Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____ to _____
Commission file number 0-12050
SAFEGUARD HEALTH ENTERPRISES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 52-1528581
(State or other jurisdiction (I.R.S. Employer
of incorporation) Identification No.)
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)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--- ---
As of November 1, 2002, the number of shares of registrant's common stock, par
value $0.01 per share, outstanding was 5,666,203 shares (not including 3,216,978
shares of common stock held in treasury), and the number of shares of
registrant's convertible preferred stock, par value $0.01 per share, outstanding
was 30,000,000 shares.
SAFEGUARD HEALTH ENTERPRISES, INC.
INDEX TO FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2002
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . 1
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk. . . . . . . . . . . . . . 21
Item 4. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Item 6. Exhibits and Reports on Form 8-K. . . . . . . . . . . . . . . . . . . . . . . . . . . 22
SIGNATURES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
CERTIFICATIONS BY CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER . . . . . . . . . . . . . . . 24
i
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2002 2001
--------------- --------------
ASSETS
Current assets:
Cash and cash equivalents $ 2,338 $ 1,497
Investments available-for-sale, at fair value 9,752 13,956
Accounts receivable, net of allowances 2,616 2,839
Other current assets 637 903
--------------- --------------
Total current assets 15,343 19,195
Property and equipment, net of accumulated depreciation 3,664 2,348
Restricted investments available-for-sale, at fair value 3,299 2,831
Notes receivable, net of allowances 778 805
Goodwill 10,846 3,920
Other assets 152 226
--------------- --------------
Total assets $ 34,082 $ 29,325
=============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,560 $ 3,168
Accrued expenses 4,059 4,827
Current portion of long-term debt 2,596 265
Claims payable and claims incurred but not reported 5,162 5,905
Deferred premium revenue 1,449 823
--------------- --------------
Total current liabilities 14,826 14,988
Long-term debt 3,343 --
Other long-term liabilities 1,032 971
Commitments and contingencies (Note 9)
Stockholders' equity:
Convertible preferred stock and additional paid-in capital 41,250 41,250
Common stock and additional paid-in capital 22,641 21,552
Retained earnings (accumulated deficit) (31,285) (31,447)
Accumulated other comprehensive income 101 63
Treasury stock, at cost (17,826) (18,052)
--------------- --------------
Total stockholders' equity 14,881 13,366
--------------- --------------
Total liabilities and stockholders' equity $ 34,082 $ 29,325
=============== ==============
See accompanying Notes to Condensed Consolidated Financial Statements.
1
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
2002 2001
-------- --------
Premium revenue, net $20,682 $20,831
Health care services expense 14,546 14,456
Selling, general and administrative expense 6,040 6,062
-------- --------
Operating income 96 313
Investment and other income 92 213
Interest expense (84) (31)
-------- --------
Income before income taxes 104 495
Income tax expense -- --
-------- --------
Net income $ 104 $ 495
======== ========
Basic net income per share $ 0.00 $ 0.01
Weighted average basic shares outstanding 35,161 34,753
Diluted net income per share $ 0.00 $ 0.01
Weighted average diluted shares outstanding 35,526 35,542
See accompanying Notes to Condensed Consolidated Financial Statements.
2
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
2002 2001
-------- --------
Premium revenue, net $61,544 $63,926
Health care services expense 43,772 44,557
Selling, general and administrative expense 17,656 19,049
-------- --------
Operating income 116 320
Investment and other income 311 903
Interest expense on debt that was converted to equity in 2001 -- (402)
Other interest expense (115) (93)
-------- --------
Income before income taxes and extraordinary item 312 728
Income tax expense -- --
-------- --------
Income before extraordinary item 312 728
Extraordinary item:
Gain on conversion of debt to convertible preferred stock -- 11,251
-------- --------
Net income $ 312 $11,979
======== ========
Basic net income per share:
Income before extraordinary item $ 0.01 $ 0.02
Extraordinary item -- 0.36
-------- --------
Net income $ 0.01 $ 0.38
======== ========
Weighted average basic shares outstanding 34,817 31,410
Diluted net income per share:
Income before extraordinary item $ 0.01 $ 0.02
Extraordinary item -- 0.35
-------- --------
Net income $ 0.01 $ 0.37
======== ========
Weighted average diluted shares outstanding 35,374 32,369
See accompanying Notes to Condensed Consolidated Financial Statements.
3
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001
(IN THOUSANDS)
(UNAUDITED)
2002 2001
-------- ---------
Cash flows from operating activities:
Net income $ 312 $ 11,979
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Gain on conversion of debt to convertible preferred stock -- (11,251)
Bad debt expense 160 225
Amortization of deferred loan costs -- 24
Depreciation and other amortization 908 1,523
Contribution to retirement plan in the form of common stock, at fair value 68 --
Gain on liquidation of notes receivable -- (175)
Gain on sale of subsidiary (9) --
Gain on sale of investments (2) (98)
Changes in operating assets and liabilities, excluding effects of acquisition:
Accounts receivable 101 111
Other current assets 457 573
Accounts payable 96 (201)
Accrued expenses (740) (1,691)
Claims payable and claims incurred but not reported (968) (1,228)
Deferred premium revenue 270 (467)
Other assets 74 --
-------- ---------
Net cash provided by (used in) operating activities 727 (676)
Cash flows from investing activities:
Purchase of investments available-for-sale (3,130) (14,324)
Proceeds from sale/maturity of investments available-for-sale 6,893 15,693
Cash paid for acquisition of business, net of cash acquired (2,702) --
Purchases of property and equipment (311) (542)
Payments received on notes receivable 27 1,320
Proceeds from sale of subsidiary 72 --
-------- ---------
Net cash provided by investing activities 849 2,147
Cash flows from financing activities:
Borrowings on long-term debt 2,000 --
Payments on debt (1,099) (174)
Increase (decrease) in bank overdrafts (1,746) (1,203)
Increase in accrued interest that was converted to equity in 2001 -- 321
Repurchase of common stock -- (10)
Exercise of stock options 49 43
Increase (decrease) in other long-term liabilities 61 (247)
-------- ---------
Net cash used in financing activities (735) (1,270)
-------- ---------
Net increase in cash and cash equivalents 841 201
Cash and cash equivalents at beginning of period 1,497 1,381
-------- ---------
Cash and cash equivalents at end of period $ 2,338 $ 1,582
======== =========
(Continued on next page)
4
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS -- CONTINUED
NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001
(IN THOUSANDS)
(UNAUDITED)
2002 2001
-------- -------
Supplementary information:
Cash paid during the period for interest $ 115 $ 306
Supplementary disclosure of non-cash activities:
Debt converted into convertible preferred stock -- 41,250
Purchases of property and equipment through capital leases 1,784 --
Liabilities assumed in acquisition of business:
Fair value of assets acquired $ 864 $ --
Goodwill related to transaction 6,926 --
Less - Secured convertible note issued in transaction (2,625) --
Less - Common stock issued in transaction (1,040) --
Less - Cash paid in transaction (3,158) --
-------- -------
Liabilities assumed in acquisition of business $ 967 $ --
======== =======
See accompanying Notes to Condensed Consolidated Financial Statements.
