7,045
Senior notes payable -- 32,500
Other 265 500
------ ---------
Total debt 265 48,045
Less - short-term portion (265) (47,780)
------ ---------
Long-term debt $ -- $ 265
====== =========
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, due April 30, 2001. As part of this
transaction, 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
F-15
million of senior notes payable plus accrued interest, to convertible preferred
stock, subject to regulatory approval and an increase in the authorized shares
of the Company's common stock.
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 ($5.3 million) into 300,000 shares of convertible preferred stock. 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
pre-tax gain of $11.3 million, which is net of approximately $350,000 of
transaction costs. There was 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. The Company's deferred tax asset related to net operating
loss carryforwards is fully reserved, due to uncertainty about whether the
deferred tax assets will be realized in the future, as discussed in Note 9.
See Note 11 for a description of the convertible preferred stock. As a result of
the conversion transaction, the ownership interest of the previously existing
common stockholders of the Company was reduced to 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 represented 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, at
which time the Bank sold its interest in the Company to other existing
stockholders. These four new directors constitute a majority of the board of
directors, which currently has a total of seven members.
In 1999, in connection with a restructuring of the senior notes payable, the
Company issued warrants to purchase 382,000 shares of its common stock for $4.51
per share to the Senior Note Holder. 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 additional paid-in
capital during 1999. The warrants were cancelled without being exercised, in
connection with the conversion of the senior notes payable into convertible
preferred stock effective January 31, 2001. Accordingly, the estimated fair
value of the warrants, which was $320,000, was debited to additional paid-in
capital and credited to retained earnings during 2001.
NOTE 8. OTHER LONG-TERM LIABILITIES
- ---------------------------------------
Other long-term liabilities consist primarily of 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 a dental HMO company
acquired by the Company in 1996, accrued lease obligations related to equipment
that is no longer used by the Company, and security deposits collected in
connection with subleases.
Annual maturities of other long-term liabilities are as follows, as of December
31, 2001 (in thousands):
2003 $ 199
2004 208
2005 192
2006 192
Thereafter 180
------
Total other long-term liabilities $ 971
======
F-16
NOTE 9. INCOME TAXES
- -----------------------
The Company's federal and state income tax expense (benefit) is as follows (in
thousands):
YEARS ENDED DECEMBER 31,
------------------------
2001 2000 1999
------ ------ --------
Income tax expense from continuing operations:
Current payable - Federal $ -- $ -- $ 648
State -- -- 358
Deferred - Federal -- -- 6,613
State -- -- 3,315
------ ------ --------
Income tax expense from continuing operations -- -- 10,934
Income tax expense (benefit) from discontinued operations -- -- (2,087)
------ ------ --------
Total income tax expense $ -- $ -- $ 8,847
====== ====== ========
A reconciliation of the expected federal income tax expense (benefit) based on
the statutory rate to the actual income tax expense (benefit) on the income
(loss) from continuing operations is as follows (in thousands):
YEARS ENDED DECEMBER 31,
---------------------------------------------------------
2001 2000 1999
----------------- ----------------- -------------------
AMOUNT % AMOUNT % AMOUNT %
--------- ------ -------- ------- --------- -------
Expected federal income tax
expense (benefit) $ 4,266 34.0% $(2,194) (34.0)% $(12,491) (34.0)%
State income tax expense
(benefit), net of effect
on federal income tax -- -- -- -- 1,903 5.2
Goodwill amortization
and impairments 35 0.3 42 0.7 8,190 22.3
Other items 855 6.8 46 0.7 451 1.2
Expiration of net operating
losses due to change of control 6,774 54.0 -- -- -- --
Change in valuation allowance (11,930) (95.1) 2,106 32.6 12,881 35.1
--------- ------ -------- ------- --------- -------
Actual income tax expense $ -- --% $ -- --% $ 10,934 29.8%
========= ====== ======== ======= ========= =======
F-17
Deferred tax assets and liabilities are related to the following items (in
thousands):
DECEMBER 31,
-------------------
2001 2000
-------- ---------
Deferred tax assets:
Net operating loss carryforward $ 3,567 $ 13,651
Depreciation and amortization 2,053 3,384
Accrued expenses 1,121 1,965
Capital loss carryforward 643 --
Bad debt reserves on notes receivable 219 1,263
Bad debt allowance on accounts receivable 218 378
Other 111 42
-------- ---------
Total deferred tax assets 7,932 20,683
Deferred tax liabilities:
State income taxes 910 958
Prepaid expenses 280 211
Gain on sale of dental offices 56 898
-------- ---------
Total deferred tax liabilities 1,246 2,067
-------- ---------
Net deferred tax assets 6,686 18,616
Valuation allowance (6,686) (18,616)
-------- ---------
Net deferred tax assets after valuation allowance $ -- $ --
======== =========
The income tax expense recorded by the Company for the year ended December 31,
2001, includes an adjustment to decrease the valuation allowance against its
deferred tax assets. The income tax expense recorded for the year ended December
31, 2000, includes an adjustment to increase the valuation allowance against its
deferred tax assets. The Company's net deferred tax assets, which were $6.7
million and $18.6 million as of December 31, 2001 and 2000, respectively, have
been fully reserved since September 30, 1999, due to uncertainty about whether
those net assets will be realized in the future. The uncertainty is primarily
due to operating losses incurred by the Company during each of the three years
ended December 31, 2000, and the existence of significant net operating loss
carryforwards. The Company's deferred tax assets remain fully reserved as of
December 31, 2001, for the same reasons.
