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, 2002 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, 2003, was $4,965,000. The number of shares of the
registrant's common stock outstanding as of March 15, 2003, was 5,697,962 (not
including 3,216,978 shares held in treasury).
SAFEGUARD HEALTH ENTERPRISES, INC.
INDEX TO FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2002
PAGE
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PART I.
Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . 1
Item 2. Properties . . . . . . . . . . . . . . . . . . . . . . . 17
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . 18
Item 4. Submission of Matters to a Vote of Security Holders. . . 18
PART II.
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters. . . . . . . . . . . . . . . . . . 18
Item 6. Selected Financial Data. . . . . . . . . . . . . . . . 20
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations. . . . . . . . . . 21
Item 7A. Quantitative and Qualitative Disclosures About
Market Risk. . . . . . . . . . . . . . . . . . . . . . 29
Item 8. Financial Statements and Supplementary Data. . . . . . . 29
Item 9. Changes in and Disagreements with Independent
Accountants on Accounting and Financial Disclosures. . 29
PART III.
Item 10. Directors and Executive Officers of the Registrant . . . 30
Item 11. Executive Compensation. . . . . . . . . . . . . . . . . 32
Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters . . . . . . 34
Item 13. Certain Relationships and Related Transactions . . . . . 36
Item 14. Controls and Procedures. . . . . . . . . . . . . . . . . 36
PART IV.
Item 15. Exhibits, Financial Statement Schedules, and Reports
on Form 8-K. . . . . . . . . . . . . . . . . . . . . . 37
SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
CERTIFICATIONS BY CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER. . . 39
(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 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 health
maintenance organization ("HMO") plan designs and preferred provider
organization ("PPO")/indemnity plan designs. The Company also provides vision
benefit plans, administrative services, and preferred provider network rental.
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, Florida and
Texas, 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 seven (7) years. 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 an indemnity insurance company, which had
no active business but was licensed in a number of states in which the Company
was not previously licensed. In August 2002, the Company acquired a second
dental HMO company located in Florida, which also had approximately $7 million
of annual revenue at the time of the acquisition. The purchase price of the
acquisition in August 2002 was approximately $6.7 million, which consisted 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 Company is currently licensed as a
dental HMO in eight 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's executive offices are located at 95 Enterprise, Suite 100, Aliso
Viejo, California 92656-2605, and its website address is www.safeguard.net. 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 Centers for Medicare & Medicaid
Services (formerly known as the Health Care Financing Administration) ("CMS")
reported that total expenditures for dental care in the United States increased
from approximately $46.8 billion in 1996 to an estimated $65.6 billion in 2001.
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 133 million in 1996 to 170 million in 2001.
1
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 24.2% from 1996 to 2001, while the CPI for
all items for all urban consumers increased by 12.9% during the same period. CMS
reported that expenditures for dental services accounted for approximately 4.6%
of total national health care expenditures during 2001. 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 170 million people, or
approximately 60% of the total population of the United States, were enrolled in
some type of dental benefit plan in 2001. The United States Census Bureau
estimated that approximately 241 million people, or approximately 85% of the
total population of the United States, were enrolled in some type of medical
benefit plan in 2001. 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 decreased from
approximately 25 million people in 1996 to approximately 24 million people in
2001. 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.
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" list that is distributed to subscribers who are enrolled in the PPO
dental plan. The subscribers who are enrolled in the plan receive a higher level
of benefits, in the form of reduced out-of-pocket 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 22 million people in 1996 to approximately 62 million people
in 2001. 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 dental benefit plan business is characterized by participation of several
large national insurance companies, and numerous regional insurance companies,
regional medical HMOs, and other independent organizations. The NADP estimated
there were approximately 90 entities offering dental HMO plans, and
approximately 65 entities offering dental PPO plans, in the United States in
2000.
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
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 cost sharing by the patient. 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
2
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
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 products and
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.
(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, labor unions,
associations, and individuals. The Company also provides dental benefit plans to
medical HMOs, which include the Company's dental coverage in their product
offerings. The Company currently has contracts with over 3,000 employers,
medical HMOs, labor unions and associations, and delivers dental or vision
benefits, or related services, to a total of over 800,000 covered individuals.
Dental care is provided to covered individuals through the Company's HMO network
of approximately 6,600 dentists, and through its PPO network of approximately
12,100 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, the
geographic location of the group, 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 generally 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. Under PPO/indemnity plan designs, subscribers are required to pay
deductibles and co-insurance amounts 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.
3
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
Company targets the large employer market 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 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 has a telephonic small group sales and service function in each of its
primary geographic 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.
ACQUISITIONS
In August 2002, the Company acquired all of the outstanding stock of Paramount
Dental Plan, Inc. ("Paramount"), which was a dental HMO company with
approximately $7 million of annual revenue located in Tampa, Florida. Paramount
was merged with the Company's preexisting dental HMO subsidiary in Florida
effective upon the closing of the acquisition. 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. During
September 2002, the Company integrated the employees of Paramount into its
Florida operations, and the former chief executive officer of Paramount is
currently President of the Company's Florida operations. The Company is
currently in the process of integrating a majority of the information systems
activities of Paramount into its primary information systems application, and is
also in the process of integrating other aspects of Paramount's business into
the Company's operations.
In January 2003, the Company entered into a definitive agreement to acquire all
of the outstanding stock of Ameritas Managed Dental Plan, Inc. ("Ameritas"),
subject to regulatory approval. Ameritas is a dental HMO company with
approximately $4 million of annual revenue, and is located in Costa Mesa,
California. The business purpose of the acquisition is to increase the Company's
market penetration in California, which is one of the Company's primary
4
geographic markets. The acquisition is expected to increase the number of
members in California for which the Company provides dental benefits from
approximately 300,000 members to approximately 330,000 members. The Company
expects to complete this transaction during the first half of 2003, although it
is still subject to regulatory approval. The Company expects to integrate the
operations of Ameritas into the Company's existing California operations and its
National Service Center in Aliso Viejo, California upon completing the
transaction. In connection with the completion of this transaction, the Company
expects to enter into a 5-year marketing services agreement with Ameritas Life
Insurance Corp., the seller of Ameritas, ("ALIC"). Under this marketing services
agreement, ALIC will market the Company's dental HMO benefit plans to clients
that purchase dental PPO and indemnity benefit plans and other employee benefits
products from ALIC.
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 or 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 primarily to serve customers in California,
Florida or Texas that have a portion of their employees located in other states.
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.
PRODUCTS
The Company operates primarily in a single business segment, which is providing
dental benefit plans to employers, labor unions, medical HMOs, 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. In order for a member to be treated by a
specialist, the member's general dentist must initiate a referral to a
specialist, and the Company reviews each referral request prior to the member's
visit to the specialist. The Company's dental HMO plan designs 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 or 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 a
majority 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
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.
5
In addition to the dental HMO plan designs described above, the Company also
provides a dental HMO plan design in Florida that covers only semi-annual exams
and cleanings, but also provides a schedule of negotiated discounts which the
member can use when obtaining other dental services. Under this type of plan
design, the subscribers and dependents must receive services from a dentist in
the Company's HMO network in order to receive the benefits of the plan.
Dental PPO/Indemnity Plan Designs. The Company offers a comprehensive range of
dental PPO/indemnity plan designs, subject to regulatory restrictions. Dental
PPO/indemnity plan designs typically cover the same dental procedures as dental
HMO plan designs. Under the Company's dental PPO/indemnity 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
dental PPO/indemnity 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 dental PPO/indemnity 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
co-insurance 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
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. Dental PPO/indemnity 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 range 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
geographic 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 customers. 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 customers. This product allows the Company to offer
a dental HMO plan design to cost-conscious customers, while also providing a
PPO/indemnity plan design for coverage of employees located outside the
geographic area served by the Company's HMO provider network, and for employees
who are willing to pay higher premiums 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 range of vision benefit plans to
employer groups and other purchasers, which cover routine eye care in exchange
for a fixed monthly premium. In addition to routine optometric care, vision
6
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
Company's 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 any of 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. In addition, in one of its primary geographic
markets, the Company sells dental PPO/indemnity benefit plans that are
underwritten by an unrelated insurance company, and provides certain
administrative services related to these plans. In exchange for its sales
efforts and administrative services, the Company receives a fixed monthly fee
for each subscriber enrolled. Currently, the Company's annual revenue from these
other products is not material.
MARKETING
The Company markets its products to employer groups, labor unions, 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 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 is 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
Company's employees (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.
7
The Company markets its benefit plans to medical HMOs primarily through direct
contact between executives of the Company and the medical HMO. The Company's
existing contracts with medical HMOs typically cover a relatively large number
of subscribers, and accordingly, executives of the Company directly maintain
these relationships and provide customer service support on an ongoing basis.
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 dental or vision coverage, or related services,
to an aggregate of approximately 800,000 individuals, who participate in the
Company's benefit plans primarily through group contracts with over 3,000
employers, medical HMOs, labor unions and other purchasers of dental or vision
benefits. The Company's customers include many large employers, including Boeing
Corporation, City of Dallas, County of Los Angeles, Joint Council of Teamsters
No. 42 Welfare Trust, North Broward Hospital District, 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.
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 6,600 dentists in its HMO network, and
has approximately 12,100 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.
8
The Company compensates the general dentists in its HMO network primarily
through monthly capitation payments and supplemental payments. Each general
dentist typically receives a fixed monthly capitation 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, depending on the plan design
purchased by each patient. The Company typically makes a fixed supplemental
payment to the general dentist each time the dentist delivers specified
procedures to members enrolled in certain benefit plans. 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 plan designs. The
general dentist also typically receives co-payments from members for certain
types of services, which vary based on the plan design under which each member
is covered. Although most general dentists in the Company's HMO network are
compensated through capitation and supplemental payments, in some cases, general
dentists are compensated based on a negotiated fee for each procedure performed.
No individual dental office provides services to five percent (5%) or more of
the members enrolled in the Company's dental HMO plan designs.
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. The approval by the Company confirms that the referral is for a service
covered by the member's benefit plan. 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 in 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. Under some benefit plan
designs offered by the Company, the Company compensates non-contracted dentists
based on a fixed amount for each procedure, and the dentist may bill the patient
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.
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 Dental Director and Director of Quality
Management. 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,
9
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 5:00 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.
The Company maintains a Quality Management ("QM") Committee under the direction
of its Dental Director and Director of Quality Management. 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,
10
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 plan designs
and one for its dental PPO/indemnity plan designs. Both of the primary business
applications include comprehensive information on the Company's eligibility
files, benefit plan designs, premium rates, claim processing activities,
provider payment arrangements, and broker commissions. Both systems are flexible
enough to accommodate a wide variety of benefit plan designs to meet the needs
of the Company's customers. The system used for the Company's dental HMO plan
designs is a proprietary application that is continuously modified by the
Company to meet the changing needs of this business. The system used for
PPO/indemnity plan designs is a standard application purchased from a vendor,
which generally meets the Company's needs for its PPO/indemnity plan designs.
During 2002, the Company purchased a new software application, which the Company
intends to use as its primary business application. 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 products. The Company is currently in the
process of converting its business to the new software application, which is
expected to reduce administrative expenses and enhance customer service. In
connection with this conversion project, the Company is also in the process of
developing an enhanced web site that will allow customers to update their
eligibility files online, allow providers to verify eligibility online, and
provide other interactive features for customers, providers and brokers.
During 2001, the Company implemented an enhanced accounts receivable application
that is currently used for its dental HMO plan designs. 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. In connection with the conversion of its business to a new
software application, as described above, the Company plans to implement the new
accounts receivable application with respect to its PPO/indemnity plan designs.
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, 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, although the Company expects to
purchase various peripheral hardware in connection with its conversion to the
new software application, as described above.
The Company recently converted a portion of the business that was acquired in
the Paramount transaction to its proprietary dental HMO system. A third software
application is used by the Company for the remaining portion of the acquired
business, which consists of dental HMO benefit plans delivered to medical HMOs.
This system is a standard application purchased from a vendor, and generally
meets the Company's needs for its products offered to medical HMOs. The Company
is currently evaluating whether to convert this portion of its business to the
new software application purchased in 2002.
11
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 $5 million of general and professional liability insurance coverage,
which covers losses on a "claims made" basis. The Company believes this amount
of coverage is adequate to manage the ordinary exposure of operating its
business. However, there can be no assurance that this amount of coverage would
be adequate to cover potential claims against the Company, or that adequate
general and professional liability insurance coverage will be available to the
Company in the future at a reasonable cost.
Prior to October 2002, the Company maintained $5 million of officers and
directors liability insurance coverage, after a $250,000 deductible. Due to a
significant increase in the cost of such insurance, the Company elected not to
purchase this insurance coverage effective October 1, 2002.