5
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002
(UNAUDITED)
NOTE 1. GENERAL
- -----------------
The accompanying unaudited condensed consolidated financial statements of
SafeGuard Health Enterprises, Inc. and subsidiaries (the "Company") as of
September 30, 2002, and for the three months and nine months ended September 30,
2002 and 2001, have been prepared in accordance with accounting principles
generally accepted in the United States of America, applicable to interim
periods. The accompanying financial statements reflect all normal and recurring
adjustments that, in the opinion of management, are necessary for a fair
presentation of the Company's financial position and results of operations for
the interim periods. The financial statements have been prepared in accordance
with the regulations of the Securities and Exchange Commission and, accordingly,
omit certain footnote disclosures and other information necessary to present the
Company's financial position and results of operations for annual periods in
accordance with accounting principles generally accepted in the United States of
America. These consolidated financial statements should be read in conjunction
with the Company's Annual Report on Form 10-K for the year ended December 31,
2001, which includes the Company's Consolidated Financial Statements and Notes
thereto for that period.
NOTE 2. SIGNIFICANT ACCOUNTING POLICIES AND RECENT ACCOUNTING PRONOUNCEMENTS
- --------------------------------------------------------------------------------
GOODWILL
Goodwill as of September 30, 2002 consists of $6.9 million of goodwill related
to the acquisition of Paramount Dental Plan, Inc. ("Paramount") in August 2002,
which is discussed in Note 3 to the accompanying condensed consolidated
financial statements, and $3.9 million of goodwill related to the acquisition of
a Texas-based dental health maintenance organization ("HMO") company in 1996. In
the case of each acquisition, goodwill represents the excess of the purchase
price of the acquired company over the fair value of the net assets acquired. In
the case of the 1996 acquisition, the balance is net of accumulated amortization
and an adjustment in 1999 to reduce the carrying value of the goodwill to its
estimated realizable value. The Company estimated that the goodwill related to
the 1996 acquisition had a useful life of 40 years from the date of acquisition
of the related entity, and amortized the goodwill over that period during the
nine months ended September 30, 2001. See Recently Adopted Accounting Principles
below for a discussion of the impact of Statement of Financial Accounting
Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets."
RECOGNITION OF PREMIUM REVENUE
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.
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, and the recent
trend in payment rates and the average number of incurred claims per covered
individual. Since the liability for claims payable and claims incurred but not
reported is 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.
NET INCOME PER SHARE
Net income per share is presented in accordance with SFAS No. 128, "Earnings Per
Share." Basic net income per share is based on the weighted-average common
shares outstanding, including the common shares into which the convertible
6
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
net income per share is based on the weighted-average common shares outstanding,
including the effect of all potentially dilutive securities. During the three
months and nine months ended September 30, 2002 and 2001, the potentially
dilutive securities of the Company that were outstanding consisted of stock
options, convertible notes, and warrants. Diluted net income per share for all
periods presented includes the effect of all outstanding stock options with an
exercise price below the average market price of the Company's common stock
during each applicable period. The Company issued two (2) convertible notes
during the three months ended September 30, 2002, as discussed in Note 4. Both
of these convertible notes would have an anti-dilutive effect on net income per
share for both periods in 2002. Accordingly, they are excluded from the
calculation of diluted net income per share for these periods. The only warrants
issued by the Company were canceled without being exercised effective January
31, 2001, as discussed in Note 5.
RECENTLY ADOPTED ACCOUNTING PRINCIPLES
In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No.
141, "Business Combinations." SFAS No. 141 requires the use of the purchase
method of accounting 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 financial statements.
See Note 3 for a business combination completed in August 2002.
In July 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets." SFAS No. 142 requires that goodwill and other intangible assets with
indefinite useful lives established after June 30, 2001 not be amortized, and
that amortization of goodwill and other intangible assets with indefinite useful
lives that existed as of June 30, 2001, be ceased effective January 1, 2002. As
a result, the Company ceased amortizing its goodwill effective January 1, 2002.
The Company recorded $28,000 and $85,000 of amortization expense related to
goodwill, and $40,000 and $120,000 of amortization expense related to a
non-competition agreement, during the three months and nine months ended
September 30, 2001, respectively. The non-competition agreement became fully
amortized in September 2001. The Company's adjusted results of operations for
the three months and nine months ended September 30, 2001, which are adjusted to
exclude goodwill amortization, are as follows (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ ------------------
2002 2001 2002 2001
-------- -------- -------- --------
Income before extraordinary item, as reported $ 104 $ 495 $ 312 $ 728
Add back - Goodwill amortization -- 28 -- 85
-------- -------- -------- --------
Income before extraordinary item, as adjusted $ 104 $ 523 $ 312 $ 813
======== ======== ======== ========
Net income, as reported $ 104 $ 495 $ 312 $ 11,979
Add back - Goodwill amortization -- 28 -- 85
-------- -------- -------- --------
Net income, as adjusted $ 104 $ 523 $ 312 $ 12,064
======== ======== ======== ========
None of the Company's reported net income per share amounts for the three months
or nine months ended September 30, 2001 would change as a result of the above
adjustment for goodwill amortization expense, due to the relatively small amount
of this adjustment.
SFAS No. 142 also requires that all goodwill be evaluated for possible
impairment as of January 1, 2002, and as of the end of each reporting period
thereafter, and establishes a new method of testing for possible impairment. The
Company had no impairment of its goodwill as of January 1, 2002, or as of
September 30, 2002, based on the method of testing for possible impairment
established by SFAS No. 142. The adoption of SFAS No. 142 had no other
significant effect on the Company's financial statements.
