UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____ to _____
Commission file number 0-12050
SAFEGUARD HEALTH ENTERPRISES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 52-1528581
(State or other jurisdiction (I.R.S. Employer
of incorporation) Identification No.)
95 ENTERPRISE, SUITE 100
ALISO VIEJO, CALIFORNIA 92656-2605
(Address of principal executive offices)
(Zip Code)
(949) 425-4300
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--- ---
As of August 1, 2003, the number of shares of registrant's common stock, par
value $0.01 per share, outstanding was 5,719,117 shares (not including 3,216,978
shares of common stock held in treasury), and the number of shares of
registrant's convertible preferred stock, par value $0.01 per share, outstanding
was 30,000,000 shares.
SAFEGUARD HEALTH ENTERPRISES, INC.
INDEX TO FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2003
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements . . . . . . . . 1
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations. . . . . . . . . . . . . . . . . . 14
Item 3. Quantitative and Qualitative Disclosures About Market Risk. 23
Item 4. Controls and Procedures . . . . . . . . . . . . . . . . . . . 24
PART II. OTHER INFORMATION
Item 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . 24
Item 6. Exhibits and Reports on Form 8-K. . . . . . . . . . . . . 24
SIGNATURES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
CERTIFICATIONS BY CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER . . . 27
i
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
(UNAUDITED)
JUNE 30, DECEMBER 31,
2003 2002
---------- --------------
ASSETS
Current assets:
Cash and cash equivalents $ 3,813 $ 3,036
Investments available-for-sale, at fair value 9,469 9,668
Accounts receivable, net of allowances 1,787 2,554
Other current assets 547 853
---------- --------------
Total current assets 15,616 16,111
Property and equipment, net of accumulated depreciation and amortization 3,654 3,532
Restricted investments available-for-sale, at fair value 3,153 3,254
Notes receivable, net of allowances 437 457
Goodwill 8,699 8,590
Intangible assets, net of accumulated amortization 2,419 2,013
Other assets 172 157
---------- --------------
Total assets $ 34,150 $ 34,114
========== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 826 $ 1,661
Accrued expenses 3,579 3,526
Current portion of long-term debt and capital lease obligations 1,268 2,430
Claims payable and claims incurred but not reported 4,945 4,690
Deferred premium revenue 2,216 1,786
---------- --------------
Total current liabilities 12,834 14,093
Long-term debt and capital lease obligations 3,289 2,997
Other long-term liabilities 959 1,013
Commitments and contingencies (Note 9)
Stockholders' equity:
Convertible preferred stock and additional paid-in capital 41,250 41,250
Common stock and additional paid-in capital 22,717 22,662
Retained earnings (accumulated deficit) (29,176) (30,170)
Accumulated other comprehensive income 103 95
Treasury stock, at cost (17,826) (17,826)
---------- --------------
Total stockholders' equity 17,068 16,011
---------- --------------
Total liabilities and stockholders' equity $ 34,150 $ 34,114
========== ==============
See accompanying Notes to Condensed Consolidated Financial Statements.
1
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2003 AND 2002
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
2003 2002
-------- --------
Premium revenue, net $23,129 $20,174
Health care services expense 15,947 14,676
Selling, general and administrative expense 6,565 5,777
-------- --------
Operating income 617 (279)
Investment and other income 79 103
Interest expense (86) (24)
-------- --------
Income before income taxes 610 (200)
Income tax expense 60 --
-------- --------
Net income $ 550 $ (200)
======== ========
Basic net income per share $ 0.02 $ (0.01)
Weighted-average basic shares outstanding 35,711 34,857
Diluted net income per share $ 0.02 $ (0.01)
Weighted-average diluted shares outstanding 36,366 34,857
See accompanying Notes to Condensed Consolidated Financial Statements.