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 several large national
insurance companies that offer dental HMO plan designs and dental PPO/indemnity
plan designs, numerous regional insurance companies and medical HMOs that offer
dental benefit plans, and numerous local or regional dental HMOs and other
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. In addition, many employers, union trust funds and
other group purchasers provide self-insured dental plans to their employees or
other constituents.
The Company believes that the key factors in a purchaser'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 dental HMO plan designs and
dental PPO/indemnity plan designs 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 dental benefit plans
with both HMO and PPO/indemnity plan designs in-house, and others contract with
dental benefits companies, such as the Company, to provide those products. The
Company believes it can compete effectively with medical HMOs that offer dental
benefit plans. The Company currently has relationships with certain medical
HMOs, under which the medical HMOs offer the Company's dental benefit plans to
their customers, and the Company intends to form relationships with additional
medical HMOs in the future.
Other than 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.
12
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 regulated primarily 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 subsidiaries 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
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 dental insurance subsidiary is 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 HMO entities, the Company is
not able to offer its dental HMO plan designs 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, SERVICE MARKS AND TRADE NAMES
The Company currently markets all of its products under the brand names
"SafeGuard" and "Paramount Dental Plan." The Company has filed, received
approval, and obtained renewal protection from the United States Patent and
Trademark office for certain trademarks and trade names for names and products
used by the Company in its ordinary course of business. The Company has also
received approvals for the use of its trademarks and trade names from state
governmental agencies, as applicable. The Company has received a trademark,
service mark or trade name for the following words and phrases used with and
without distinctive logos maintained by the Company:
13
- - SafeGuard(R) used with a distinctive logo depicting a modified smile used
in connection with all the products offered by the Company;
- - SafeGuard Health Plans(R) used in descriptive material to describe the
products offered by the Company;
- - SafeGuard Dental Plans(TM) used to describe the various dental HMO plan
designs offered by the Company;
- - SafeHealth Life(R) used with a descriptive logo depicting a modified smile
used by the Company to describe its dental PPO/indemnity plan designs; and
- - Paramount Dental Plan with a distinctive logo of three triangles stacked on
top of each other used by the Company in the integration of its recent
acquisition of Paramount into the Company's Florida operations.
Collectively, these trademarks, service marks and trade names 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.
EMPLOYEES
At March 15, 2003, the Company had approximately 225 employees, of which
approximately 40 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, and
subject to certain anti-discrimination provisions. 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 and 2002, is set in advance of each fiscal year by the
Company's board of directors, and has been set at 25% for 2003. The Company
contributed 66,000 shares and 33,000 shares of its common stock to the 401(k)
plan for the years ended December 31, 2002 and 2001. The Company made no
contributions to the plan during the year ended December 31, 2000. Employees
become vested in the Company's contributions to the 401(k) plan at the rate of
20% for each of the first five years of employment with the Company, with credit
given for past service. 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.
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 effective manner. In such
case, the profitability of the Paramount operations could be lower than
expected, and the general and administrative expenses of the Company could be
higher than expected, which could have a negative impact on the Company's
overall profitability.
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 significant
14
rate increases for unprofitable customers, 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 was profitable during the two years
ended December 31, 2002, as shown in the accompanying consolidated financial
statements. The Company plans to improve its profitability through various
actions, including continuing improvement of various customer service
activities, further streamlining of its operations, increasing customer
retention, increasing its volume of new business, the development of new
products, and the completion of profitable acquisitions. However, there can be
no assurance that the Company will be successful in implementing those actions
or maintaining its profitability.
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 benefits companies
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.
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 December
31, 2002, the Company is contingently liable for an aggregate of approximately
$3.3 million of office lease obligations related to those practices for which
the leases have been assigned. Although 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.
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.
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.
15
Ability to Maintain Revenue. The Company's premium revenue decreased from $84.8
million in 2001 to $83.0 million in 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 maintain its relationships with existing customers
and brokers, 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 dental PPO/indemnity
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.
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.
RECAPITALIZATION TRANSACTION
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 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. 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
16
operating loss carry-forwards for tax purposes, as discussed in Note 13 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 one share 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
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 canceled without being
exercised, in connection with the conversion of the senior notes payable into
convertible preferred stock effective January 31, 2001.
DIVESTITURE OF DENTAL PRACTICES
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 remaining 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 8 to the accompanying
consolidated financial statements for a discussion of impairment charges that
were recognized in 2000 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 a number of
these leases, which expire on various dates through 2007, as discussed in Note
14 to the accompanying consolidated financial statements. In the opinion of
management, the Company's facilities are adequate for its current needs.
17
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. 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 expense in the accompanying consolidated
statement of operations.
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, 2003:
First Quarter, through March 15, 2003. $ 1.25 $ 1.16
Year ended December 31, 2002:
First Quarter. . . . . . . . . . . . . $ 1.95 $ 1.19
Second Quarter . . . . . . . . . . . . 1.45 1.25
Third Quarter. . . . . . . . . . . . . 1.40 1.15
Fourth Quarter . . . . . . . . . . . . 1.35 1.15
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
(b) HOLDERS
As of March 15, 2003, there were approximately 800 holders of the Company's
common stock, including approximately 500 holders of record, and 21 holders of
the Company's convertible preferred stock.
18
(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.
19
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 2002 2001 2000 1999 1998
-------- -------- --------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA):
Premium revenue, net $83,043 $84,822 $ 97,251 $ 96,225 $ 97,449
Health care services expense 57,937 58,692 68,568 69,528 66,020
Selling, general and administrative expense 24,540 25,391 31,203 35,072 36,259
Loss on impairment of assets (1) 334 -- 450 24,576 2,397
-------- -------- --------- --------- ---------
Operating income (loss) 232 739 (2,970) (32,951) (7,227)
Investment and other income 607 1,060 1,431 2,067 624
Interest expense (232) (504) (4,913) (5,855) (4,311)
-------- -------- --------- --------- ---------
Income (loss) before income taxes, discontinued
operations and extraordinary item 607 1,295 (6,452) (36,739) (10,914)
Income tax expense (benefit) (2) (820) -- -- 10,934 (3,406)
-------- -------- --------- --------- ---------
Income (loss) before discontinued
operations and extraordinary item 1,427 1,295 (6,452) (47,673) (7,508)
Discontinued operations:
Loss from assets transferred under contractual
arrangements (3) -- -- (2,500) (4,363) --
Loss from operations to be disposed of (4) -- -- -- -- (2,430)
Extraordinary item:
Gain on conversion of debt to
convertible preferred stock (5) -- 11,251 -- -- --
-------- -------- --------- --------- ---------
Net income (loss) $ 1,427 $12,546 $ (8,952) $(52,036) $ (9,938)
======== ======== ========= ========= =========
Basic net income (loss) per share:
Income (loss) before discontinued
operations and extraordinary item $ 0.04 $ 0.04 $ (1.36) $ (10.04) $ (1.58)
Loss from discontinued operations -- -- (0.53) (0.92) (0.51)
Extraordinary item -- 0.35 -- -- --
-------- -------- --------- --------- ---------
Net income (loss) per basic share $ 0.04 $ 0.39 $ (1.89) $ (10.96) $ (2.09)
======== ======== ========= ========= =========
Weighted average basic shares outstanding (6) 35,130 32,253 4,747 4,747 4,747
Diluted net income (loss) per share:
Income (loss) before discontinued
operations and extraordinary item $ 0.04 $ 0.04 $ (1.36) $ (10.04) $ (1.58)
Loss from discontinued operations -- -- (0.53) (0.92) (0.51)
Extraordinary item -- 0.34 -- -- --
-------- -------- --------- --------- ---------
Net income (loss) per diluted share $ 0.04 $ 0.38 $ (1.89) $ (10.96) $ (2.09)
======== ======== ========= ========= =========
Weighted average diluted shares outstanding 35,638 33,009 4,747 4,747 4,747
BALANCE SHEET DATA AS OF DECEMBER 31 (IN THOUSANDS):
Cash and short-term investments $12,704 $15,453 $ 16,702 $ 6,281 $ 4,935
Current assets 16,111 19,195 21,268 10,380 13,411
Total assets 34,114 29,325 33,095 28,577 78,749
Current liabilities (5) 14,093 14,988 72,180 18,129 25,314
Long-term debt and capital lease obligations 2,997 -- 265 39,545 32,500
Other long-term liabilities 1,013 971 1,079 2,517 1,169
Stockholders' equity (deficit) 16,011 13,366 (40,429) (31,614) 19,766
See note explanations on the following page.
20
NOTE EXPLANATIONS TO SELECTED FINANCIAL DATA:
(1) Represents reductions in the carrying value of notes receivable in 2000,
goodwill in 1999, and notes receivable and real estate in 1998, to their
estimated realizable values. See Note 8 to the accompanying consolidated
financial statements.
(2) The 2002 amount primarily represents a decrease in the accrual for
estimated income tax liabilities related to certain transactions that
occurred in prior years. The 1999 amount primarily represents a charge to
establish a valuation allowance against net deferred tax assets. See Note
13 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 8 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 3 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 expense incurred in January 2001) into 30 million
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.
CRITICAL 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 are 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
critical accounting policies used to prepare the accompanying consolidated
financial statements are the following:
21
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 other than
temporary, the loss would be reported in the statement of operations, instead of
in a separate caption of stockholders' equity. As of December 31, 2002, there
were no unrealized losses that the Company believed to be other than temporary.
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, 2002. However, there can be no assurance that the bad debt
losses ultimately incurred will not exceed the reserve for bad debts established
by the Company.
NOTES RECEIVABLE
Notes receivable are stated at their estimated realizable values, 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, 2002. However, there can be no assurance that the Company will realize the
carrying amount of its notes receivable.
GOODWILL
Goodwill as of December 31, 2002 consists of $4.7 million of goodwill related to
the acquisition of Paramount Dental Plan, Inc. ("Paramount") in August 2002,
which is discussed in Note 2 to the accompanying 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 through December 31, 2001.
In accordance with Statement of Financial Accounting Standards ("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, on an annual basis thereafter, and any time an event that
may have affected the value of the goodwill occurs. SFAS No. 142 also
establishes a new method of testing for possible impairment. The Company has
established October 1 as the date on which it conducts its annual evaluation of
goodwill for possible impairment. In accordance with SFAS No. 142, the Company
tested its goodwill for possible impairment by estimating the fair value of each
of its reporting units that include goodwill, and comparing the fair value of
each reporting unit to the book value of the net assets of each reporting unit.
The fair value of each reporting unit was determined primarily by estimating the
discounted future cash flows of the reporting unit, and by estimating the amount
for which the reporting unit could be sold to a third party, based on a market
multiple of earnings. The Company had no impairment of its goodwill as of
January 1, 2002, or as of October 1, 2002, based on the method of testing for
possible impairment established by SFAS No. 142. The estimates to which
the results of the Company's test are the most sensitive are the amount of
shared administrative expenses that are charged to each reporting unit, and the
market multiple of earnings that is used to estimate the fair value of each
reporting unit. The Company believes the estimates used in its test are
reasonable and appropriate, but a significant change in either of these
estimates could result in the indication of an impairment of goodwill. The
22
Company is not aware of any events that have occurred since October 1, 2002 that
may have affected the value of its goodwill. However, there can be no assurance
that impairment will not occur in the future.
INTANGIBLE ASSETS
Intangible assets as of December 31, 2002 consist of customer relationships and
other intangible assets with an aggregate net book value of $2.0 million, all of
which were acquired in connection with the acquisition of Paramount in August
2002, as discussed in Note 2 to the accompanying consolidated financial
statements. The amount of the purchase price that was allocated to each of the
intangible assets was equal to the Company's estimate of the fair value of each
asset. Each intangible asset is being amortized over its estimated useful life
on a straight-line basis.
CLAIMS PAYABLE AND CLAIMS INCURRED BUT NOT REPORTED
The estimated liability for claims payable and claims incurred but not reported
("IBNR") 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.
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 premium revenue.
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 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 December 31,
2002, and the existence of significant net operating loss carryforwards.
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 net income (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, 2002,
the potentially dilutive securities of the Company that were outstanding
consisted of stock options, convertible notes, and warrants. The only
convertible notes issued by the Company were the two (2) convertible notes
issued during the three months ended September 30, 2002, as discussed in Notes 2
and 10 to the accompanying consolidated financial statements. Both of these
convertible notes would have an anti-dilutive effect on net income per share in
23
2002. Accordingly, they are excluded from the calculation of diluted net income
per share for this period. The calculation of diluted net income per share for
the years ended December 31, 2002 and 2001 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 period. There were no outstanding
stock options or warrants with an exercise price below the average market price
of the Company's common stock during the year ended December 31, 2000.
Accordingly, the Company's diluted net loss per share is the same as its basic
net loss per share for that period. The only warrants issued by the Company were
canceled without being exercised effective January 31, 2001, as discussed in
Note 11 to the accompanying consolidated financial statements.