7
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 Accounting Principles Board Opinion No. 30, "Reporting the
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual, and Infrequently Occurring Events 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. The Company adopted SFAS No. 144 effective on January
1, 2002. The adoption of SFAS No. 144 had no significant effect on the Company's
financial statements.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
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
expects that SFAS No. 143 will not have a significant effect on its financial
statements.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections."
SFAS No. 145 updates, clarifies, and simplifies existing accounting
pronouncements. This statement rescinds SFAS No. 4, which required all gains and
losses from extinguishment of debt to be aggregated and, if material, classified
as an extraordinary item, net of related income tax effect. As a result, the
criteria in APB No. 30 will now be used to classify those gains and losses. SFAS
No. 64 amended SFAS No. 4 and is no longer necessary as SFAS No. 4 has been
rescinded. SFAS No. 44 has been rescinded, as it is no longer necessary. SFAS
No. 145 amends SFAS No. 13 to require that certain lease modifications that have
economic effects similar to sale-leaseback transactions must be accounted for in
the same manner as sale-lease transactions. This statement also makes certain
technical corrections to existing pronouncements. While those corrections are
not substantive in nature, in some instances, they may change accounting
practice. The Company is currently evaluating whether SFAS No. 145 will have a
significant effect on its financial statements.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities." SFAS No. 146 requires that a liability for
the cost of an exit or disposal activity be recognized when the liability is
incurred. SFAS No. 146 also requires that the liability be initially measured
and recorded at fair value. SFAS No. 146 supersedes Emerging Issues Task Force
("EITF") Issue No. 94-3, "Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring)." Under EITF Issue No. 94-3, a liability for an exit cost,
as defined in the EITF Issue, was recognized at the date of an entity's
commitment to an exit plan. SFAS No. 146 is effective for exit or disposal
activities that are initiated after December 31, 2002.
NOTE 3. ACQUISITION
- ---------------------
Effective August 30, 2002, the Company acquired all of the outstanding capital
stock of Paramount Dental Plan, Inc. ("Paramount") for a purchase price of
approximately $6.7 million, consisting of $3.0 million in cash, a secured
convertible note for $2,625,000, and 769,231 shares of the Company's common
stock. Paramount is a dental benefits company located in Florida, and was merged
into the Company's dental HMO effective August 30, 2002. The secured convertible
note bears interest at 7.0% annually, and is payable in 36 equal monthly
installments of principal and interest, beginning in October 2002. The
outstanding balance under the secured convertible note is convertible into
common stock of the Company at a conversion price of $1.625 per share, at any
time after August 30, 2003. The convertible note is secured by the stock of the
Company's dental HMO subsidiary in Florida.
The business purpose of the acquisition was to increase the Company's market
penetration in Florida, which is one of the Company's primary geographic
markets. The acquisition increased the number of members in Florida for which
the Company provides dental benefits from approximately 50,000 members to
approximately 275,000 members.
8
In connection with this transaction, the Company entered into a three-year
employment agreement with the seller of Paramount, who is currently employed as
president of the Company's operations in Florida. The Company also entered into
a three-year office lease agreement with the seller of Paramount, related to the
office space that will be used as the Company's administrative office in Florida
beginning in late 2002.
The cost of the acquisition was allocated among the assets acquired as follows
(in thousands):
Cost of acquisition:
Cash portion of purchase price $3,000
Secured convertible note issued to seller 2,625
Common stock issued to seller 1,040
Transaction expenses incurred by the Company 158
-------
Total cost $6,823
=======
Fair value of net assets acquired:
Cash and cash equivalents $ 456
Restricted investment 50
Property and equipment 129
Other assets 229
Goodwill 6,926
Accounts payable and accrued liabilities (386)
Claims payable and claims incurred but not reported (225)
Deferred premium revenue (356)
-------
Net assets acquired $6,823
=======
The value used for the Company's common stock issued in the acquisition is based
on 769,231 shares of common stock issued, and a market value of $1.35 per share.
The market value of $1.35 per share is the average closing price of the
Company's common stock during the period from five (5) business days prior to
execution of the Stock Purchase Agreement to five (5) business days after
execution of the agreement. The Stock Purchase Agreement was executed on April
24, 2002.
The Company made a preliminary determination of whether the assets acquired
include any separately identifiable intangible assets apart from goodwill. The
Company's preliminary conclusion is that there are no such intangible assets,
and accordingly, the total excess of the purchase price over the net tangible
assets acquired has been allocated to goodwill in the accompanying condensed
consolidated financial statements.
9
The operations of Paramount are included in the accompanying condensed
consolidated financial statements beginning on September 1, 2002. Following is
certain pro forma statement of operations information, which reflects
adjustments to the Company's historical financial statements as if the
acquisition had been completed as of the beginning of each period presented (in
thousands):
NINE MONTHS ENDED
SEPTEMBER 30,
----------------
2002 2001
------- -------
Premium revenue, net $66,823 $68,359
Operating income 354 998
Income before extraordinary item 194 1,248
Net income 194 12,499
Basic net income per share before extraordinary item 0.01 0.04
Basic net income per share 0.01 0.39
Diluted net income per share before extraordinary item 0.01 0.04
Diluted net income per share 0.01 0.38
The above pro forma statement of operations information is not intended to
indicate the results that would have occurred if the acquisition had actually
been completed on the dates indicated, or the results that may occur in any
future period.
NOTE 4. LONG-TERM DEBT
- -------------------------
Long-term debt consists of the following (in thousands):
SEPTEMBER 30, DECEMBER 31,
2002 2001
--------------- --------------
Secured convertible promissory note $ 2,559 $ --
Unsecured convertible promissory note 1,900 --
Capital lease obligations 1,411 --
Other 69 265
--------------- --------------
Total debt 5,939 265
Less - Current portion (2,596) (265)
--------------- --------------
Long-term portion of debt $ 3,343 $ --
=============== ==============
See Note 3 for a description of the secured convertible promissory note, which
was issued in the acquisition of Paramount in August 2002.