Due to the conversion of outstanding debt into convertible preferred stock, as
described in Note 7, there was a "change of control" of the Company for purposes
of Internal Revenue Code Section 382, effective January 31, 2001. As a result,
effective January 31, 2001, the amount of pre-existing net operating loss
carryforwards that can be used to offset current taxable income on the Company's
federal income tax return is limited to approximately $350,000 per year. As of
December 31, 2001, the Company had net operating loss carryforwards for federal
and state tax purposes of approximately $9.0 million and $8.1 million,
respectively, which are net of the amounts that will expire unused due to the
change of control limitation. The federal and state net operating loss
carryforwards will begin to expire in 2018 and 2003, respectively.
F-18
NOTE 10. COMMITMENTS AND CONTINGENCIES
- ------------------------------------------
LEASE COMMITMENTS
The Company leases administrative office space and office equipment under a
number of operating leases. Rent expense was $3,465,000, $3,986,000, and
$4,289,000 in 2001, 2000, and 1999, respectively. The Company has subleased
certain of its office space to unrelated 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
----------- ---------- -----------
2002 $ 2,830 $ (278) $ 2,552
2003 2,155 (130) 2,025
2004 2,034 (43) 1,991
2005 1,850 -- 1,850
2006 1,838 -- 1,838
Thereafter 3,064 -- 3,064
----------- ---------- -----------
Total minimum payments $ 13,771 $ (451) $ 13,320
=========== ========== ===========
The Company has accrued all of the future lease payments related to certain
leases for equipment that is no longer used by the Company. The Company has also
accrued the excess of the future lease payments for office space that is no
longer used by the Company, over the expected future collections of sublease
payments related to that office space. The future lease payments that have been
accrued are not included in the above summary of operating lease commitments.
LITIGATION
The Company is subject to various claims and legal actions arising 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 have a material adverse effect on the
Company's consolidated 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 and its officers. On October 6, 2000, the plaintiffs filed an appeal of
the dismissal of the lawsuit, and the dismissal was overturned on February 22,
2002. The case was remanded back to the District Court with instructions to
allow the plaintiff to file a second amended complaint. The Company has
directors and officers liability insurance, and intends to vigorously defend any
second amended complaint that may be filed by the plaintiff. In the opinion of
management, the ultimate outcome of this litigation will not have a material
adverse effect on the Company's consolidated financial position or results of
operations.
CONTINGENT LEASE OBLIGATIONS
The Company sold all of 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 of the
office lease agreements related to those practices have been assigned to the
respective purchasers of those practices, except for three of the leases. The
Company is currently in the process of obtaining assignments for the remaining
three leases, although there can be no assurance that it will be successful in
doing so.
F-19
In the case of the assigned leases, the Company is secondarily liable for the
lease payments in the event the purchasers of those practices fail to make the
payments. As of December 31, 2001, the total of the minimum annual payments
under these leases was approximately $1.5 million, and the aggregate contingent
liability of the Company related to these leases was approximately $4.4 million
over the terms of the lease agreements, which expire at various dates through
2007. Management has not been notified of any defaults under these leases that
would materially affect the Company's consolidated financial position. The
aggregate contingent lease obligation of $4.4 million excludes $175,000 of
estimated lease obligations that have been accrued as of December 31, 2001, due
to an expected failure by one of the entities to make the lease payments under a
lease that was assigned to that entity by the Company. This estimated lease
obligation is included in the accompanying consolidated balance sheet under the
caption "Other accrued expenses."