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,
------------------------
2002 2001 2000
------- ------ -------
Premium revenue, net 100.0% 100.0% 100.0%
Health care services expense 69.8 69.2 70.5
Selling, general and administrative expense 29.5 29.9 32.1
Loss on impairment of assets 0.4 -- 0.5
------- ------ -------
Operating income (loss) 0.3 0.9 (3.1)
Investment and other income 0.7 1.2 1.5
Interest expense (0.3) (0.6) (5.0)
------- ------ -------
Income (loss) before income taxes, discontinued
operations and extraordinary item 0.7 1.5 (6.6)
Income tax expense (benefit) (1.0) -- --
------- ------ -------
Income (loss) before discontinued
operations and extraordinary item 1.7 1.5 (6.6)
Loss from discontinued operations -- -- (2.6)
Extraordinary item -- 13.3 --
------- ------ -------
Net income (loss) 1.7% 14.8% (9.2)%
======= ====== =======
2002 COMPARED TO 2001
Premium revenue decreased by $1.8 million, or 2.1%, from $84.8 million in 2001
to $83.0 million in 2002. The average membership for which the Company provided
dental coverage was approximately 616,000 members during 2002, compared to
615,000 members during 2001. Average membership increased in 2002 by
approximately 80,000 members due to the Paramount acquisition, but this increase
was offset by the loss of a number of the Company's customers, and a net
decrease in its enrollment within retained customers. The operations of
Paramount are included in the accompanying consolidated financial statements
beginning on September 1, 2002. The Paramount acquisition added approximately
240,000 members to the Company during the last four months of 2002, which
resulted in an average increase of 80,000 members for the full year. The Company
believes the net decrease in its enrollment within retained customers is
primarily due to reduced employment levels within its customers due to general
economic conditions, and to reduced enrollment in the Company's dental benefit
plans due to significant increases in the cost of medical coverage. Premium
revenue decreased by 2.1% in 2002 even though average membership was
approximately the same in both years. This was primarily due to the Paramount
acquisition, as the business acquired from Paramount consists largely of
products that have significantly lower premium rates than the Company's
pre-existing business. 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 1.3%, from $58.7
million in 2001 to $57.9 million in 2002. Health care services expense as a
percentage of premium revenue (the "loss ratio") increased slightly from 69.2%
24
in 2001 to 69.8% in 2002. The business acquired from Paramount has a
significantly lower loss ratio than the Company's pre-existing business, which
is primarily due to the type of benefit plan designs sold by Paramount. The
effect of the Paramount acquisition on the loss ratio was offset by increases in
specialty referral services, supplemental payments, and discounted
fee-for-service payments to dental HMO providers. The increase in the cost of
specialty referral services was due to an increase in the utilization rate for
those services in 2002. Supplemental payments are additional payments made to
dentists who are compensated primarily through capitation payments, in
connection with the delivery of certain dental procedures by those dentists. The
increases in supplemental and discounted fee-for-service payments were partially
due to high-cost arrangements with certain providers, which were started early
in 2002, and which were terminated prior to the end of 2002. These arrangements
resulted in an unusually large amount of supplemental payments and discounted
fee-for-service payments in 2002. There was also a general increase in
supplemental payments in 2002, which the Company believes is due to more
comprehensive submission of claims information by the dentists in its HMO
network.
Selling, general and administrative ("SG&A") expense decreased by $0.9 million,
or 3.4%, from $25.4 million in 2001 to $24.5 million in 2002. SG&A expenses as a
percentage of premium revenue decreased from 29.9% in 2001 to 29.5% in 2002.
The decrease in SG&A expenses is primarily due to decreases in depreciation
expense and furniture 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
14 to the accompanying consolidated financial statements. The decrease in
depreciation expense is primarily due to the fact that a significant component
of the Company's computer software became fully depreciated during 2002. 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 10 to the accompanying
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, as noted
above. 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.
Loss on impairment of assets increased from zero in 2001 to $334,000 in 2002.
The loss on impairment in 2002 is due to an increase in the reserve related to
notes receivable, as discussed in Note 8 to the accompanying consolidated
financial statements.
Investment and other income decreased by $0.5 million, from $1.1 million in 2001
to $0.6 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 2001, 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 accrued expenses and
claims payable and IBNR during both 2001 and 2002. By intentionally accelerating
its payment of claims, the Company intends to enhance its image among dental
providers.
Total interest expense decreased by $0.3 million, from $0.5 million in 2001 to
$0.2 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 $0.7 million, from $1.3 million in 2001
to $0.6 million in 2002. Income before income taxes as a percentage of premium
revenue decreased from 1.5% in 2001 to 0.7% 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.
There was an income tax benefit of $820,000 in 2002, which primarily represents
a decrease in the Company's accrual for estimated income tax liabilities related
to certain transactions that occurred in prior years, as discussed in Note 13 to
the accompanying consolidated financial statements. There was no current income
tax expense in 2002, due to temporary differences between income before income
taxes for accounting purposes and taxable income for tax purposes. Those
temporary differences resulted in a loss for tax purposes in 2002. There was
also no deferred income tax expense in 2002, due to the valuation allowance
against the Company's net deferred tax assets, as discussed in Note 13 to the
accompanying consolidated financial statements.
25
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. 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 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 expense decreased by $5.8 million, or 18.6%, from $31.2 million in 2000 to
$25.4 million in 2001. SG&A expense as a percentage of premium revenue decreased
from 32.1% in 2000 to 29.9% in 2001. The decrease in SG&A expense 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 expense 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 8 to the accompanying consolidated
financial statements.
Investment and other income decreased by $0.3 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 2001 and 2000, 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 11 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.
26
This improvement was primarily due to a $4.4 million decrease in interest
expense, a $5.8 million decrease in SG&A expense, 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 13
to the accompanying consolidated financial statements. There was no income tax
benefit in 2000 because the Company had previously used all of 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 re-sold to another unrelated party in October 2000, as discussed in Note 3
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 11 to the accompanying
consolidated financial statements for more information on this extraordinary
gain.
LIQUIDITY AND CAPITAL RESOURCES
The Company's net working capital decreased from $4.2 million as of December 31,
2001 to $2.0 million as of December 31, 2002, primarily due to the acquisition
of Paramount Dental Plan, Inc. ("Paramount") in August 2002, as discussed in
Note 2 to the accompanying 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
impact of the Paramount acquisition was partially offset by an increase in
working capital due to net income of $1.5 million during 2002. The Company
borrowed $2.0 million of working capital in August 2002, but this increase in
working capital was largely offset by the current portion of the two capital
lease obligations entered into in June 2002, as discussed in Note 10 to the
accompanying consolidated financial statements, which was $1.0 million, and the
current portion of the unsecured convertible note issued in August 2002, which
was $0.6 million.
The Company's total debt increased from $265,000 as of December 31, 2001 to $5.4
million as of December 31, 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 noted above, which added
$1.8 million of debt during the second quarter of 2002. The Company made an
aggregate of $1.7 million of principal payments on debt and capital lease
obligations during 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 new capital leases discussed above,
and to provide for the payments due under the settlement of the stockholder
litigation discussed in Note 13 to the accompanying 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 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 consolidated financial statements beginning on September 1, 2002.
27
Net cash provided by operating activities was $1.2 million during 2002, compared
to $0.7 million of net cash used by operating activities in 2001. This change is
primarily due to a $0.6 million increase in deferred premium revenue in 2002,
compared to a $0.5 million decrease in deferred premium revenue in 2001, and the
fact that net cash used to reduce accrued expenses decreased from $2.1 million
in 2001 to $1.3 million in 2002. The changes in deferred revenue are primarily
due to changes in the volume of individual plan customers who pay the Company
for a year of coverage in advance. The volume of this business increased during
2002, compared to a decrease in the volume of this business during 2001. The
decrease in accrued expenses in 2001 was primarily due to $1.3 million of
payments made to reduce the obligations assumed in connection with the re-sale
of certain dental practices in October 2000, as described in Note 3 to the
accompanying consolidated financial statements. Claims payable and claims
incurred but not reported ("IBNR") decreased by $1.4 million in 2002 and $1.6
million in 2001, 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
$1.5 million in 2001. In 2002, the Company had a net liquidation of $3.9
million of investments, the proceeds of which were used primarily to finance the
acquisition of Paramount and capital expenditures. In 2001, the Company had a
net liquidation of $1.3 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 capital expenditures and a reduction in bank
overdrafts, as discussed below.
Net cash used in financing activities decreased from $0.7 million in 2001 to
$0.5 million in 2002. The net cash used in both 2001 and 2002 was primarily due
to reductions in the amount of bank overdrafts, which are due to outstanding
checks not yet presented for payment.
A summary of the Company's future commitments is as follows (in thousands):
PAYMENTS DUE IN
-------------------------------------------
LESS THAN 1 TO 3 3 TO 5 MORE THAN
ONE YEAR YEARS YEARS FIVE YEARS TOTAL
--------- ------- ----------- ----------- -------
CONTRACTUAL OBLIGATIONS:
Long-term debt $ 1,461 $ 2,764 $ -- $ -- $ 4,225
Capital lease obligations 1,047 228 30 -- 1,305
Other long-term liabilities -- 491 385 137 1,013
Operating lease commitments, net 1,845 4,177 3,680 1,838 11,540
--------- ------- ----------- ----------- -------
Total contractual obligations $ 4,353 $ 7,660 $ 4,095 $ 1,975 $18,083
========= ======= =========== =========== =======
OTHER COMMITMENTS:
Contingent liability for dental office
leases assigned to other entities $ 1,369 $ 1,591 $ 300 $ -- $ 3,260
Contingent liability for subleased
office space 443 192 -- -- 635
--------- ------- ----------- ----------- -------
Total other commitments $ 1,812 $ 1,783 $ 300 $ -- $ 3,895
========= ======= =========== =========== =======
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 12 to the accompanying consolidated
financial statements for more information on other long-term liabilities, and
see Note 14 for more information on operating lease commitments and contingent
lease obligations.
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 $3.3 million and $2.8 million as of
December 31, 2002 and 2001, 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
28
required with respect to all of the Company's subsidiaries that are subject to
minimum capital and surplus requirements was approximately $8.8 million as of
December 31, 2002. The aggregate statutory capital and surplus in these
subsidiaries as of December 31, 2002 was approximately $9.9 million. As a
result of these regulatory requirements, approximately $10.3 million of the
Company's consolidated stockholders' equity as of December 31, 2002 was not
available for the payment of dividends to the Company's stockholders.
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 for a planned
increase in cash used for capital expenditures in 2003 and any financing that
may be required in connection with potential acquisitions. The Company
anticipates that its cash outlays for capital expenditures, which were $0.4
million during 2002, will increase in 2003 due to a planned conversion to a new
computer software application, as discussed in Note 10 to the accompanying
consolidated financial statements.
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
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
obligations as they become due, or 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 information
on 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 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 services expense is mitigated in the short-term by
the fact that approximately 33% 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, 2002,
the Company's total investments were approximately $12.9 million. Therefore, a
one percentage-point change in short-term interest rates would have a $129,000
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 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
- ---------------------------------------------------
The Consolidated Financial Statements and the related Notes and Schedule thereto
filed as part of this 2002 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 DISCLOSURES
-------------------------
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.
29
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 66 President, Chief Executive Officer and Director
Stephen J. Baker 45 Executive Vice President and Chief Operating Officer
Ronald I. Brendzel, JD 53 Senior Vice President, General Counsel, Secretary and Director
Dennis L. Gates, CPA 47 Senior Vice President, Chief Financial Officer and Director
Kenneth E. Keating 39 Vice President, Marketing and Chief Marketing Officer
Michael J. Lauffenburger 42 Chief Information Officer
Barbara Lucci 43 Vice President, Service Center Operations
Michael B. Sutherland, DDS 56 Dental Director and Director of Quality Management
Steven J. Baileys, DDS 49 Chairman of the Board of Directors
Neil R. Anderson 47 Director
Stephen J. Blewitt 43 Director (1)
Leslie B. Daniels 55 Director (1)
- ----------------
(1) Member, Compensation and Stock Option Committee, and Audit Committee.
Mr. Buncher, Jack R. 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. Jack R.
Anderson resigned from his position as a director effective March 11, 2003, and
Neil R. Anderson became a director effective March 13, 2003. All directors of
the Company are elected annually. Officers of the Company serve at the pleasure
of the board of directors. See Item 11. - Executive Compensation below for a
description of severance 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 one other non-public health care company.
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
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.
30
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.
Mr. Lauffenburger has been Chief Information Officer since November 2002. He
served as Director, Information Services from January 2001, when he joined the
Company, to November 2002. From November 1998 to January 2001, he was IS
Manager, Year 2000, then Senior Project Manager, at Scripps Health. Mr.