In August 2002, the Company borrowed $2.0 million from one of its principal
stockholders, which was used to increase the Company's working capital, to
provide for the payments due under the two capital leases discussed below, and
to provide for the payments due under the settlement of the stockholder
litigation discussed in Note 9. The borrowing was made under an unsecured
convertible note that bears interest at 7.0% annually, and is payable in 36
equal monthly installments of principal and interest, beginning in September
2002. The outstanding balance under the convertible note is convertible into
common stock of the Company at a conversion price of $1.625 per share, at any
time after one year from the date of the borrowing.
In June 2002, the Company entered into two capital lease obligations with an
aggregate value of approximately $1.8 million. The two leases are related to the
purchase of a new computer software application and the purchase of formerly
leased furniture for the Company's primary administrative office. The Company
intends to use the new software as its primary business application, which will
be used for eligibility file maintenance, billing and collections, payment of
health care expenses, utilization review and other related activities. The new
software application will replace the Company's two existing systems with a
single system that can be used for all of the Company's existing product lines.
The cost of both of the Company's two existing systems is fully depreciated as
of September 30, 2002. The aggregate annual principal payments due under the
two capital leases are $260,000 during the remainder of 2002, $963,000 during
2003 and $188,000 during 2004. Under each of the two capital leases, the Company
has an option to purchase the leased assets for $1.00 at the expiration of the
lease.
10
NOTE 5. CONVERSION OF DEBT TO CONVERTIBLE PREFERRED STOCK
- -----------------------------------------------------------------
On March 1, 2000, the Company entered into a Recapitalization Agreement 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. In addition, the Investors,
the Bank, and the Senior Note Holder agreed to convert the investor senior loan,
the outstanding balance under the revolving credit facility, and the senior
notes payable into convertible preferred stock, subject to regulatory and
stockholder approval.
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 30 million shares of convertible preferred stock.
The estimated value of the convertible preferred stock was $1.375 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 one share of common
stock. The number of shares of convertible preferred stock, the estimated value
per share, and the conversion ratio indicated above have all been adjusted to
reflect an exchange of the Company's outstanding shares of convertible preferred
stock that was completed in May 2002. See Note 6 for more information on this
exchange.
Based on the estimated value of the convertible preferred stock as of January
31, 2001, the conversion transaction resulted in an extraordinary 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 carryforwards for tax purposes. 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 7.
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. These warrants were canceled without being
exercised, in connection with the conversion of the senior notes payable into
convertible preferred stock effective January 31, 2001.
NOTE 6. EXCHANGE OF CONVERTIBLE PREFERRED STOCK
- -----------------------------------------------------
Prior to May 2002, there were 300,000 shares of convertible preferred stock
issued and outstanding. Each share had a par value of $100 and a liquidation
preference of $100, and was convertible into 100 shares of the Company's common
stock. In May 2002, each outstanding share of convertible preferred stock was
exchanged for 100 new shares of convertible preferred stock. Each new share of
convertible preferred stock has a par value of $1.00 and a liquidation
preference of $1.00, and is convertible into one share of the Company's common
stock. All other rights and preferences of the convertible preferred stock
remained the same.
NOTE 7. 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 cumulative operating losses
incurred by the Company during the period from January 1, 1998 to September 30,
2002, and the existence of significant net operating loss carryforwards.
11
Due to the conversion of outstanding debt into convertible preferred stock, as
described in Note 5, 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 preexisting 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.
The Company had taxable income for the nine months ended September 30, 2002 and
2001, but its taxable income in both periods was completely offset by net
operating loss carryforwards from previous years.
NOTE 8. TOTAL COMPREHENSIVE INCOME
- --------------------------------------
Total comprehensive income includes the change in stockholders' equity during
the period from transactions and other events and circumstances from
nonstockholder sources. Total comprehensive income of the Company for the nine
months ended September 30, 2002 and 2001, includes net income and other
comprehensive income or loss, which consists of unrealized gains and losses on
marketable securities, net of realized gains and losses that occurred during the
period. Other comprehensive income (loss) was $47,000 and $27,000 for the three
months ended September 30, 2002 and 2001, respectively, and $38,000 and
$(52,000) for the nine months ended September 30, 2002 and 2001, respectively.
Total comprehensive income was $151,000 and $522,000 for the three months ended
September 30, 2002 and 2001, respectively, and $350,000 and $11,927,000 for the
nine months ended September 30, 2002 and 2001, respectively.
NOTE 9. COMMITMENTS AND CONTINGENCIES
- -----------------------------------------
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. In September 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. In October 2000, the plaintiffs filed an appeal of the
dismissal of the lawsuit, and the dismissal was overturned in February 2002. The
case was remanded back to the District Court with instructions to allow the
plaintiff to file a second amended complaint. Subsequently, the Company
conducted mediation and reached an agreement with the plaintiffs to settle the
lawsuit for a payment of $1.25 million to the plaintiffs, without an admission
of liability by any party. The agreement between the Company and the plaintiffs
was approved by the District Court in September 2002. The Company's insurer paid
$1.0 million of the cost of the settlement. Accordingly, the Company recorded a
$250,000 expense during the three months ended June 30, 2002, which is included
in selling, general and administrative expenses in the accompanying condensed
consolidated statement of operations.
CONTINGENT LEASE OBLIGATIONS
The Company sold all of its general dental practices and orthodontic practices
in 1996, 1997 and 1998. The Company also re-sold certain of these practices in
October 2000, after the original purchaser of a number of the practices
defaulted on its obligations to the Company. The office lease agreements related
to those practices either have been assigned to the respective purchasers of the
practices, or have expired.
12
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 September 30, 2002, the total of the minimum annual payments
under these leases was approximately $1.4 million, and the aggregate contingent
liability of the Company related to these leases was approximately $3.5 million
over the terms of the lease agreements, which expire at various dates through
2007. The aggregate contingent liability related to these leases was
approximately $5.2 million as of September 30, 2001. 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 $3.5 million excludes $120,000 of estimated lease obligations that
have been accrued as of September 30, 2002, due to a 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 condensed consolidated balance sheet under the caption "Accrued
expenses."
LIABILITY INSURANCE
The Company's directors' and officers' liability insurance policy, which
contained $5 million of coverage after a $250,000 deductible, expired on
September 30, 2002. Due to a significant increase in the cost of such insurance,
the Company has elected not to purchase this insurance coverage effective
October 1, 2002.