The Company remains primarily liable for the three lease agreements that have
not yet been assigned, although the purchasers of the related practices have
agreed to make all of the remaining payments under those leases. The lease
commitments related to these three leases are included in the above summary of
lease commitments in this Note 10.
EMPLOYMENT AGREEMENT COMMITMENTS
The Company has entered into employment agreements with several members of its
management. Under each of these employment agreements, if the employee is
terminated without cause, the Company would be obligated to make a severance
payment equal to between 50% and 100% of the employee's annual salary, depending
upon the timing of the termination in relation to the expiration of the
employment agreement. The total of the annual salaries under these employment
agreements is approximately $1.7 million.
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 $51,000 of matching contributions to
the Plan for the year ended December 31, 2001, in the form of 33,000 shares of
its common stock. Of the total of 33,000 shares of common stock contributed,
18,000 shares were contributed in 2001, and an additional 15,000 shares were
contributed in 2002, the value of which is included in accrued expenses as of
December 31, 2001. Employees become vested in the matching contributions at the
rate of 20% per year during the first five years of employment with the Company,
with employees receiving credit for past years of service. There are no
restrictions on the ability of employees to liquidate the Company's common stock
that is credited to their account, except for vesting requirements. The Company
made no contributions to the Plan during the two years ended December 31, 2000.
PROFESSIONAL LIABILITY INSURANCE
The Company maintains professional liability insurance that covers losses on a
claims made basis.
GOVERNMENT REGULATION
The dental benefits industry is subject to extensive 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 dental HMO plan or a dental insurance company, including the
maintenance of a minimum amount of 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.
HEALTH INSURANCE PORTABILITY AND ACCOUNTABILITY ACT OF 1996 ("HIPAA")
HIPAA imposes responsibilities on the Company, including but not limited to,
privacy notice requirements to members of the Company's benefit plans, the
security and privacy of individually identifiable health information, the use of
unique identifiers for all of the contractual relationships the Company has with
members, providers and group and individual contract holders, the adoption of
standardized electronic transaction code sets, and prevention of unauthorized
use or disclosure of personal data maintained by the Company. The Company is in
F-20
the process of developing policies and procedures to comply with these
requirements and has provided privacy notices as required by HIPAA and the
Gramm-Leach-Bliley Act. The total cost of compliance with HIPAA is not known at
this time.
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, the
obligation to complete orthodontic treatments for certain dental HMO patients
who previously paid for the treatments in full. The amount of these liabilities
is subject to uncertainties and there can be no assurance that the ultimate
amount of these liabilities will not exceed the amounts accrued on the Company's
consolidated balance sheet as of December 31, 2001.
NOTE 11. CAPITAL STOCK
- -------------------------
CONVERTIBLE PREFERRED STOCK
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 $30
million liquidation preference over the Company's common stock.
STOCK REPURCHASES
As of December 31, 2001, the Company had 3,266,755 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 shares of the Company's outstanding common stock, of
which 10,000 shares had been repurchased as of December 31, 2001.
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 Rights
become exercisable upon the occurrence of certain defined events related to a
possible change of control of the Company. 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. The Rights Agreement may be amended by the Company's board of
directors without the approval of the Rights holders, at any time prior to the
Rights becoming exercisable. The Rights Agreement was amended in March 2000 to
specify that the recapitalization transaction initiated in March 2000 would not
cause the Rights to become exercisable.
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 Compensation and Stock Option Committee of the board of
directors of the Company administers the Plan.