Lauffenburger was Senior Programmer, then Project Manager, then Director,
Electronic Data Interchange of Community Care Network, Inc., from April 1991 to
November 1998.
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.
Dr. Sutherland has been Dental Director since May 2000, when he joined the
Company, and has been Director of Quality Management since June 2002. He also
served as Vice President, Provider Relations from July 2001 to May 2002. Dr.
Sutherland 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. He 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 Fund, a healthcare investment and
consulting firm, since 1988. He currently serves on the board of directors of
three non-public health care companies, and has been a director of several other
private health care companies.
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 of Hancock Mezzanine Advisors LLC, a
subsidiary of John Hancock, and the managing member of Hancock Mezzanine
Partners, L.P. and Hancock Mezzanine Partners II, L.P., funds that invest
primarily in mezzanine debt securities. Mr. Blewitt is currently a director of
several private companies.
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
Laboratories, Inc. He was a past Chairman of Zenith Laboratories, Inc. and has
been a director of several other public and private companies.
31
ITEM 11. EXECUTIVE COMPENSATION
- -------------------------------
The following table shows the compensation paid to the Company's Chief Executive
Officer as of December 31, 2002, and the other four most highly compensated
executive officers as of December 31, 2002 who received total compensation in
excess of $100,000 during the year ended December 31, 2002 (the "Named Executive
Officers"). The compensation disclosed is for the three years ended December 31,
2002.
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 2002 $ 250,000 $ 25,000 $ 2,750 --
Executive Officer (2) 2001 246,000 -- 928 100,000
2000 187,500 -- -- 600,000
Stephen J. Baker Executive Vice President 2002 220,000 20,000 -- --
and Chief Operating 2001 152,000 -- -- 300,000
Officer (3) 2000 -- -- -- --
Dennis L. Gates Senior Vice President 2002 204,000 15,000 2,750 20,000
and Chief Financial 2001 197,000 -- -- --
Officer 2000 203,750 -- -- 375,000
Ronald I. Brendzel Senior Vice President, 2002 191,000 15,000 2,738 207,500
General Counsel and 2001 193,000 -- -- --
Secretary 2000 185,000 -- -- 120,000
Kenneth E. Keating Vice President, 2002 186,000 -- 2,319 2,500
Marketing and Chief 2001 180,000 -- 938 --
Marketing Officer (4) 2000 170,654 -- -- 120,000
- -----------------
(1) Other compensation consists of matching contributions to the Company's
401(k) plan.
(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. 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.
During 2002, the Company entered into a Severance Agreement with each of the
Named Executive Officers, which continues until the officer's employment by the
Company terminates for any reason. Pursuant to each of these agreements, either
the Company or the officer can terminate the officer's employment with the
Company at any time. In the event the Company terminates the officer's
employment, or implements a substantial diminution of the officer's
responsibilities, and as a result, the officer resigns, within one year and as a
result of a "change in control" as defined below, the Company is obligated to
pay the officer an amount equal to the officer's annual salary then in effect,
plus an amount equal to the bonus earned by the officer during the last calendar
year. A "change in control" is defined as the acquisition of the Company by
another entity, a sale of substantially all of the assets of the Company, a
merger of the Company with another entity, the acquisition by any person or
group of persons of 50% or more of the combined voting power of the Company's
then outstanding securities, or a change of 50% or more of the directors of the
Company within a one-year period.
During 2003, the Company implemented a Retention Bonus Plan with respect to each
of the Named Executive Officers, which continues until the officer's employment
by the Company terminates for any reason. The purpose of the Retention Bonus
Plan is to provide an incentive for the senior management of the Company to
remain employed during a reasonable transition period in the event of the sale
of the Company to a third party. In the event that more than 50% of the Company
is sold to an entity that is not otherwise a current stockholder of the Company,
each of the Named Executive Officers would receive a variable retention bonus
32
that is based on the amount of proceeds from the sale transaction. The retention
bonus amounts to be paid by the Company are the following amounts for each $1.00
per share of common stock that is realized in a sale transaction: $325,000 to
Mr. Buncher, $250,000 to Mr. Baker, $150,000 to Mr. Gates, $150,000 to Mr.
Brendzel, and $75,000 to Mr. Keating. Of the total amount of each officer's
retention bonus, 25% would be paid at the closing of the transaction, provided
the officer is still employed at that time, and 75% would be paid in monthly
installments over the nine months following the closing of the transaction,
provided the officer is still employed by the purchaser at the time each payment
is due. Notwithstanding the previous sentence, the entire retention bonus would
be paid in the event the purchaser reduces the officer's compensation rate or
terminates the officer's employment.
STOCK OPTION GRANTS DURING THE YEAR ENDED DECEMBER 31, 2002
Stock options granted to the Named Executive Officers during the year ended
December 31, 2002 were as follows.
INDIVIDUAL STOCK OPTION GRANTS
- ------------------------------------------------------------------------------- POTENTIAL REALIZABLE VALUE
NUMBER OF % OF TOTAL AT ASSUMED ANNUAL RATES
SHARES OPTIONS OF STOCK PRICE APPRECIATION
UNDERLYING GRANTED TO EXERCISE FOR OPTION TERM(3)
OPTIONS EMPLOYEES PRICE PER EXPIRATION ----------------------------
NAME GRANTED IN 2002 SHARE(1) DATE(2) 5% 10%
- --------------------------- ----------- ----------- ---------- ------------ ------------- -------------
James E. Buncher -- -- $ -- -- $ -- $ --
Stephen J. Baker -- -- -- -- -- --
Dennis L. Gates 20,000 4.9% 1.25 Feb 2012 15,722 39,844
Ronald I. Brendzel 7,500 1.9% 1.25 Feb 2012 5,896 14,941
Ronald I. Brendzel 200,000 49.4% 1.23 Oct 2012 154,708 392,061
Kenneth E. Keating 2,500 0.6% 1.25 Feb 2012 1,965 4,980
- ----------------
(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.
The dates on which the options can be exercised 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 assumed level. Unless the market price of the common
stock does in fact appreciate over the option term, the Named Executive
Officers will realize no value from the option grants.
33
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, 2002. Stock options held by the Named
Executive Officers at December 31, 2002 are shown in the following table. There
were no stock appreciation rights outstanding as of December 31, 2002.
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 -- $ -- 500,000 200,000 $ 93,333 $ 26,667
Stephen J. Baker -- -- 100,000 200,000 -- --
Dennis L. Gates -- -- 316,667 78,333 63,333 11,667
Ronald I. Brendzel -- -- 80,000 247,500 16,000 8,000
Kenneth E. Keating -- -- 80,000 42,500 16,000 8,000
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
- -----------------------------------------------------------------------
AND RELATED STOCKHOLDER MATTERS
-------------------------------
The following table shows the number of shares of common stock beneficially
owned as of March 15, 2003, 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
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, 2003 was 5,697,962 and the total number of
shares of preferred stock outstanding as of that date was 30,000,000, 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 % OF
BENEFICIALLY TOTAL SHARES
OFFICER OR DIRECTOR OWNED(1) OUTSTANDING(2)
- ------------------------------------------------------------------- ------------------- --------------
John Hancock Life Insurance Company (3) 15,000,000 42.0
CAI Capital Partners & Company II, Limited Partnership (4) 8,514,579 23.9
Leslie B. Daniels (5) 84,500 *
Jack R. Anderson (6) 3,210,615 9.0
Steven J. Baileys (7) 2,844,600 7.9
The Burton Partnership (8) 2,328,685 6.5
James E. Buncher (9) 892,333 2.5
Dennis L. Gates (10) 481,667 1.3
Ronald I. Brendzel (11) 353,173 1.0
Stephen J. Baker (12) 204,534 *
Kenneth E. Keating (13) 126,833 *
Stephen J. Blewitt (3) -- *
All directors and Named Executive Officers as a group (9 persons) 31,628,334 84.9
All principal stockholders in total 33,957,019 91.1
* Indicates less than one percent (1%)
See note explanations on the following page.
34
(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, 2003. 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, 2003. 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 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 540 Madison Avenue, 22nd
Floor, New York, New York 10022.
(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 540 Madison Avenue, 22nd
Floor, New York, New York 10022.
(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,
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, and options to
purchase 133,333 shares of common stock. 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 162,700 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 488,100 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.
35
(9) Includes 59,000 shares of common stock, 200,000 shares issuable upon
conversion of shares of convertible preferred stock, and options to
purchase 633,333 shares of common stock.
(10) Includes 100,000 shares issuable upon conversion of shares of convertible
preferred stock, and options to purchase 381,667 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 122,500 shares of common stock.
(12) Includes 21,200 shares of common stock and options to purchase 183,334
shares of common stock.
(13) Includes 6,000 shares of common stock and options to purchase 120,833
shares of common stock.
The following is a summary of the Company's equity compensation plans as of
December 31, 2002:
SHARES OF WEIGHTED NUMBER
STOCK TO BE AVERAGE OF SHARES
ISSUED UPON EXERCISE AVAILABLE
EXERCISE OF PRICE OF FOR ISSUANCE
OUTSTANDING OUTSTANDING UNDER STOCK
STOCK OPTIONS STOCK OPTIONS OPTION PLAN
------------- -------------- ------------
Equity compensation plans approved by stockholders 2,725,834 $ 1.15 874,166
Equity compensation plans not approved by
stockholders -- -- --
------------- -------------- ------------
Total 2,725,834 $ 1.15 874,166
============= ============== ============
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
- -------------------------------------------------------
The Company paid $153,000, $200,000 and $117,000 of consulting fees to the
chairman of its board of directors during the years ended December 31, 2002,
2001 and 2000, respectively. This consulting arrangement terminated effective
January 31, 2003. In addition, please see the discussion of the Company's
recapitalization transaction under "Recapitalization Transaction" in Part I,
Item 1 of this Form 10-K.
ITEM 14. 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.
36
PART IV
ITEM 15. 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 2002 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 2002 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
The Company filed a Current Report on Form 8-K on February 14, 2002, to report
the execution of a definitive agreement to acquire all of the outstanding stock
of Ameritas Managed Dental Plan, Inc., a California managed dental health
maintenance organization, for a purchase price of $1.1 million in cash, subject
to regulatory approval. See Note 19 to the accompanying consolidated financial
statements for more information on this transaction, which is currently pending
regulatory approval.
37
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 21, 2003
-------------------------------------------- ----------------------
James E. Buncher
President, Chief Executive Officer and Director
(Principal Executive Officer)
By: /s/ Dennis L. Gates Date: March 21, 2003
-------------------------------------------- ----------------------
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, the
following persons have signed this report below on behalf of the registrant and
in the capacities and on the dates indicated.
By: /s/ James E. Buncher Date: March 21, 2003
-------------------------------------------- ----------------------
James E. Buncher
President, Chief Executive Officer and Director
By: /s/ Steven J. Baileys Date: March 21, 2003
-------------------------------------------- ----------------------
Steven J. Baileys, DDS
Chairman of the Board of Directors
By: /s/ Ronald I. Brendzel Date: March 21, 2003
-------------------------------------------- ----------------------
Ronald I. Brendzel, JD
Senior Vice President, General Counsel, Secretary and Director
By: /s/ Dennis L. Gates Date: March 21, 2003
-------------------------------------------- ----------------------
Dennis L. Gates
Senior Vice President, Chief Financial Officer and Director
By: /s/ Neil R. Anderson Date: March 21, 2003
-------------------------------------------- ----------------------
Neil R. Anderson
Director
By: /s/ Stephen J. Blewitt Date: March 21, 2003
-------------------------------------------- ----------------------
Stephen J. Blewitt
Director
By: /s/ Leslie B. Daniels Date: March 21, 2003
-------------------------------------------- ----------------------
Leslie B. Daniels
Director
38
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002;
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2002
Each of the undersigned hereby certifies in his capacity as an officer of
SafeGuard Health Enterprises, Inc. (the "Company"), that the Annual Report of
the Company on Form 10-K for the period ended December 31, 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 21st day of March 2003.
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)
39
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;
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2002
I, James E. Buncher, President and Chief Executive Officer, certify that:
1. I have reviewed this annual report on Form 10-K 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 21st day of March 2003.
SAFEGUARD HEALTH ENTERPRISES, INC.
By: /s/ James E. Buncher
-----------------------
James E. Buncher
President and Chief Executive Officer
(Principal Executive Officer)
40
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;
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2002
I, Dennis L Gates, Senior Vice President and Chief Financial Officer, certify
that:
1. I have reviewed this annual report on Form 10-K 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 21st day of March 2003.
SAFEGUARD HEALTH ENTERPRISES, INC.