ITEM 2. 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. In addition to the Risk Factors
section of the Company's Annual Report on Form 10-K for the year ended December
31, 2001, the Current Reports on Form 8-K dated as of April 24, 2002, and August
30, 2002, and the Current Report on Form 8-K/A dated as of August 30, 2002, all
of which have been filed with the Securities and Exchange Commission, the
following risk factors should be considered in connection with this Quarterly
Report on Form 10-Q for the period ended September 30, 2002.
The statements contained in this Management's Discussion and Analysis of
Financial Condition and Results of Operations concerning expected growth, the
outcome of business strategies, future operating results and financial position,
economic and market events and trends, future premium revenue, future health
care expenses, the Company's ability to control health care, selling, general
and administrative expenses, and all other statements that are not historical
facts, are forward-looking statements. Words such as expects, projects,
anticipates, intends, plans, believes, seeks or estimates, or variations of such
words and similar expressions, are also intended to identify forward-looking
statements. These forward-looking statements are subject to significant risks,
uncertainties and contingencies, many of which are beyond the control of the
Company. Actual results may differ materially from those projected in the
forward-looking statements, which statements involve risks and uncertainties.
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, there can be
no assurance that the Company will be able to maintain its current market
position. 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.
PARAMOUNT INTEGRATION
The Company is in the process of integrating the business operations of
Paramount into the Company's operations. Due to the complexities inherent in
this process, there is a risk that the Company may not be able to complete such
integration activities in a timely and cost effective manner. In such case, the
general and administrative expenses of the Company may be higher than
anticipated, which could have a negative impact on the Company's overall
profitability.
13
GOVERNMENT REGULATION
The dental benefits industry is subject to extensive state and local laws, rules
and regulations. A number of the Company's subsidiaries, which generate
substantially all of the Company's revenue, are 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 various responsibilities on the Company, and 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.
CONTINGENT LEASE OBLIGATIONS
The Company sold all of its general dental practices and orthodontic practices
in 1996, 1997 and 1998. The Company also re-sold certain of these practices in
October 2000, after the original purchaser of a number of the practices
defaulted on its obligations to the Company. All of the office lease agreements
related to those practices either have been assigned to the respective
purchasers of the practices, or have expired. As of September 30, 2002, the
Company is contingently liable for an aggregate of approximately $3.5 million of
office lease obligations related to those practices for which the leases have
been assigned. Although all the leases have been assigned to the purchasers of
those practices, 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.
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 pay for orthodontic treatments for certain dental HMO patients who
previously paid for the treatments in full. The remaining amount of the
liabilities is subject to uncertainties, and there can be no assurance that the
ultimate amount of the remaining liabilities will not exceed the amounts accrued
on the Company's balance sheet as of September 30, 2002.
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 to the Company,
which are secured by the assets purchased. There can be no assurance that each
of these dentists will make timely payments on the 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.
14
COMPETITIVE MARKET
The Company operates in a highly competitive industry. Its ability to operate on
a profitable basis is affected by significant competition for employer groups
and for contracting dental providers. Dental providers are becoming more
sophisticated, their practices are busier, and they are less willing to join the
Company's networks under capitation arrangements or discounted fees. There can
be no assurance the Company will be able to compete successfully enough to be
profitable. 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 premium revenue decreased from $63.9 million for the nine months
ended September 30, 2001 to $61.5 million for the first nine months of 2002,
primarily due to the loss of a number of its customers, and a net decrease in
its enrollment within existing 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
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 competitive
networks of dental providers, 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 preferred provider ("PPO")/indemnity dental plan designs,
the Company assumes the underwriting risk related to the frequency and cost of
dental care services. If the Company does not accurately assess these
underwriting risks, the premium rates charged to its customers might 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.
Under the Company's dental HMO plan designs, the Company assumes underwriting
risk related to the frequency and cost of specialist services, the cost of
supplemental payments made to general dentists, and the frequency and 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 might 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 nonexclusive 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.
15
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.
All of the risks set forth herein could negatively impact the earnings of the
Company in the future. The Company's expectations for the future are based on
current information and its evaluation of external influences. Changes in any
one factor could materially impact the Company's expectations related to
revenue, premium rates, benefit plans offered, membership enrollment, health
care expenses, general and administrative expenses, 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 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 condensed consolidated financial statements are the following:
RECOGNITION OF PREMIUM REVENUE
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.
GOODWILL
Goodwill as of September 30, 2002 consists of $6.9 million of goodwill related
to the acquisition of Paramount Dental Plan, Inc. ("Paramount") in August 2002,
which is discussed in Note 3 to the accompanying condensed consolidated
financial statements, and $3.9 million of goodwill related to the acquisition of
a Texas-based dental HMO company in 1996. In the case of each acquisition,
goodwill represents the excess of the purchase price of the acquired company
over the fair value of the net assets acquired, and in the case of the 1996
acquisition, the balance is net of accumulated amortization and an adjustment in
1999 to reduce the carrying value of the goodwill to its estimated realizable
value. The Company estimated that the goodwill related to the 1996 acquisition
had a useful life of 40 years from the date of acquisition of the related
entity, and amortized the goodwill over that period during the nine months ended
September 30, 2001. In accordance with SFAS No. 142, "Goodwill and Other
Intangible Assets," the Company ceased amortizing its goodwill effective January
1, 2002. SFAS No. 142 requires that all goodwill be evaluated for possible
impairment as of January 1, 2002, and as of the end of each reporting period
thereafter, and establishes a new method of testing for possible impairment. The
Company had no impairment of its goodwill as of January 1, 2002, or as of
September 30, 2002, based on the method of testing for possible impairment
established by SFAS No. 142. However, there can be no assurance that impairment
will not occur in the future.
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, and the recent
trend in payment rates and the average number of incurred claims per covered
individual. Since the liability for claims payable and claims incurred but not
reported is 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.
16
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 cumulative operating losses
incurred by the Company during the period from January 1, 1998, to September 30,
2002, and the existence of significant net operating loss carryforwards.