2
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 2003 AND 2002
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
2003 2002
-------- --------
Premium revenue, net $45,041 $40,862
Health care services expense 31,040 29,226
Selling, general and administrative expense 12,919 11,616
-------- --------
Operating income 1,082 20
Investment and other income 158 219
Interest expense (186) (31)
-------- --------
Income before income taxes 1,054 208
Income tax expense 60 --
-------- --------
Net income $ 994 $ 208
======== ========
Basic net income per share $ 0.03 $ 0.01
Weighted-average basic shares outstanding 35,702 34,835
Diluted net income per share $ 0.03 $ 0.01
Weighted-average diluted shares outstanding 36,191 35,481
See accompanying Notes to Condensed Consolidated Financial Statements.
3
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
SIX MONTHS ENDED JUNE 30, 2003 AND 2002
(IN THOUSANDS)
(UNAUDITED)
2003 2002
-------- --------
Cash flows from operating activities:
Net income $ 994 $ 208
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Bad debt expense 78 98
Depreciation and amortization 879 610
Contribution to retirement plan in the form of common stock, at fair value 61 63
Changes in operating assets and liabilities, excluding effects of acquisition:
Accounts receivable 754 330
Other current assets 429 (32)
Other assets (15) (57)
Accounts payable (97) (56)
Accrued expenses (179) (752)
Claims payable and claims incurred but not reported 223 (1,181)
Deferred premium revenue 172 518
-------- --------
Net cash provided by (used in) operating activities 3,299 (251)
Cash flows from investing activities:
Purchase of investments available-for-sale (1,826) (758)
Proceeds from sale/maturity of investments available-for-sale 2,599 2,063
Purchases of property and equipment (402) (237)
Cash paid for acquisition of business, net of cash acquired (887) --
Payments received on notes receivable 20 --
-------- --------
Net cash (used in) provided by investing activities (496) 1,068
Cash flows from financing activities:
Decrease in bank overdrafts (780) (740)
Payments on debt and capital lease obligations (1,192) (464)
Exercise of stock options -- 49
Increase (decrease) in other long-term liabilities (54) 40
-------- --------
Net cash used in financing activities (2,026) (1,115)
-------- --------
Net increase (decrease) in cash and cash equivalents 777 (298)
Cash and cash equivalents at beginning of period 3,036 1,497
-------- --------
Cash and cash equivalents at end of period $ 3,813 $ 1,199
======== ========
Supplementary information:
Cash paid during the period for interest $ 191 $ 27
Supplementary disclosure of non-cash activities:
Purchases of property and equipment through capital leases $ 335 $ 1,784
Liabilities assumed in acquisition of business:
Fair value of identifiable assets acquired $ 1,336 $ --
Goodwill related to transaction 109 --
Less - Cash paid in transaction, net of cash acquired (887) --
Less - Liability for contingent purchase price (226) --
-------- --------
Liabilities assumed in acquisition of business $ 332 $ --
======== ========
See accompanying Notes to Condensed Consolidated Financial Statements.
4
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
NOTE 1. GENERAL
- ----------------
The accompanying unaudited condensed consolidated financial statements of
SafeGuard Health Enterprises, Inc. and subsidiaries (the "Company") as of June
30, 2003, and for the three months and six months ended June 30, 2003 and 2002,
have been prepared in accordance with accounting principles generally accepted
in the United States of America, applicable to interim periods. The accompanying
financial statements reflect all normal and recurring adjustments that, in the
opinion of management, are necessary for a fair presentation of the Company's
financial position and results of operations for the interim periods. The
financial statements have been prepared in accordance with the regulations of
the Securities and Exchange Commission and, accordingly, omit certain footnote
disclosures and other information necessary to present the Company's financial
position and results of operations for annual periods in accordance with
accounting principles generally accepted in the United States of America. These
condensed consolidated financial statements should be read in conjunction with
the Company's Annual Report on Form 10-K for the year ended December 31, 2002,
which includes the Company's Consolidated Financial Statements and Notes thereto
for that period.