By: /s/ Dennis L. Gates
---------------------
Dennis L. Gates
Senior Vice President and Chief Financial Officer
(Chief Accounting Officer)
41
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 Amended and Restated Certificate of Incorporation (15)
3.1.3 Amended and Restated Certificate of Incorporation (17)
3.1.4 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)
10.5.1 Amended and Restated Stock Option Plan (17)
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.(13)
10.21 Administrative Services Agreement between the Company and Total
Dental Administrators Health Plan, Inc. (13)
10.22 Stock Purchase Agreement between the Company and Total Dental
Administrators, Inc. (13)
10.23 Promissory Note and Security Interest given by Total Dental
Administrators, Inc. to the Company (13)
10.24 Administrative Services Agreement between the Company and Total
Dental Administrators, Inc. (13)
10.25 Stock Purchase Agreement between the Company and Dental Source of
Missouri and Kansas, Inc. (13)
10.26 First Amendment to Stock Purchase Agreement between the Company
and Dental Source of Missouri and Kansas, Inc. (13)
10.27 Administrative Services Agreement between the Company and Dental
Source of Missouri and Kansas, Inc.(13)
10.28 Amended and Restated 401(k) Plan (13)
10.29 First Amendment to Amended and Restated 401(k) Plan (13)
10.30 Stock Purchase Agreement dated as of April 24, 2002 by and
between the Company and Nicholas M. Kavouklis (14)
10.31 First Amendment to Stock Purchase Agreement dated as of June 17,
2002 between the Company and Nicholas M. Kavouklis (16)
10.32 Secured Convertible Promissory Note dated as of August 30, 2002
issued by the Company to Nicholas M. Kavouklis in connection
with Exhibit 10.31 above (16)
10.33 Registration Rights Agreement dated as of August 30, 2002 between
the Company and Nicholas M. Kavouklis in connection with
Exhibit 10.31 above (16)
10.34 Employment Agreement dated as of August 30, 2002 between the
Company and Nicholas M. Kavouklis (16)
E-1
10.35 Lease Agreement dated as of August 30, 2002 between the Company
and an affiliate of Nicholas M. Kavouklis (16)
10.36 Pledge Agreement dated as of August 30, 2002 between the Company
and Nicholas M. Kavouklis in connection with Exhibit 10.31
above (16)
10.37 Guarantee Agreement dated as of August 30, 2002 between the
Company and an affiliate of Nicholas M. Kavouklis in connection
with Exhibit 10.35 above (16)
10.38 Stipulation and Settlement dated as of September 17, 2002 of
stockholder class action lawsuit filed against the Company in
1999 (17)
10.39 Order Preliminarily Approving Settlement, providing for notice to
the class, and scheduling final approval of settlement dated as
of September 19, 2002 (17)
10.40 Convertible Promissory Note dated as of August 8, 2002 issued by
the Company to Jack R. Anderson (18)
10.41 Registration Rights Agreement dated as of August 8, 2002 between
the Company and Jack R. Anderson (18)
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.
(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.
(13) 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,
2001.
(14) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Report on Form 8-K dated as of April 24, 2002.
(15) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Registration Statement on Form S-8 filed as of August 30,
2002.
(16) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Report on Form 8-K dated as of August 30, 2002.
(17) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Report on Form 8-K dated as of September 19,2002.
(18) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Quarterly Report on Form 10-Q for the quarter ended September
30, 2002.
E-2
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 2002
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-8 to F-31
Financial Statement Schedule:
Schedule II - Valuation and Qualifying Accounts . . . . . . . F-32
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, 2002 and
2001, and the related consolidated statements of operations, stockholders'
equity (deficit) and other comprehensive income (loss), and cash flows for each
of the three years in the period ended December 31, 2002. Our audits also
included the consolidated financial statement schedule for the years ended
December 31, 2002, 2001, and 2000, included in the Index at Item 15(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, 2002 and 2001, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2002, 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.
As discussed in Note 1 to the consolidated financial statements, the Company
changed its method of accounting for goodwill and other intangible assets as a
result of adopting Statement of Financial Accounting Standards No. 142, Goodwill
and Other Intangible Assets, effective January 1, 2002.
DELOITTE & TOUCHE LLP
Costa Mesa, California
March 13, 2003
F-2
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2002 AND 2001
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
2002 2001
--------- ---------
ASSETS
Current assets:
Cash and cash equivalents $ 3,036 $ 1,497
Investments available-for-sale, at fair value 9,668 13,956
Accounts receivable, net of allowances of $325 in 2002 and $508 in 2001 2,554 2,839
Other current assets 853 903
--------- ---------
Total current assets 16,111 19,195
Property and equipment, net of accumulated depreciation and amortization 3,532 2,348
Restricted investments available-for-sale, at fair value 3,254 2,831
Notes receivable, net of allowances of $801 in 2002 and $467 in 2001 457 805
Goodwill 8,590 3,920
Intangible assets, net of accumulated amortization of $257 in 2002 2,013 --
Other assets 157 226
--------- ---------
Total assets $ 34,114 $ 29,325
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,661 $ 3,168
Accrued expenses 3,526 4,827
Current portion of long-term debt and capital lease obligations 2,430 265
Claims payable and claims incurred but not reported 4,690 5,905
Deferred premium revenue 1,786 823
--------- ---------
Total current liabilities 14,093 14,988
Long-term debt and capital lease obligations 2,997 --
Other long-term liabilities 1,013 971
Commitments and contingencies (Note 14)
Stockholders' equity:
Convertible preferred stock and additional paid-in capital - $0.01 par value;
31,000,000 shares authorized; 30,000,000 shares issued and outstanding in 2002
and 2001; liquidation preference of $30 million 41,250 41,250
Common stock and additional paid-in capital - $0.01 par value;
42,500,000 shares authorized; 8,900,000 shares and 8,065,000 shares
issued in 2002 and 2001, respectively; 5,683,000 shares and 4,798,000 shares
outstanding in 2002 and 2001, respectively 22,662 21,552
Retained earnings (accumulated deficit) (30,170) (31,447)
Accumulated other comprehensive income 95 63
Treasury stock, at cost (17,826) (18,052)
--------- ---------
Total stockholders' equity 16,011 13,366
--------- ---------
Total liabilities and stockholders' equity $ 34,114 $ 29,325
========= =========
See accompanying Notes to Consolidated Financial Statements.
F-3
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000
(IN THOUSANDS, EXCEPT PER SHARE DATA)
2002 2001 2000
-------- -------- --------
Premium revenue, net $83,043 $84,822 $97,251
Health care services expense 57,937 58,692 68,568
Selling, general and administrative expense 24,540 25,391 31,203
Loss on impairment of assets 334 -- 450
-------- -------- --------
Operating income (loss) 232 739 (2,970)
Investment and other income 607 1,060 1,431
Interest expense on debt that was converted
to equity in 2001 -- (402) (4,801)
Other interest expense (232) (102) (112)
-------- -------- --------
Income (loss) before income taxes,
discontinued operations and extraordinary item 607 1,295 (6,452)
Income tax expense (benefit) (820) -- --
-------- -------- --------
Income (loss) before discontinued operations
and extraordinary item 1,427 1,295 (6,452)
Discontinued operations:
Loss from assets transferred under contractual arrangements -- -- (2,500)
Extraordinary item:
Gain on conversion of debt to convertible preferred stock -- 11,251 --
-------- -------- --------
Net income (loss) $ 1,427 $12,546 $(8,952)
======== ======== ========
Basic net income (loss) per share:
Income (loss) before discontinued
operations and extraordinary item $ 0.04 $ 0.04 $ (1.36)
Loss from discontinued operations -- -- (0.53)
Extraordinary item -- 0.35 --
-------- -------- --------
Net income (loss) $ 0.04 $ 0.39 $ (1.89)
======== ======== ========
Weighted average basic shares outstanding 35,130 32,253 4,747
Diluted net income (loss) per share:
Income (loss) before discontinued
operations and extraordinary item $ 0.04 $ 0.04 $ (1.36)
Loss from discontinued operations -- -- (0.53)
Extraordinary item -- 0.34 --
-------- -------- --------
Net income (loss) $ 0.04 $ 0.38 $ (1.89)
======== ======== ========
Weighted average diluted shares outstanding 35,638 33,009 4,747
See accompanying Notes to Consolidated Financial Statements.
F-4
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) AND
OTHER COMPREHENSIVE INCOME (LOSS)
YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000
(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)
----------------- ----------- ----------- --------- --------- --------------- ---------
Balance, January 1, 2000 -- 8,022 (3,275) $ -- $ 21,829 $ (35,302) $ (18)
Net loss -- -- -- -- -- (8,952) --
Other comprehensive income (loss):
Net unrealized gains on
investments available-for-sale 137
---------
Total comprehensive income (loss)
----------------- ----------- ----------- --------- --------- --------------- ---------
Balance, 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 30,000 -- -- 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 -- --
----------------- ----------- ----------- --------- --------- --------------- ---------
Balance, December 31, 2001 30,000 8,065 (3,267) 41,250 21,552 (31,447) 63
Net income -- -- -- -- -- 1,427 --
Other comprehensive income:
Net unrealized gains on
investments available-for-sale 32
Total comprehensive income
Issuance of common stock -- 786 -- -- 1,061 -- --
Reissuance of treasury stock in
contribution to retirement plan -- -- 50 -- -- (150) --
Exercise of stock options -- 49 -- -- 49 -- --
----------------- ----------- ----------- --------- --------- --------------- ---------
Balance, December 31, 2002 30,000 8,900 (3,217) $ 41,250 $ 22,662 $ (30,170) $ 95
================= =========== =========== ========= ========= =============== =========
TREASURY
STOCK TOTAL
--------- ---------
Balance, January 1, 2000 $(18,123) $(31,614)
Net loss -- (8,952)
Other comprehensive income (loss):
Net unrealized gains on
investments available-for-sale 137
---------
Total comprehensive income (loss) (8,815)
--------- ---------
Balance, 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
--------- ---------
Balance, December 31, 2001 (18,052) 13,366
Net income -- 1,427
Other comprehensive income:
Net unrealized gains on
investments available-for-sale 32
---------
Total comprehensive income 1,459
Issuance of common stock -- 1,061
Reissuance of treasury stock in
contribution to retirement plan 226 76
Exercise of stock options -- 49
--------- ---------
Balance, December 31, 2002 $(17,826) $ 16,011
========= =========
(1) These warrants were canceled 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 11.
See accompanying Notes to Consolidated Financial Statements.
F-5
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2002, 2002, AND 2000
(IN THOUSANDS)
2002 2001 2000
-------- --------- ---------
Cash flows from operating activities:
Net income (loss) $ 1,427 $ 12,546 $ (8,952)
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Loss from discontinued operations -- -- 2,500
Gain on conversion of debt to convertible preferred stock -- (11,251) --
Loss on impairment of assets 334 -- 450
Bad debt expense 220 245 300
Write-off and amortization of deferred loan costs -- 24 339
Depreciation and other amortization 1,474 1,838 2,767
Gain on liquidation of notes receivable -- (175) --
Gain on sale of investments (2) (101) (18)
Gain on sale of property and equipment -- -- (83)
Gain on sale of subsidiary (14) -- --
Contribution to retirement plan in the form
of common stock, at fair value 87 51 --
Changes in operating assets and liabilities, excluding
effects of acquisition:
Accounts receivable 103 (306) (100)
Other current assets 241 685 (667)
Other assets 69 58 (129)
Accounts payable (653) (144) (355)
Accrued expenses (1,271) (2,063) 3,266
Claims payable and claims incurred but not reported (1,440) (1,649) (1,092)
Deferred premium revenue 607 (469) (562)
-------- --------- ---------
Net cash provided by (used in) operating activities 1,182 (711) (2,336)
Cash flows from investing activities:
Purchases of investments available-for-sale (3,448) (15,599) (42,477)
Proceeds from sale/maturity of investments available-for-sale 7,334 16,878 31,941
Cash paid for acquisition of business, net of cash acquired (2,708) -- --
Purchases of property and equipment (444) (1,109) (646)
Proceeds from sale of property and equipment -- -- 218
Payments received on notes receivable 14 1,320 1,305
Proceeds from sale of subsidiary 77 -- --
Additions to deferred loan costs -- -- (339)
-------- --------- ---------
Net cash provided by (used in) investing activities 825 1,490 (9,998)
Cash flows from financing activities:
Borrowings on long-term debt 2,000 -- 8,000
Increase in accrued interest that was converted to equity in 2001 -- 321 3,783
Payments on debt and capital lease obligations (1,663) (235) (255)
(Decrease) increase in bank overdrafts (896) (674) 779
Repurchase of common stock -- (10) --
Exercise of stock options 49 43 --
Increase (decrease) in other long-term liabilities 42 (108) (231)
-------- --------- ---------
Net cash provided by (used in) financing activities (468) (663) 12,076
-------- --------- ---------
Net increase (decrease) in cash and cash equivalents 1,539 116 (258)
Cash and cash equivalents at beginning of year 1,497 1,381 1,639
-------- --------- ---------
Cash and cash equivalents at end of year $ 3,036 $ 1,497 $ 1,381
======== ========= =========
(Continued on next page)
F-6
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS -- CONTINUED
YEARS ENDED DECEMBER 31, 2002, 2002, AND 2000
(IN THOUSANDS)
2002 2001 2000
-------- ------- ------
Supplementary information:
Cash paid during the year for interest $ 207 $ 315 $ 720
Supplementary disclosure of non-cash activities:
Debt converted into convertible preferred stock $ -- $41,250 $ --
Purchases of property and equipment through capital leases 1,836 -- --
Issuance of debt in exchange for cancellation of lease -- -- 500
Liabilities assumed in acquisition of business:
Fair value of assets acquired, excluding cash $ 2,670 $ -- $ --
Goodwill related to transaction 4,670 -- --
Less - Secured convertible note issued to seller (2,625) -- --
Less - Common stock issued in transaction (1,040) -- --
Less - Cash paid in transaction, net of cash acquired (2,708) -- --
-------- ------- ------
Liabilities assumed in acquisition of business $ 967 $ -- $ --
======== ======= ======
See accompanying Notes to Consolidated Financial Statements.