RESULTS OF OPERATIONS
The following table shows the Company's results of operations as a percentage of
premium revenue, and is used in the period-to-period comparisons discussed
below.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2002 SEPTEMBER 30,
------------------ -----------------
2002 2001 2002 2001
-------- -------- -------- --------
Premium revenue, net 100.0% 100.0% 100.0% 100.0%
Health care services expense 70.3 69.4 71.1 69.7
Selling, general and administrative expense 29.2 29.1 28.7 29.8
-------- -------- -------- --------
Operating income 0.5 1.5 0.2 0.5
Investment and other income 0.4 1.0 0.5 1.4
Interest expense on debt that was converted
to equity in 2001 (1) -- -- -- (0.6)
Other interest expense (0.4) (0.1) (0.2) (0.2)
-------- -------- -------- --------
Income before income taxes and extraordinary item 0.5 2.4 0.5 1.1
Income tax expense -- -- -- --
-------- -------- -------- --------
Income before extraordinary item 0.5 2.4 0.5 1.1
Extraordinary item -- -- -- 17.6
-------- -------- -------- --------
Net income 0.5% 2.4% 0.5% 18.7%
======== ======== ======== ========
(1) Substantially all of the Company's debt was converted into convertible preferred
stock effective January 31, 2001. See Note 5 to the accompanying condensed consolidated
financial statements.
17
THREE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2001
Premium revenue decreased by $0.1 million, or 0.7%, from $20.8 million in 2001
to $20.7 million in 2002. The average membership for which the Company provided
dental coverage increased by approximately 6,000 members, or 1.0%, from 601,000
members during 2001 to 607,000 during 2002. The small decrease in premium
revenue was primarily due to the loss of a number of the Company's customers,
and a net decrease in its enrollment within retained customers, which were
offset by an increase in premium revenue due to the Paramount acquisition, which
is included in the accompanying condensed consolidated financial statements
beginning on September 1, 2002. Premium revenue decreased slightly even though
average membership increased, which was due to the impact of the Paramount
acquisition. The acquired Paramount business has lower premium revenue per
member than the Company's preexisting business. This is due to the dental plan
designs offered by Paramount, which include a significantly lower level of
benefits than the benefit plans offered by the Company prior to the acquisition
of Paramount. Substantially all of the Company's premium revenue was derived
from dental benefit plans in 2002 and 2001. Premium revenue from vision benefit
plans and other products was not material in 2002 or 2001.
Health care services expense increased slightly from 2001 to 2002, but was
approximately $14.5 million in both periods. Health care services expense as a
percentage of premium revenue (the "loss ratio") increased from 69.4% in 2001 to
70.3% in 2002. The increase in the loss ratio was primarily due to a shift in
the type of plan designs toward preferred provider ("PPO")/indemnity plan
designs, which have a higher loss ratio than HMO plan designs.
Selling, general and administrative ("SG&A") expense was approximately $6.0
million in both 2002 and 2001, and SG&A expense as a percentage of premium
revenue increased slightly, from 29.1% in 2001 to 29.2% in 2002.
Investment and other income decreased by $0.1 million, from $0.2 million in 2001
to $0.1 million in 2002. This decrease is primarily due to a decrease in
interest rates on short-term fixed-income investments during the past year, a
decrease in interest income from notes receivable, due to the liquidation of a
portion of the Company's notes receivable during the past year, and a decrease
in the amount of investments held by the Company, compared to the third quarter
of 2001. The decrease in investments was primarily due to the Company's use of
its cash to make significant reductions in accounts payable, accrued expenses,
and claims payable and claims incurred but not reported ("IBNR") during the past
year. By intentionally accelerating its payment of claims, the Company believes
it will enhance its image among dental providers.
Income before income taxes decreased by $0.4 million, from $0.5 million in 2001
to $0.1 million in 2002. Income before income taxes as a percentage of premium
revenue decreased from 2.4% in 2001 to 0.5% in 2002. This decrease was primarily
due to an increase in the loss ratio from 69.4% in 2001 to 70.3% in 2002, as
well as a decrease in investment income and an increase in interest expense.
NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2001
Premium revenue decreased by $2.4 million, or 3.7%, from $63.9 million in 2001
to $61.5 million in 2002. The average membership for which the Company provided
dental coverage decreased by approximately 58,000 members, or 9.3%, from 626,000
members during 2001 to 568,000 during 2002. The decrease in membership was
primarily due to the loss of a number of the Company's customers, and a net
decrease in its enrollment within retained customers, which were partially
offset by an increase in premium revenue due to the Paramount acquisition, which
is included in the accompanying condensed consolidated financial statements
beginning on September 1, 2002. Premium revenue decreased by only 3.7% even
though average membership decreased by 9.3%. This was primarily due to increases
in premium rates and a shift in the type of plan designs toward 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 2002 and 2001. Premium revenue from vision benefit plans and
other products was not material in 2002 or 2001.
Health care services expense decreased by $0.8 million, or 1.8%, from $44.6
million in 2001 to $43.8 million in 2002. The loss ratio increased from 69.7% in
2001 to 71.1% in 2002. The increase in the loss ratio was primarily due to
increases in supplemental payments and discounted fee-for-service payments to
dental HMO providers, and a shift in the type of plan designs toward
PPO/indemnity plan designs, which have a higher loss ratio than HMO plan
designs. The increases in supplemental and discounted fee-for-service payments
were partially due to high-cost arrangements with certain providers, which were
18
started early in 2002, and which have been terminated. These arrangements
resulted in an unusually large amount of supplemental payments and discounted
fee-for-service payments in 2002. The increase was also partially due to a
general increase in supplemental payments, which the Company believes is due to
more comprehensive submission of claims information by the dentists in its HMO
network.
SG&A expenses decreased by $1.4 million, or 7.3%, from $19.0 million in 2001 to
$17.6 million in 2002. SG&A expenses as a percentage of premium revenue
decreased from 29.8% in 2001 to 28.7% in 2002. The decrease in SG&A expenses is
primarily due to decreases in depreciation and amortization, furniture rent,
property rent, and a $350,000 refund of maintenance fees from one of the
Company's vendors, which were partially offset by a $250,000 expense in 2002
related to the settlement of stockholder litigation, as described in Note 9 to
the accompanying condensed consolidated financial statements. The decrease in
depreciation and amortization expense is primarily due to the fact that a
significant component of the Company's computer software became fully
depreciated during the past year, and the fact that the Company had no
amortization of goodwill or other intangible assets during 2002, as discussed in
Note 2 to the accompanying condensed consolidated financial statements. There
was $205,000 of amortization expense related to goodwill and another intangible
asset during the first nine months of 2001. The decrease in furniture rent was
due to the purchase of the office furniture used in the Company's primary
administrative office through a new capital lease during the second quarter of
2002, as discussed in Note 4 to the accompanying condensed consolidated
financial statements. The related furniture was formerly leased under an
operating lease with relatively expensive terms, compared to the new capital
lease. The new capital lease caused an increase in depreciation expense, but
this was more than offset by other decreases in depreciation and amortization,
as noted above. The decrease in property rent was primarily due to the fact that
the Company recorded an expense of approximately $300,000 in the second quarter
of 2001 to accrue all the future rent payments under a lease for office space
previously occupied by the Company. The Company had been subleasing the space to
an unrelated entity, and that entity ceased making rent payments in the second
quarter of 2001, due to its insolvency. The refund of maintenance fees was
primarily due to the settlement of a dispute over the amount of equipment
maintenance fees paid by the Company in several prior years.