NOTE 2. SIGNIFICANT ACCOUNTING POLICIES ANDRECENTLY ADOPTED ACCOUNTING
- ----------------------------------------------------------------------------
PRINCIPLES
- ----------
GOODWILL
The Company's accounting for goodwill is in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible
Assets," which the Company adopted as of January 1, 2002. Goodwill as of June
30, 2003 consists of $4.7 million of goodwill related to the acquisition of
Paramount Dental Plan, Inc. ("Paramount") in August 2002, $3.9 million of
goodwill related to the acquisition of First American Dental Benefits, Inc.
("First American") in 1996, and $0.1 million of goodwill related to the
acquisition of Ameritas Managed Dental Plan, Inc. ("Ameritas") in March 2003.
See Note 3 for more information on the Paramount and Ameritas acquisitions. In
the case of each acquisition, goodwill represents the excess of the purchase
price of the acquired company over the fair value of the net assets acquired. In
the case of the First American acquisition, the balance is net of an adjustment
in 1999 to reduce the carrying value of the goodwill to its estimated realizable
value. The Company has not yet completed its identification of the intangible
assets that were acquired in the Ameritas acquisition, or its determination of
the fair values of those intangible assets. The amount of goodwill related to
the Ameritas acquisition reflects the Company's preliminary estimate of the
aggregate fair value of the intangible assets acquired, pending its final
determination.
SFAS No. 142 requires that goodwill be evaluated for possible impairment on an
annual basis and any time an event occurs that may have affected the value of
the goodwill. 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 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 Company is not aware of any events that have
occurred since October 1, 2002, that represent an indication of a possible
impairment.
5
Changes in the carrying amount of goodwill during the six months ended June 30,
2003 were as follows (in thousands):
Balance at December 31, 2002 $ 8,590
Goodwill acquired (see Note 3) 109
-----------
Balance at June 30, 2003 $ 8,699
===========
INTANGIBLE ASSETS
Intangible assets as of June 30, 2003 consist of customer relationships and
other intangible assets with an aggregate net book value of $2.4 million, all of
which were acquired in connection with the acquisitions of Paramount in August
2002 and Ameritas in March 2003, as discussed in Note 3. 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
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, the recent trend
in payment rates, and the recent trend in 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 and vision
coverage is provided to the covered individuals. Payments received from
customers in advance of the related period of coverage are reflected on the
accompanying condensed consolidated balance sheet as deferred premium revenue.
STOCK-BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation," provides a choice of
two different methods of accounting for stock options granted to employees. SFAS
No. 123 encourages, but does not require, entities to recognize compensation
expense equal to the fair value of employee stock options granted. Under this
method of accounting, the fair value of a stock option is measured at the grant
date, and compensation expense is recognized over the period during which the
stock option becomes exercisable. Alternatively, an entity may choose to use the
accounting method described in Accounting Principles Board Opinion ("APB") No.
25, "Accounting for Stock Issued to Employees." Under APB No. 25, no
compensation expense is generally recognized as long as the exercise price of
each stock option is at least equal to the market price of the underlying stock
at the time of the grant. If an entity chooses to use the accounting method
described in APB No. 25, SFAS No. 123 requires that the pro forma effect of
using the fair value method of accounting on its net income be disclosed in a
note to the financial statements.
The Company has chosen to use the accounting method described in APB No. 25. 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 in the
accompanying condensed consolidated statements of operations. Stock options
granted generally become exercisable in equal annual installments over a
three-year period after the date of grant.
6
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 and net income per share (in thousands, except per share amounts):
SIX MONTHS ENDED
JUNE 30,
----------------------
2003 2002
---------- ----------
Net income, as reported $ 994 $ 208
Less - Employee compensation expense based on the fair value
method of accounting for stock options, net of applicable tax effect (299) (428)
---------- ----------
Pro forma net income $ 695 $ (220)
========== ==========
Basic net income per share, as reported $ 0.03 $ 0.01
Pro forma basic net income per share 0.02 (0.01)
Diluted net income per share, as reported $ 0.03 $ 0.01
Pro forma diluted net income per share 0.02 (0.01)
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
estimates the fair value of stock options by using the Black-Scholes
option-pricing model.