F-7
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 800,000 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 33%, 37% and 41% of the Company's total health
care services expense during the years ended December 31, 2002, 2001 and 2000,
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 $3.3 million and $2.8 million as of
December 31, 2002 and 2001, 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 $8.8 million as of
December 31, 2002. The aggregate statutory capital and surplus in these
subsidiaries as of December 31, 2002, was approximately $9.9 million. As a
result of these regulatory requirements, approximately $10.3 million of the
Company's consolidated stockholders' equity as of December 31, 2002, was not
available for the payment of dividends to the Company's stockholders.
F-8
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 other than temporary, the loss would be reported in the statement
of operations, instead of in a separate caption of stockholders' equity. As of
December 31, 2002, there were no unrealized losses that the Company believed to
be other than temporary.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The accompanying consolidated balance sheets include the following financial
instruments as of December 31, 2002: 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.
GOODWILL
Goodwill as of December 31, 2002 consists of $4.7 million of goodwill related to
the acquisition of Paramount Dental Plan, Inc. ("Paramount") in August 2002 (see
Note 2), 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 through December 31, 2001.
See Recently Adopted Accounting Principles below in this Note 1 for information
on the Company's adoption of SFAS No. 142, "Goodwill and Other Intangible
Assets," which changed the accounting for goodwill effective January 1, 2002.
INTANGIBLE ASSETS
Intangible assets as of December 31, 2002 consist of customer relationships and
other intangible assets with an aggregate net book value of $2.0 million, all of
which were acquired in connection with the acquisition of Paramount in August
2002, as discussed in Note 2. The amount of the purchase price that was
allocated to each of the intangible assets was equal to the Company's estimate
of the fair value of each asset. Each intangible asset is being amortized over
its estimated useful life on a straight-line basis.
F-9
LONG-LIVED ASSETS
In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," 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 assets as of December 31, 2002 are property
and equipment, intangible assets and notes receivable. The Company is not aware
of any events or circumstances that may have affected the fair value of its
property and equipment or intangible assets. See Note 8 for a discussion of
impairment charges with respect to notes receivable.
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 premium 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 earned 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, 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.
ADMINISTRATIVE SERVICES ARRANGEMENTS
The Company processed approximately $2.6 million, $3.2 million, and $3.2 million
of dental claims under administrative services only ("ASO") agreements during
the years ended December 31, 2002, 2001 and 2000, 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
F-10
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. All
stock options granted by the Company have an exercise price equal to the market
value of the Company's common stock on the date of grant, and accordingly, there
is no employee compensation expense related to stock options reflected the
accompanying consolidated statements of operations. The weighted average fair
value of stock options granted by the Company was $0.75, $1.13, and $0.76 per
share during the years ended December 31, 2002, 2001 and 2000, respectively.
Stock options granted generally become exercisable in equal annual installments
over a three-year period after the date of grant.
The following table shows the pro forma effect of using the fair value method of
accounting for stock options, as described by SFAS No. 123, on the Company's net
income (loss) and net income (loss) per share (in thousands, except per share
amounts):
YEARS ENDED DECEMBER 31,
---------------------------
2002 2001 2000
------- -------- --------
Net income (loss), as reported $1,427 $12,546 $(8,952)
Less - Employee compensation expense based
on the fair value method of accounting for
stock options, net of applicable tax effect (856) (833) (781)
------- -------- --------
Pro forma net income (loss) $ 571 $11,713 $(9,733)
======= ======== ========
Basic net income (loss) per share, as reported $ 0.04 $ 0.39 $ (1.89)
Pro forma basic net income (loss) per share 0.02 0.36 (2.05)
Diluted net income (loss) per share, as reported $ 0.04 $ 0.38 $ (1.89)
Pro forma diluted net income (loss) per share 0.02 0.35 (2.05)
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 82% in 2002, 160% in 2001, and 184% in
2000; no expected dividends; and a risk-free interest rate of approximately 2.0%
in 2002, 3.8% in 2001, and 6.0% in 2000. The assumptions regarding the expected
life of the options and the expected volatility of the stock price are
subjective, and these assumptions have a significant effect on the estimated
fair value amounts.
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 $153,000, $200,000 and $117,000 of consulting fees to the
chairman of its board of directors during the years ended December 31, 2002,
2001 and 2000, respectively.
See Notes 2 and 10 for information regarding a secured convertible promissory
note payable to a member of the Company's senior management, the outstanding
balance of which was $2.4 million as of December 31, 2002. The convertible note
was issued in the acquisition of Paramount Dental Plan, Inc. in August 2002, and
the former owner of Paramount is currently a member of the Company's senior
management.
See Note 10 for information regarding a $2.0 million working capital loan from
one of the Company's principal stockholders in August 2002, of which $1.8
million was outstanding as of December 31, 2002. See Note 11 for information
regarding an $8.0 million senior investor loan from stockholders of the Company
in March 2000, none of which was outstanding as of December 31, 2002.
ADVERTISING
Advertising expense was $185,000, $110,000, and $49,000 for the years ended
December 31, 2002, 2001 and 2000, respectively.
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 net income (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 net income (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, 2002,
the potentially dilutive securities of the Company that were outstanding
consisted of stock options, convertible notes, and warrants. The only
convertible notes issued by the Company were the two (2) convertible notes
issued during the three months ended September 30, 2002, as discussed in Notes 2
F-11
and 10. Both of these convertible notes would have an anti-dilutive effect on
net income per share in 2002. Accordingly, they are excluded from the
calculation of diluted net income per share for this period. The calculation of
diluted net income per share for the years ended December 31, 2002 and 2001
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 period.
There were no outstanding stock options or warrants with an exercise price below
the average market price of the Company's common stock during the year ended
December 31, 2000. Accordingly, the Company's diluted net loss per share is the
same as its basic net loss per share for that period. The only warrants issued
by the Company were canceled without being exercised effective January 31, 2001,
as discussed in Note 11.
The differences between weighted average basic shares outstanding and weighted
average diluted shares outstanding in each of the three years ended December 31,
2002, are as follows (in thousands):
2002 2001 2000
------ ------ -----
Weighted average basic shares outstanding 35,130 32,253 4,747
Effect of dilutive stock options 508 756 --
------ ------ -----
Weighted average diluted shares outstanding 35,638 33,009 4,747
====== ====== =====
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 2 for a business combination completed in August 2002.
Effective January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other
Intangible Assets." SFAS No. 142 requires that goodwill and other intangible
assets with indefinite useful lives not be amortized. SFAS No. 142 also requires
that all goodwill be evaluated for possible impairment as of January 1, 2002, on
an annual basis thereafter, and any time an event that may have affected the
value of the goodwill occurs. SFAS No. 142 also establishes a new method of
testing goodwill for possible impairment. The adoption of SFAS No. 142 had no
significant effect on the Company's consolidated financial statements. See Note
6 for more information.
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. The
Company adopted SFAS No. 144 effective January 1, 2002. The adoption of SFAS No.
144 had no significant effect on the Company's consolidated 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 any 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. 44 has been rescinded, as it is no longer necessary. SFAS No. 64 amended
SFAS No. 4 and is no longer necessary, as SFAS No. 4 has been rescinded. 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-leaseback transactions, and to require that the fair
value of a lease guarantee be recorded as a liability on the guarantor's balance
sheet for all guarantees issued after May 15, 2002. 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. SFAS No. 145 is generally effective for financial
statements issued after May 15, 2002. The adoption of SFAS No. 145 had no
significant effect on the Company's consolidated financial statements.
F-12
In December 2002, the FASB Issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," which is an amendment of SFAS No.
123, "Accounting fo (C) (C) (C) S No. 148 provides
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. It also requires
prominent disclosures in both annual and interim financial statements about the
method of accounting for stock-based employee compensation and the effect of the
method used on reported results. SFAS No. 148 is effective for fiscal years
ending after December 15, 2002. The adoption of SFAS No. 148 had no significant
effect on the Company's consolidated 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 consolidated
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.
In November 2002, the FASB issued FASB Interpretation ("FIN") No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others." FIN No. 45 is an interpretation
of FASB Statements No. 5, 57, and 107, and a rescission of FIN No. 34,
"Disclosure of Indirect Guarantees of Indebtedness of Others." FIN No. 45
requires that a guarantor recognize a liability for the fair value of certain
types of guarantees, at the time the guarantee is initially made. It also
elaborates on the financial statement disclosures to be made by a guarantor
about its obligations under certain types of guarantees. The initial
recognition and measurement provisions of this interpretation are applicable on
a prospective basis to guarantees issued or modified after December 31, 2002.
The disclosure requirements are effective for financial statements for periods
ending after December 15, 2002. The Company expects that FIN No. 45 will not
have a significant effect on its consolidated financial statements.
In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest
Entities," an interpretation of Accounting Research Bulletin No. 51. FIN No. 46
requires that variable interest entities be consolidated by the investing
company if the investing company is obligated to absorb a majority of the losses
incurred by the variable interest entity, or is entitled to receive a majority
of the profits earned by the entity, or both. FIN No. 46 also requires
disclosures about significant variable interests in entities that don't meet the
criteria for consolidation. The consolidation requirements of FIN No. 46 are
effective for all periods with respect variable interest entities that are
created after January 31, 2003. The consolidation requirements with respect to
variable interest entities created prior to February 1, 2003 are effective for
periods beginning after June 15, 2003. The disclosure requirements are
effective for all financial statements issued after January 31, 2003. The
Company had no variable interest entities as of December 31,2002, and expects
that FIN No. 46 will not 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.
F-13
NOTE 2. 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 was 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.
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. Also in connection with this
transaction, the Company entered into a three-year office lease agreement with
the seller of Paramount, the term of which started in November 2002, related to
the office space that is currently used as the Company's primary administrative
office in Florida.
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
---------
Purchase price paid to seller 6,665
Transaction expenses incurred by the Company 164
---------
Total cost $ 6,829
=========
Fair value of net assets acquired:
Cash and cash equivalents $ 456
Restricted investment 50
Property and equipment 121
Goodwill 4,670
Intangible assets 2,270
Other assets 229
Accounts payable and accrued expenses (386)
Claims payable and claims incurred but not reported (225)
Deferred premium revenue (356)
---------
Net assets acquired $ 6,829
=========
The value indicated above 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.
F-14
The intangible assets acquired consist of the following (in thousands):
WEIGHTED
AVERAGE
AMOUNT AMORTIZATION
ALLOCATED PERIOD
---------- ------------
Customer relationships $ 1,926 4.5 years
Other intangible assets 344 10.1 years
----------
Total $ 2,270 5.3 years
==========
None of the amortization expense related to the above intangible assets is
deductible for income tax purposes, and there is no goodwill amortization
related to this transaction that is deductible for income tax purposes.
The operations of Paramount are included in the accompanying 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):
YEARS ENDED DECEMBER 31,
------------------------
2002 2001
------------ ----------
(unaudited)
Premium revenue, net $ 88,322 $ 90,863
Operating income 470 1,504
Income before extraordinary item 1,499 1,852
Net income 1,499 13,103
Basic net income per share before extraordinary item $ 0.04 $ 0.06
Basic net income per share 0.04 0.40
Diluted net income per share before extraordinary item $ 0.04 $ 0.06
Diluted net income per share 0.04 0.39
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 3. 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
consolidated balance sheet, and were stated at their estimated realizable value.
The Company's consolidated 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 reflected the economic substance of the transactions, as distinct
from the legal form of the transactions. See Note 8 for information on an
impairment charge recognized in 2000 with respect to the net assets of these
dental and orthodontic practices.