Investment and other income decreased by $0.6 million, from $0.9 million in 2001
to $0.3 million in 2002. This decrease is primarily due to realized gains on the
sale of investments in 2001, a decrease in interest rates on short-term
fixed-income investments during the past year, a decrease in interest income
from notes receivable, due to the liquidation of a portion of the Company's
notes receivable during the past year, and a decrease in the amount of
investments held by the Company, compared to the prior year. The decrease in the
Company's investments was primarily due to significant reductions in accounts
payable, accrued expenses, and claims payable and IBNR during the past year. By
intentionally accelerating its payment of claims, the Company hopes to enhance
its image among dental providers.
Total interest expense decreased by $0.4 million, from $0.5 million in 2001 to
$0.1 million in 2002, primarily due to the conversion of substantially all of
the Company's debt into convertible preferred stock effective January 31, 2001,
which eliminated nearly all of the Company's interest expense.
Income before income taxes decreased by $0.4 million, from $0.7 million in 2001
to $0.3 million in 2002. Income before income taxes as a percentage of premium
revenue decreased from 1.1% in 2001 to 0.5% in 2002. This decrease was primarily
due to an increase in the loss ratio, which was partially offset by a decrease
in SG&A expense as a percentage of premium revenue.
LIQUIDITY AND CAPITAL RESOURCES
The Company's net working capital decreased from $4.2 million as of December 31,
2001, to $0.5 million as of September 30, 2002, primarily due to the acquisition
of Paramount in August 2002, as discussed in Note 3 to the accompanying
condensed consolidated financial statements. The Paramount acquisition decreased
working capital by a total of $3.5 million, including $2.7 million of net cash
used in the acquisition and the current portion of the secured convertible note
issued in the transaction, which is $0.8 million. The Company borrowed $2.0
million of working capital in August 2002, but this increase in working capital
was offset by the current portion of the two capital lease obligations entered
into in June 2002, as discussed in Note 4 to the accompanying condensed
consolidated financial statements.
19
The Company's total debt increased from $265,000 as of December 31, 2001, to
$5.9 million as of September 30, 2002, primarily due to the $2.6 million
convertible note issued in the Paramount acquisition, the $2.0 million unsecured
convertible note issued in August 2002, and the two capital leases discussed
above, which added $1.8 million of debt during the second quarter of 2002. The
aggregate principal payments due under all of the Company's debt, including its
capital leases, are $563,000 during the remainder of 2002, $2,424,000 in 2003,
$1,755,000 in 2004, and $1,197,000 in 2005.
In August 2002, the Company borrowed $2.0 million from one of its principal
stockholders, which was used to increase the Company's working capital, to
provide for the payments due under the two new capital leases discussed above,
and to provide for the payments due under the settlement of the stockholder
litigation discussed in Note 9 to the accompanying condensed consolidated
financial statements. The borrowing was made under an unsecured convertible note
that bears interest at 7.0% annually, and is payable in 36 equal monthly
installments of principal and interest, beginning in September 2002. The
outstanding balance under the convertible note is convertible into common stock
of the Company at a conversion price of $1.625 per share, at any time after one
year from the date of the borrowing.
Effective August 30, 2002, the Company acquired all of the outstanding capital
stock of Paramount Dental Plan, Inc. ("Paramount") for a purchase price of
approximately $6.7 million, consisting of $3.0 million in cash, a secured
convertible note for $2,625,000, and 769,231 shares of the Company's common
stock. The secured convertible note bears interest at 7.0% annually, and is
payable in 36 equal monthly installments of principal and interest, beginning in
October 2002. The outstanding balance under the secured convertible note is
convertible into common stock of the Company at a conversion price of $1.625 per
share, at any time after August 30, 2003. The convertible note is secured by the
stock of the Company's dental HMO subsidiary in Florida. The operations of
Paramount are included in the accompanying condensed consolidated financial
statements beginning on September 1, 2002.
The Company believes it has adequate financial resources to continue its current
operations for the foreseeable future, and that it will be able to meet its
various financial obligations from its existing financial resources and future
cash flows from its operations. However, there can be no assurance that the
Company's future earnings will be adequate to make all of the payments on the
Company's various obligations as they become due.
Net cash provided by operating activities was $0.7 million during the nine
months ended September 30, 2002, compared to $0.7 million of net cash used by
operating activities in the same period last year. The change is primarily due
to the fact that net cash used to reduce accounts payable, accrued expenses and
claims payable and claims incurred but not reported ("IBNR") decreased from
$3.1 million in 2001 to $1.6 million in 2002. The most significant decreases in
both periods were payments made to reduce the obligations assumed in connection
with the re-sale of certain dental practices in October 2000, and reductions in
claims payable and IBNR. The obligations assumed in connection with the re-sale
of dental practices were reduced by $680,000 during 2001 and by $360,000 during
2002, due to payments made during both periods. Claims payable and IBNR
decreased by $1.2 million in 2001 and $1.0 million in 2002, primarily due to
intentional decreases in the processing time for payment of provider claims, and
in the case of 2001, partially due to a decrease in the Company's volume of
PPO/indemnity business during the period. Due in part to the recent decline in
interest rates on investments, the Company has adopted the practice of paying
all provider claims as rapidly as possible, in order to enhance its image among
dental providers.