F-21
The following is a summary of activity in stock options:
YEARS ENDED DECEMBER 31,
-----------------------------------
2001 2000 1999
----------- ----------- ---------
Outstanding at beginning of year 2,216,300 755,300 769,800
Stock options granted 805,000 2,080,000 55,000
Stock options exercised (43,332) -- --
Stock options canceled (363,468) (619,000) (69,500)
----------- ----------- ---------
Outstanding at end of year 2,614,500 2,216,300 755,300
=========== =========== =========
Exercisable at end of year 616,107 105,966 551,000
Weighted average exercise price of options granted $ 1.26 $ 1.00 $ 3.72
Weighted average exercise price of options exercised 1.00 -- --
Weighted average exercise price of options canceled 3.81 9.96 12.70
Weighted average exercise price of options outstanding 1.14 1.53 9.88
Weighted average exercise price of options exercisable 1.23 10.39 10.39
The following is a summary of stock options outstanding as of December 31, 2001:
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 - 1.50 2,600,000 8.64 years $ 1.08 601,607 $ 1.00
9.00 - 11.88 13,500 3.97 years 10.62 13,500 10.62
15.75 1,000 4.22 years 15.75 1,000 15.75
--------- ---------
Total 2,614,500 8.61 years $ 1.14 616,107 $ 1.23
========= =========
The weighted average fair value of stock options granted was $1.13, $0.76, and
$2.73 per share during the years ended December 31, 2001, 2000, and 1999,
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,
----------------------------
2001 2000 1999
------- -------- ---------
Net income (loss), as reported $12,546 $(8,952) $(52,036)
Pro forma net income (loss) 11,713 (9,733) (52,360)
Diluted income (loss) per share, as reported 0.38 (1.89) (10.96)
Pro forma diluted income (loss) per share 0.35 (2.05) (11.03)
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 160% in 2001, 184% in 2000, and 97% in
1999; no expected dividends; and a risk-free interest rate of approximately 3.8%
F-22
in 2001, and 6.0% in 2000 and 1999. 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,
-----------------------------
2001 2000 1999
-------- -------- ---------
Net realized gains on sale of investments $ 101 $ 18 $ 1,200
Interest income 945 1,330 932
Other, net 14 83 (65)
-------- -------- ---------
Total investment and other income $ 1,060 $ 1,431 $ 2,067
======== ======== =========
F-23
NOTE13. UNAUDITED SELECTED QUARTERLY INFORMATION
- ----------------------------------------------------
QUARTERLY RESULTS OF OPERATIONS
Unaudited quarterly results of operations for the years ended December 31, 2001
and 2000 are shown below (in thousands, except per share data). The unaudited
quarterly results should be read in conjunction with the accompanying audited
consolidated financial statements.
YEAR ENDED DECEMBER 31, 2001
------------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
--------- --------- --------- ---------
Premium revenue, net $ 21,643 $ 21,452 $ 20,831 $ 20,896
Health care services expense 15,187 14,914 14,456 14,135
Selling, general and administrative expense 6,534 6,453 6,062 6,342
--------- --------- --------- ---------
Operating income (loss) (78) 85 313 419
Investment and other income 435 255 213 157
Interest expense on debt that was
converted to equity in 2001 (402) -- -- --
Other interest expense (32) (30) (31) (9)
--------- --------- --------- ---------
Income (loss) before income taxes
and extraordinary item (77) 310 495 567
Income tax expense -- -- -- --
--------- --------- --------- ---------
Income (loss) before extraordinary item (77) 310 495 567
Extraordinary item:
Gain on conversion of debt to
convertible preferred stock 11,251 -- -- --
--------- --------- --------- ---------
Net income $ 11,174 $ 310 $ 495 $ 567
========= ========= ========= =========
Basic net income per share:
Income before extraordinary item $ -- $ 0.01 $ 0.01 $ 0.02
Extraordinary item 0.45 -- -- --
--------- --------- --------- ---------
Net income $ 0.45 $ 0.01 $ 0.01 $ 0.02
========= ========= ========= =========
Weighted average basic shares outstanding 24,738 34,740 34,753 34,781
Diluted net income per share:
Income before extraordinary item $ -- $ 0.01 $ 0.01 $ 0.02
Extraordinary item 0.45 -- -- --
--------- --------- --------- ---------
Net income $ 0.45 $ 0.01 $ 0.01 $ 0.02
========= ========= ========= =========
Weighted average diluted shares outstanding 24,738 35,502 35,542 35,564
F-24
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 17,738 17,710 17,572 15,548
Selling, general and administrative expense 8,413 7,119 7,436 8,235
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 was
converted to equity in 2001 (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-25
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 2001, 2000, AND 1999
(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, 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
YEAR ENDED DECEMBER 31, 2001:
Allowance for doubtful accounts:
Accounts receivable $ 868 $ 245 $ -- $ (605) $ 508
Long-term notes receivable $ 2,806 $ -- $ -- $ (2,339) $ 467
F-26