F-15
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
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, 2002, the Company has collected the funds in the escrow
account, and has satisfied most of the obligations described above. However, the
ultimate cost of the obligations assumed by the Company is subject to various
uncertainties, and the remaining amount of these obligations is reflected as a
liability on the accompanying consolidated balance sheet based on the Company's
best estimates. See Note 8 for information on an impairment charge recognized
in 2000 in connection with this transaction.
NOTE 4. INVESTMENTS
- -------------------
Gross realized gains on sales of investments were $2,000, $101,000, and $19,000
for the years ended December 31, 2002, 2001, and 2000, respectively. Gross
realized losses on sales of investments were zero, zero, and $1,000 for the
years ended December 31, 2002, 2001, and 2000, respectively. The historical cost
of specific securities sold is used to compute the gain or loss on the sale of
investments. At December 31, 2002, the Company had net unrealized gains of
$95,000, which is included in stockholders' equity under the caption
"Accumulated other comprehensive income."
The Company's investments as of December 31, 2002 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 $ 2,303 $ 87 $ -- $ 2,390
State and municipal obligations 255 8 -- 263
Other marketable debt securities 10,269 -- -- 10,269
---------- ----------- ----------- -------
Total available-for-sale $ 12,827 $ 95 $ -- $12,922
========== =========== =========== =======
The maturity dates of the Company's investments as of December 31, 2002 are
summarized below (in thousands):
COST/ ESTIMATED
AMORTIZED FAIR
COST VALUE
---------- ----------
Classified as available-for-sale:
Due in 2003 $ 11,434 $ 11,446
Due in 2004 168 178
Due in 2005 and thereafter 1,225 1,298
---------- ----------
Total available-for-sale $ 12,827 $ 12,922
========== ==========
F-16
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
========== =========== ============ =======
NOTE 5. PROPERTY AND EQUIPMENT
- ------------------------------
The Company's property and equipment consist of the following (in thousands):
DECEMBER 31,
------------------
2002 2001
-------- --------
Leasehold improvements $ 842 841
Furniture and office equipment 1,504 634
Computer hardware and software 7,767 10,527
-------- --------
Total, at cost 10,113 12,002
Less - accumulated depreciation and amortization (6,581) (9,654)
-------- --------
Total, net of accumulated depreciation and amortization $ 3,532 $ 2,348
======== ========
The Company's property and equipment that was acquired through capital leases,
which is included above, consists of the following (in thousands):
DECEMBER 31,
----------------
2002 2001
------- -------
Furniture and office equipment $ 950 $ --
Computer software 1,250 --
------- -------
Total cost of property acquired through capital leases 2,200 --
Less - accumulated depreciation and amortization (344) --
------- -------
Total, net of accumulated depreciation and amortization $1,856 $ --
======= =======
NOTE 6. GOODWILL
- ----------------
Changes in the carrying amount of goodwill were as follows (in thousands):
YEARS ENDED DECEMBER 31,
------------------------
2002 2001
----------- -----------
Balance at beginning of year $ 3,920 $ 4,033
Goodwill acquired (see Note 2) 4,670 --
Goodwill amortization -- (113)
----------- -----------
Balance at end of year $ 8,590 $ 3,920
=========== ===========
F-17
In accordance with SFAS No. 142, the Company ceased amortizing its goodwill
effective January 1, 2002. The Company recorded $113,000 of amortization expense
related to goodwill during each of the two years ended December 31, 2001 and
2000. The Company's adjusted results of operations for the three years ended
December 31, 2002, which are adjusted to exclude goodwill amortization, are as
follows (in thousands):
YEARS ENDED DECEMBER 31,
--------------------------
2002 2001 2000
------- ------- --------
Income (loss) before discontinued operations
and extraordinary item, as reported $ 1,427 $ 1,295 $(6,452)
Add back - Goodwill amortization -- 113 113
------- ------- --------
Income (loss) before discontinued operations
and extraordinary item, as adjusted $ 1,427 $ 1,408 $(6,339)
======= ======= ========
Net income (loss), as reported $ 1,427 $12,546 $(8,952)
Add back - Goodwill amortization -- 113 113
------- ------- --------
Net income (loss), as adjusted $ 1,427 $12,659 $(8,839)
======= ======= ========
None of the Company's reported net income per share amounts for the year ended
December 31, 2001 would change as a result of the above adjustment for goodwill
amortization expense, due to the relatively small amount of this adjustment. For
the year ended December 31, 2000, the adjusted loss per basic share before
discontinued operations would be $1.34, compared to the reported amount of
$1.36, and the adjusted net loss per basic share would be $1.86, compared to the
reported amount of $1.89. As noted above under "Income (Loss) Per Share," the
Company's diluted net loss per share amounts for the year ended December 31,
2000 are the same as its basic net loss per share amounts.
SFAS No. 142 requires that all goodwill be evaluated for possible impairment as
of January 1, 2002, on an annual basis thereafter, and any time an event that
may have affected the value of the goodwill occurs. SFAS No. 142 also
establishes a new method of testing for possible impairment. The Company has
established October 1 as the date on which it conducts its annual evaluation of
goodwill for possible impairment. In accordance with SFAS No. 142, the Company
tested its goodwill for possible impairment by estimating the fair value of each
of its reporting units that include goodwill, and comparing the fair value of
each reporting unit to the book value of the net assets of each reporting unit.
For purposes of this test, the Company has three reporting units, which are its
operations in California, Florida and Texas. As of December 31, 2002, the
Company has goodwill in the Florida and Texas reporting units. The fair value of
each reporting unit was determined primarily by estimating the discounted future
cash flows of the reporting unit, and by estimating the amount for which the
reporting unit could be sold to a third party, based on a market multiple of
earnings. The Company had no impairment of its goodwill as of January 1, 2002,
or as of October1, 2002, based on the method of testing for possible impairment
established by SFAS No. 142. The Company is not aware of any events that
have occurred since October 1, 2002, that may have affected the value of its
goodwill.
NOTE 7. INTANGIBLE ASSETS
- -------------------------
The Company's intangible assets consist of the following (in thousands):
DECEMBER 31, 2002 DECEMBER 31, 2001
------------------------- -----------------------
GROSS GROSS
CARRYING ACCUMULATED CARRYING ACCUMULATED
AMOUNT AMORTIZATION AMOUNT VALUE
--------- -------------- --------- ------------
Customer relationships $ 1,926 $ (253) $ -- $ --
Other intangible assets 344 (4) -- --
--------- -------------- --------- ------------
Total available-for-sale $ 2,270 $ (257) $ -- $ --
========= ============== ========= ============
F-18
The aggregate amortization expense during the years ended December 31, 2002 and
2001 and the expected amortization expense during the succeeding five years are
as follows (in thousands):
Year ended December 31, 2001 $ 120
Year ended December 31, 2002 257
Expected during the year ending:
December 31, 2003 $ 467
December 31, 2004 467
December 31, 2005 326
December 31, 2006 283
December 31, 2007 198
The amortization expense during the year ended December 31, 2001 was related to
a non-competition agreement that became fully amortized in September 2001.
NOTE 8. 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 to a
single purchaser (the "Purchaser") in 1998 and 1997, as described in Note 3. In
October 2000, the Company completed a transaction with the Purchaser and another
third party (the "New Purchaser"), under which the assets of discontinued
operations transferred under contractual arrangements were sold to the New
Purchaser. As a result of this transaction, the Company recorded a $2.5 million
charge to earnings during 2000 to reduce the carrying value of these assets to
the estimated net proceeds from this transaction. This charge is reflected on
the Company's consolidated statement of operations under the caption "Loss from
assets transferred under contractual arrangements." See Note 3 for more
information on the sale transaction completed in October 2000.
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 3. The Company reviews the carrying amount of
its notes receivable for possible impairment on an ongoing basis, based on its
best estimate of the amounts that will ultimately be collected from the notes.
During 2002 and 2000, the Company increased the reserve on its notes receivable
by recording impairment losses of $334,000 and $450,000, respectively. There was
no impairment loss recorded during 2001. The Company's estimate of the amounts
that will be collected from the notes is 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. As of December 31, 2002, the net carrying amount of the outstanding
notes receivable was $457,000, which is based on the Company's estimate of the
net realizable value of the promissory notes.
NOTE 9. 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 related to 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, 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.
F-19
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.
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, 2001 $ 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
Incurred claims related to:
Current year - 2002 23,133 5,958 4,833 33,924
Prior years (594) (112) (94) (800)
Paid claims related to:
Current year - 2002 (20,092) (5,196) (3,946) (29,234)
Prior years (3,658) (980) (467) (5,105)
----------- ------------ -------- ---------
Balance at December 31, 2002 $ 3,041 $ 762 $ 887 $ 4,690
=========== ============ ======== =========
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,
2002 and 2001, the aggregate adjustments to the liability to reflect these
differences, which are reflected in the above table, were not material.
NOTE 10. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
- -----------------------------------------------------
Long-term debt and capital lease obligations consisted of the following (in
thousands):
DECEMBER 31,
-----------------
2002 2001
-------- -------
Secured convertible promissory note $ 2,427 $ --
Unsecured convertible promissory note 1,798 --
Capital lease obligations 1,202 --
Other -- 265
-------- -------
Total debt 5,427 265
Less - short-term portion (2,430) (265)
-------- -------
Long-term debt and capital lease obligations $ 2,997 $ --
======== =======
F-20
See Note 2 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 14. 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 December 31, 2002. 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.
Annual maturities of long-term debt and future minimum lease payments under
capital lease obligations were as follows, as of December 31, 2002 (in
thousands):
CAPITAL LESS - AMOUNT
LONG-TERM LEASE REPRESENTING
DEBT OBLIGATIONS INTEREST TOTAL
---------- -------------- -------------- ---------
Payable in 2003 $ 1,461 $ 1,047 $ (78) $ 2,430
Payable in 2004 1,567 212 (14) 1,765
Payable in 2005 1,197 16 (5) 1,208
Payable thereafter -- 30 (6) 24
---------- -------------- -------------- ---------
Total balance at December 31, 2002 $ 4,225 $ 1,305 $ (103) $ 5,427
========== ============== ============== =========
NOTE 11. 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 Company's revolving credit facility lender
(the "Bank"), and the holder of certain senior notes payable issued by the
Company (the "Senior Note Holder"). Pursuant to this agreement, 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 $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 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 15 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
F-21
no income tax effect related to this transaction, due to the Company's net
operating loss carryforwards for tax purposes, as discussed in Note 13. 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 13.
See Note 15 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 agreement, 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 on February 8, 2001. These four new
directors were still on the Company's board of directors as of December 31,
2002, and they 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 canceled 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 12. OTHER LONG-TERM LIABILITIES
- ------------------------------------
Other long-term liabilities consist primarily of 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 as of December 31, 2002 are as
follows (in thousands):
2004 $ 288
2005 203
2006 193
2007 192
Thereafter 137
--------
Total other long-term liabilities $ 1,013
========
NOTE 13. INCOME TAXES
- ---------------------
The Company's federal and state income tax expense (benefit) is as follows (in
thousands):
YEARS ENDED DECEMBER 31,
------------------------
2002 2001 2000
------- ------ -------
Currently payable: Federal $ -- $ -- $ --
State -- -- --
Deferred: Federal (670) -- --
State (150) -- --
------- ------ -------
Total income tax expense (benefit) $ (820) $ -- $ --
======= ====== =======
The income tax benefit in 2002 primarily represents a decrease in the Company's
accrual for estimated income tax liabilities related to certain transactions
that occurred in prior years, which are no longer pending as of December 31,
2002. The Company incurred net losses for tax purposes during each of the three
years ended
F-22
December 31, 2002, primarily due to temporary differences that reduced the
Company's income for tax purposes, and the fact that the Company's gain on
conversion of debt in 2001 (see Note 11) was not taxable. In addition, the
Company's net deferred tax assets have been fully reserved during the three
years ended December 31, 2002, as described below. Accordingly, the Company had
no income tax expense in any of the three years ended December 31, 2002.