Net cash provided by investing activities was $0.8 million in 2002, compared to
$2.1 million in 2001. In 2002, the Company had a net liquidation of $3.8
million of investments, the proceeds of which were used primarily to finance the
acquisition of Paramount and to finance the reduction in bank overdrafts, as
discussed below. In 2001, the Company had a net liquidation of $1.4 million of
investments and received $1.3 million from the liquidation of certain of its
notes receivable, the proceeds of which were used primarily to finance the
reduction in bank overdrafts, as discussed below, and to finance the reductions
in accounts payable, accrued expenses and claims payable and IBNR, as discussed
above.
Net cash used in financing activities decreased from $1.3 million in 2001 to
$0.7 million in 2002. The net cash used in both periods was primarily due to
reductions in the amount of bank overdrafts, which are due to outstanding checks
not yet presented for payment.
20
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 2 to the accompanying condensed consolidated financial statements for a
discussion of recently adopted accounting principles and recently issued
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 expense. 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 partially mitigated in the short-term
by the fact that approximately 30% 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 3. 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 September 30, 2002,
the Company's total cash and investments were approximately $15.4 million.
Therefore, a one percentage-point change in short-term interest rates would have
a $154,000 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.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
Within 90 days prior to the date of this report, the Company completed an
evaluation, under the supervision and with the participation of the Company's
management, including the Chief Executive Officer and the Chief Financial
Officer, of the effectiveness of the design and operation of the Company's
disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based
on that evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that the Company's disclosure controls and procedures are effective in
alerting them, on a timely basis, to material information related to the Company
required to be included in the Company's periodic filings with the Securities
and Exchange Commission.
CHANGES IN INTERNAL CONTROLS
No significant changes to the Company's internal controls were made during the
periods covered by this report.
PART II. OTHER INFORMATION
ITEM 1. 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. In September 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. In October 2000, the plaintiffs filed an appeal of the
dismissal of the lawsuit, and the dismissal was overturned in February 2002. The
21
case was remanded back to the District Court with instructions to allow the
plaintiff to file a second amended complaint. Subsequently, the Company
conducted mediation and reached an agreement with the plaintiffs to settle the
lawsuit for a payment of $1.25 million to the plaintiffs, without an admission
of liability by any party. The agreement between the Company and the plaintiffs
was approved by the District Court in September 2002. The Company's insurer paid
$1.0 million of the cost of the settlement. Accordingly, the Company recorded a
$250,000 expense during the three months ended June 30, 2002, which is included
in selling, general and administrative expense in the accompanying condensed
consolidated statement of operations.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
EXHIBIT DESCRIPTION
------- -----------
10.30 Convertible Promissory Note dated August 8, 2002.
10.31 Registration Rights Agreement dated August 8, 2002.
10.32 Amended and Restated Stock Option Plan.
10.33 Amendment to Restated Certificate of Incorporation.
(b) REPORTS ON FORM 8-K.
The Company filed a Current Report on Form 8-K on September 13, 2002, related to
the completion of the acquisition of Paramount Dental Plan, Inc. The Company
also filed a Current Report on Form 8-K/A on November 12, 2002, which includes
historical financial statements of Paramount and pro forma financial information
for the Company related to this acquisition. See Note 3 to the accompanying
condensed consolidated financial statements for more information on this
transaction.
The Company filed a Current Report on Form 8-K on October 1, 2002, related to
the Company's settlement of the stockholder litigation filed against the
Company. See Note 9 to the accompanying condensed consolidated financial
statements for more information on the settlement.
22
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, in the City of Aliso
Viejo, State of California, on the 13th day of November 2002.
SAFEGUARD HEALTH ENTERPRISES, INC.
By: /s/ James E. Buncher
-----------------------
James E. Buncher
President and Chief Executive Officer
(Principal Executive Officer)
By: /s/ Dennis L. Gates
----------------------
Dennis L. Gates
Senior Vice President and Chief Financial Officer
(Chief Accounting Officer)
23
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002;
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2002
Each of the undersigned hereby certifies in his capacity as an officer of
SafeGuard Health Enterprises, Inc. (the "Company"), that the Quarterly Report of
the Company on Form 10-Q for the period ended September 30, 2002 (the "Report")
fully complies with the requirements of Section 13(a) of the Securities Exchange
Act of 1934 and that the information contained in the Report fairly presents, in
all material respects, the financial condition of the Company at the end of such
period and the results of operations of the Company for such period.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, this certification has been signed by the undersigned in the City
of Aliso Viejo, State of California, on the 13th day of November 2002.
SAFEGUARD HEALTH ENTERPRISES, INC.
By: /s/ James E. Buncher
-----------------------
James E. Buncher
President and Chief Executive Officer
(Principal Executive Officer)
By: /s/ Dennis L. Gates
----------------------
Dennis L. Gates
Senior Vice President and Chief Financial Officer
(Chief Accounting Officer)
24
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002;
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2002
I, James E. Buncher, President and Chief Executive Officer, certify that:
1. I have reviewed this quarterly report on Form 10-Q of SafeGuard Health
Enterprises, Inc., (the "Report").
2. Based on my knowledge, this Report does not contain any untrue statement of
a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this
Report;
3. Based on my knowledge, the financial statements, and other financial
information included in this Report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this Report;
4. The registrant's other certifying officers and I, are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
Report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this Report (the "Evaluation Date"); and
c) presented in this Report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
Report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, this certification has been signed by the undersigned in the City
of Aliso Viejo, State of California, on the 13th day of November 2002.
SAFEGUARD HEALTH ENTERPRISES, INC.
By: /s/ James E. Buncher
-----------------------
James E. Buncher
President and Chief Executive Officer
(Principal Executive Officer)
25
CERTIFICATION OF CHIEF FINANCIAL OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002;
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2002
I, Dennis L Gates, Senior Vice President and Chief Financial Officer, certify
that:
1. I have reviewed this quarterly report on Form 10-Q of SafeGuard Health
Enterprises, Inc., (the "Report").
2. Based on my knowledge, this Report does not contain any untrue statement of
a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this
Report;
3. Based on my knowledge, the financial statements, and other financial
information included in this Report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this Report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
Report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this Report (the "Evaluation Date"); and
c) presented in this Report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officer and I have indicated in this
Report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, this certification has been signed by the undersigned in the City
of Aliso Viejo, State of California, on the 13th day of November 2002.
SAFEGUARD HEALTH ENTERPRISES, INC.
By: /s/ Dennis L. Gates
----------------------
Dennis L. Gates
Senior Vice President and Chief Financial Officer
(Chief Accounting Officer)
26