NET INCOME PER SHARE
Net income per share is presented in accordance with SFAS No. 128, "Earnings Per
Share." Basic net income per share is based on the weighted-average common
shares outstanding, including the common shares into which the convertible
preferred stock is convertible, but excluding the effect of other potentially
dilutive securities. The number of basic common shares outstanding includes the
common share equivalents of the convertible preferred stock, because the Company
believes the convertible preferred stock is essentially equivalent to common
stock, based on all the rights and preferences of both types of stock. Diluted
net income per share is based on the weighted- average common shares
outstanding, including the effect of all potentially dilutive securities. During
the three months and six months ended June 30, 2003 and 2002, the potentially
dilutive securities outstanding consisted of stock options and convertible
notes. Diluted net income per share includes the effect of all outstanding stock
options with an exercise price below the average market price of the Company's
common stock during each applicable period. The Company issued two (2)
convertible notes during the three months ended September 30, 2002, as discussed
in Note 5. Each of these convertible notes would have an anti-dilutive effect on
net income per share for the three months and six months ended June 30, 2003.
Accordingly, the convertible notes are excluded from the calculation of diluted
net income per share for these periods. As of June 30, 2003, these two
convertible notes were convertible into an aggregate of 2,201,000 shares of
common stock. Due to a net loss incurred during the three months ended June 30,
2002, the outstanding stock options would have an antidilutive effect on diluted
net loss per share for this period. Accordingly, stock options are excluded
from the calculation of diluted net loss per share for this period. Therefore,
the Company's diluted net loss per share is the same as its basic net loss per
share for the three months ended June 30, 2002. The stock options outstanding
during this period were equivalent to 535,000 additional common shares.
7
The differences between weighted-average basic shares outstanding and
weighted-average diluted shares outstanding are as follows (in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------- ------------------
2003 2002 2003 2002
---------- -------- -------- --------
Weighted-average basic shares outstanding 35,711 34,857 35,702 34,835
Effect of dilutive stock options 655 -- 489 646
---------- -------- -------- --------
Weighted-average diluted shares outstanding 36,366 34,857 36,191 35,481
========== ======== ======== ========
RECENTLY ADOPTED ACCOUNTING PRINCIPLES
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statement Nos.
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 are now 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.
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. The adoption of SFAS No.
146 had no significant effect on the Company's consolidated financial
statements.
In November 2002, the FASB issued FASB Interpretation No. ("FIN") 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others." FIN 45 is an interpretation of
FASB Statement Nos. 5, 57, and 107, and a rescission of FIN No. 34, "Disclosure
of Indirect Guarantees of Indebtedness of Others." FIN 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 adoption of FIN 45 had no significant effect on the
Company's consolidated financial statements.
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. SFAS 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
8
of SFAS No. 148 had no significant effect on the Company's consolidated
financial statements.
In January 2003, the FASB issued FIN 46, "Consolidation of Variable Interest
Entities," an interpretation of Accounting Research Bulletin No. 51. FIN 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 46 also requires disclosures
about significant variable interests in entities that don't meet the criteria
for consolidation. The consolidation requirements of FIN 46 are effective for
all periods with respect to variable interest entities 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 June 30, 2003, and the adoption of FIN 46 had no significant
effect on its consolidated financial statements.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Instruments
with Characteristics of Both Liabilities and Equity", which establishes
standards for how an issuer classifies and measures certain financial
instruments with characteristics of both liabilities and equity. SFAS No. 150
requires that an issuer classify a financial instrument that is within its
scope, which may have previously been reported as equity, as a liability (or an
asset in some circumstances). This statement is effective for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003. We believe the adoption of SFAS No. 150 will not have a material effect on
our consolidated financial position or results of operations.