A reconciliation of the expected federal income tax expense (benefit) based on
the statutory rate to the actual income tax expense (benefit) is as follows (in
thousands):
YEARS ENDED DECEMBER 31,
--------------------------------------------------------
2002 2001 2000
------------------ ----------------- -----------------
AMOUNT % AMOUNT % AMOUNT %
-------- -------- --------- ------ -------- -------
Expected federal income tax
expense (benefit) $ 206 34.0% $ 4,266 34.0% $(2,194) (34.0)%
State income tax expense
(benefit), net of effect
on federal income tax 23 3.7 -- -- -- --
Amortization of goodwill and
and tangible assets 87 14.4 35 0.3 42 0.7
Other items 45 7.4 855 6.8 46 0.7
Decrease in income tax accrual (820) (135.1) -- -- -- --
Expiration of net operating
losses due to change of control -- -- 6,774 54.0 -- --
Change in valuation allowance (361) (59.5) (11,930) (95.1) 2,106 32.6
-------- -------- --------- ------ -------- -------
Actual income tax
expense (benefit) $ (820) (135.1)% $ -- --% $ -- --%
======== ======== ========= ====== ======== =======
Deferred tax assets and liabilities are related to the following items (in
thousands):
DECEMBER 31,
------------------
2002 2001
-------- --------
Deferred tax assets:
Net operating loss carryforward $ 3,690 $ 3,567
Depreciation and amortization 1,498 2,053
Accrued expenses 948 1,121
Capital loss carryforward 610 643
Other items 166 548
-------- --------
Total deferred tax assets 6,912 7,932
Deferred tax liabilities:
State income taxes 321 910
Other items 266 336
-------- --------
Total deferred tax liabilities 587 1,246
-------- --------
Net deferred tax assets 6,325 6,686
Valuation allowance (6,325) (6,686)
-------- --------
Net deferred tax assets after valuation allowance $ -- $ --
======== ========
The income tax expense recorded by the Company for the years ended December 31,
2002 and 2001 includes adjustments to decrease the valuation allowance against
its net 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 net deferred tax assets. The Company's net deferred tax assets,
which were $6.3 million and $6.7 million as of December 31, 2002 and 2001,
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 cumulative operating losses incurred by the
Company during the period from January 1, 1998 to December 31, 2002 and the
existence of significant net operating loss carryforwards.
F-23
Due to the conversion of outstanding debt into convertible preferred stock, as
described in Note 11, 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, 2002, the Company had net operating loss carryforwards
for federal and state tax purposes of approximately $9.8 million and $5.2
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 2020 and 2012, respectively.
NOTE 14. COMMITMENTS AND CONTINGENCIES
- --------------------------------------
LEASE COMMITMENTS
The Company leases administrative office space and office equipment under a
number of operating leases. Rent expense was $2,960,000, $3,465,000, and
$3,986,000 in 2002, 2001, and 2000, 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 LEASE
OBLIGATION PAYMENTS OBLIGATION
----------- ---------- -----------
2003 $ 2,288 $ (443) $ 1,845
2004 2,302 (183) 2,119
2005 2,067 (9) 2,058
2006 1,842 -- 1,842
2007 1,838 -- 1,838
Thereafter 1,838 -- 1,838
----------- ---------- -----------
Total minimum payments $ 12,175 $ (635) $ 11,540
=========== ========== ===========
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. These accruals are included in "accrued
expenses" on the accompanying consolidated balance sheets. 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. During 2002 the Company 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 consolidated statement of operations.
F-24
CONTINGENT LEASE OBLIGATIONS
The Company sold all of its general dental practices and orthodontic practices
in 1996, 1997 and 1998, as discussed in Note 3. 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 3. The office lease agreements related to all of the practices sold by the
Company either have been assigned to the respective purchasers of the practices,
or have expired.
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, 2002, 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 $3.3 million
over the terms of the lease agreements, which expire at various dates through
2007. In the event that the parties to which these lease agreements have been
assigned defaulted on the leases, the aggregate contingent liability of
approximately $3.3 million could be mitigated by the Company by subleasing the
related office space to other parties, although there can be no assurance it
would be able to do so. The Company has not been notified of any defaults under
these leases that would have a material effect on the Company's consolidated
financial position. The aggregate contingent lease obligation of $3.3 million
excludes $100,000 of estimated lease obligations that have been accrued as of
December 31, 2002, 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 "Accrued expenses."
GUARANTEES AND INDEMNITIES
As discussed above, the Company has contingent lease obligations under which it
is secondarily liable for the lease payments under dental office leases that
have been assigned to third parties. In the event those third parties fail to
make the lease payments, the Company could be obligated to make the lease
payments itself. The Company has purchased a letter of credit for $250,000 in
connection with a certain customer agreement. In the event the Company fails to
meet its financial obligations to the customer, the customer would be able to
use the letter of credit to satisfy the Company's obligations, in which case the
Company would be obligated to repay the issuer of the letter of credit. The
Company also indemnifies its directors and officers to the maximum extent
permitted by Delaware law. In addition, the Company makes indemnities to its
customers in connection with the sale of dental and vision benefit plans in the
ordinary course of business. The maximum amount of potential future payments
under all of the preceding guarantees and indemnities cannot be determined. The
Company has recorded no liabilities related to these guarantees and indemnities
in the accompanying consolidated balance sheets, except as described above under
"Contingent Lease Obligations."
EMPLOYMENT AGREEMENT COMMITMENTS
The Company has an employment agreement with one of its senior officers, which
expires on August 30, 2005, and has severance agreements with several other
officers of the Company, which continue for as long as each officer remains
employed by the Company. In the event there is a change in control of the
Company, each officer would receive a severance payment under certain
circumstances, which is equal to that officer's annual salary then in effect,
plus the amount of the bonus, if any, earned by the officer for the previous
calendar year. The maximum aggregate commitment under the employment agreement
and the severance agreements is approximately $2.4 million as of December 31,
2002. None of the future commitments under the employment agreement or the
severance agreements are accrued as of December 31, 2002, as these commitments
are all related to services to be performed by the officers subsequent to 2002.
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 $87,000 and $51,000 of matching
contributions to the Plan for the years ended December 31, 2002 and 2001,
respectively, in the form of 66,000 shares and 33,000 shares of its common
stock, respectively. Of the total of 66,000 shares of common stock related to
F-25
2002, 51,000 shares were contributed in 2002, and an additional 15,000 shares
were contributed in 2003, the value of which is included in accrued expenses as
of December 31, 2002. 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 year ended December 31, 2000.
PROFESSIONAL LIABILITY INSURANCE
The Company maintains professional liability insurance that covers losses on a
claims-made basis. The Company's professional liability insurance policy
provides $5 million of coverage and has an aggregate deductible of $250,000.
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 and
compliance with numerous other financial requirements. 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.
As of December 31, 2002 and 2001, one of the Company's subsidiaries, which had
an insignificant amount of revenue in 2002 and 2001, was not in compliance with
the applicable regulatory net worth requirement. The Company has not invested
the required funds in this subsidiary because the Company is in the process of
closing that subsidiary's business, and the Company has received a waiver of
compliance from the applicable regulatory agency. During the years ended
December 31, 2002, 2001 and 2000, another of the Company's subsidiaries was not
in compliance with a regulatory requirement that limits the amount of the
subsidiary's administrative expenses as a percentage of premium revenue. The
Company has discussed this noncompliance with the applicable regulatory agency,
and that agency has taken no action with respect to this noncompliance. The
Company believes these two instances of noncompliance with regulatory
requirements will have no significant effect on its consolidated financial
statements.
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. 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 (see Note 3), 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, 2002.
CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject the Company to concentrations of
credit risk consist primarily of bank deposits, investments and accounts
receivable. As of December 31, 2002, the Company had bank deposits that were
approximately $4.0 million in excess of the maximum amounts insured by Federal
Deposit Insurance Corporation. The Company's investments consist entirely of
high-quality marketable securities.
F-26
NOTE 15. 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 one share 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. In the aggregate, the convertible preferred
stock has a $30 million liquidation preference over the Company's common 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. All references to the convertible preferred stock in the
accompanying consolidated financial statements reflect the effects of this
exchange on a retroactive basis.
STOCK REPURCHASES
As of December 31, 2002, the Company had 3,216,978 shares of treasury stock,
which were acquired by the Company for an aggregate of $17.8 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, 2002.
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 "Rights"). 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
3,600,000 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-27
The following is a summary of stock options outstanding as of December 31, 2002:
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 2,712,834 7.90 years $ 1.11 1,306,142 $ 1.05
9.00 - 11.88 12,000 2.73 years 10.73 12,000 10.73
15.75 1,000 3.22 years 15.75 1,000 15.75
-------------- ----------
Total 2,725,834 7.88 years $ 1.15 1,319,142 $ 1.15
============== ==========
The following is a summary of activity in stock options:
YEARS ENDED DECEMBER 31,
-------------------------------------
2002 2001 2000
----------- ----------- -----------
Outstanding at beginning of year 2,614,500 2,216,300 755,300
Stock options granted 404,500 805,000 2,080,000
Stock options exercised (48,332) (43,332) --
Stock options canceled (244,834) (363,468) (619,000)
----------- ----------- -----------
Outstanding at end of year 2,725,834 2,614,500 2,216,300
=========== =========== ===========
Exercisable at end of year 1,319,142 616,107 105,966
Weighted average exercise price of options granted $ 1.24 $ 1.26 $ 1.00
Weighted average exercise price of options exercised 1.00 1.00 --
Weighted average exercise price of options canceled 1.16 3.81 9.96
Weighted average exercise price of options outstanding 1.15 1.14 1.53
Weighted average exercise price of options exercisable 1.15 1.23 10.39
F-28
NOTE 16. INVESTMENT AND OTHER INCOME
- ------------------------------------
Investment and other income consist of the following (in thousands):
YEARS ENDED DECEMBER 31,
------------------------
2002 2001 2000
------ ------- -------
Investment income, including realized gains $ 318 $ 1,046 $ 1,348
Other income, net 289 14 83
------ ------- -------
Total investment and other income $ 607 $ 1,060 $ 1,431
====== ======= =======
NOTE 17. UNAUDITED SELECTED QUARTERLY INFORMATION
- -------------------------------------------------
FOURTH QUARTER ADJUSTMENTS
During the fourth quarter of 2002, the Company recorded an $820,000 income tax
benefit, which primarily represents a decrease in the Company's accrual for
estimated income tax liabilities related to certain transactions that occurred
in prior years, as discussed in Note 13. During the fourth quarter of 2002, the
Company also increased the bad debt reserve on its notes receivable by $334,000
to reduce the carrying value of those notes to their estimated realizable
values.
F-29
QUARTERLY RESULTS OF OPERATIONS
Unaudited quarterly results of operations for the years ended December 31, 2002
and 2001 are shown below (in thousands, except per share data). This information
has been prepared on the same basis as the accompanying consolidated financial
statements for the years ended December 31, 2002 and 2001, and all necessary
adjustments, which consist only of normal recurring adjustments, have been
included in the quarterly results of operations below. The unaudited quarterly
results should be read in conjunction with the accompanying audited consolidated
financial statements.
YEAR ENDED DECEMBER 31, 2002
------------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
--------- --------- --------- ---------
Premium revenue, net $ 20,688 $ 20,174 $ 20,682 $ 21,499
Health care services expense 14,550 14,676 14,546 14,165
Selling, general and administrative expense 5,839 5,777 6,040 6,884
Loss on impairment of assets -- -- -- 334
--------- --------- --------- ---------
Operating income (loss) 299 (279) 96 116
Investment and other income 116 103 92 296
Interest expense (7) (24) (84) (117)
--------- --------- --------- ---------
Income (loss) before income taxes 408 (200) 104 295
Income tax expense -- -- -- (820)
--------- --------- --------- ---------
Net income (loss) $ 408 $ (200) $ 104 $ 1,115
========= ========= ========= =========
Basic net income per share $ 0.01 $ (0.01) $ 0.00 $ 0.03
Weighted average basic shares outstanding 34,812 34,857 35,161 35,677
Diluted net income per share $ 0.01 $ (0.01) $ 0.00 $ 0.03
Weighted average diluted shares outstanding 35,568 34,857 35,526 36,010
F-30
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
NOTE 19. SUBSEQUENT EVENT
- -------------------------
In January 2003, the Company entered into a definitive agreement to acquire all
of the outstanding stock of Ameritas Managed Dental Plan, Inc. ("Ameritas") for
$1.1 million in cash, subject to regulatory approval. Ameritas is a dental HMO
company with approximately $4 million of annual revenue and is located in Costa
Mesa, California. The Company expects to complete this transaction during the
first half of 2003, although it is still subject to regulatory approval.
During January 2003, the Company implemented a Retention Bonus Plan (the "Plan")
with respect to certain senior executives of the Company. The purpose of the
Plan is to provide an incentive for the senior management of the Company to
remain employed during a reasonable transition period in the event of the sale
of the Company to a third party. In the event that more than 50% of the Company
is sold to an entity that is not otherwise a current stockholder of the Company,
each eligible officer would receive a variable retention bonus that is based on
the amount of proceeds from the sale transaction. The aggregate amount of
retention bonuses paid by the Company under the Plan would be approximately $1.3
million for each $1.00 of proceeds per share of common stock realized by the
Company's stockholders in a sale of the Company.
F-31
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000
(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, 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
YEAR ENDED DECEMBER 31, 2002:
Allowance for doubtful accounts:
Accounts receivable $ 508 $ 220 $ -- $ (403) $ 325
Long-term notes receivable $ 467 $ 334 $ -- $ -- $ 801
F-32