NOTE 3. ACQUISITIONS
- ----------------------
Effective August 30, 2002, the Company acquired all of the outstanding capital
stock of Paramount Dental Plan, Inc. ("Paramount") for an aggregate cost of
approximately $6.8 million, including acquisition expenses. Paramount was a
dental benefits company located in Florida and was merged into the Company's
Florida dental HMO subsidiary effective August 30, 2002. 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.
The operations of Paramount are included in the Company's 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 for the six months ended June 30, 2002, as if
the acquisition had been completed as of the beginning of that period (in
thousands):
Premium revenue, net $ 44,708
Operating income 216
Net income 119
Basic net income per share $ 0.00
Diluted net income per share 0.00
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 date indicated, or the results that may occur in any
future period.
Effective March 31, 2003, the Company acquired all of the outstanding capital
stock of Ameritas Managed Dental Plan, Inc. ("Ameritas") for a purchase price of
$1.1 million in cash, plus contingent monthly payments during the five years
following the acquisition date. Each contingent monthly payment is equal to 10%
of the actual premium revenue during the month from customers of Ameritas that
existed as of March 31, 2003. As of June 30, 2003, the Company has accrued a
total of $255,000 of contingent purchase price, which has been added to the cost
of the acquisition for accounting purposes. This amount represents contingent
monthly payments related to the period from the acquisition date through June
30, 2003, plus the estimated contingent monthly payments related to the
remaining portion of annual customer contracts that are in force as of July 1,
2003. The Company intends to accrue additional portions of the contingent
purchase price in the future, if and when the payment of such amounts becomes
probable, based on the renewal of existing customer contracts. Ameritas had
premium revenue of $3.7 million during the year ended December 31, 2002, and
accordingly, the maximum aggregate amount of the contingent monthly payments
over the five-year period would be approximately $1.8 million, if the Company
retained all of the existing customers of Ameritas for five years after the
acquisition date at the premium rates in effect during 2002.
Ameritas was a dental benefits company located in California and was merged into
the Company's California dental HMO subsidiary effective March 31, 2003. The
business purpose of the acquisition was to increase the Company's market
9
penetration in California, which is one of the Company's primary geographic
markets. The acquisition increased the number of members in California for which
the Company provides dental benefits from approximately 300,000 members to
approximately 330,000 members.
The aggregate purchase price recorded by the Company as of June 30, 2003,
including the amount paid at closing, the contingent purchase price accrued as
of June 30, 2003, and certain acquisition expenses, is approximately $1.4
million. The cost of the acquisition was allocated among the net assets acquired
as follows (in thousands):
Fair value of net assets acquired:
Cash and cash equivalents $ 276
Investments 465
Intangible assets 675
Goodwill 109
Other assets 196
Accounts payable and claims payable and claims
incurred but not reported (74)
Deferred premium revenue (258)
---------
Total cost of acquisition $ 1,389
=========
The Company has not yet completed its identification of the intangible assets
that were acquired in the Ameritas acquisition, or its determination of the fair
values and amortization periods of those intangible assets. The accompanying
condensed consolidated financial statements reflect the Company's preliminary
estimate of the aggregate fair value of the intangible assets acquired, and the
amortization periods of those assets, pending its final determination. The
operations of Ameritas are included in the Company's consolidated financial
statements beginning on April 1, 2003.
NOTE 4. PENDING ACQUISITIONS
- -------------------------------
On April 7, 2003, the Company entered into a definitive agreement to purchase
all of the outstanding capital stock of Health Net Dental, Inc. ("HN Dental"),
which is a California dental HMO, and certain PPO/indemnity dental business
underwritten by Health Net Life Insurance Company ("HN Life"), which is an
affiliate of HN Dental, subject to regulatory approval. The purchase price is
$9.0 million in cash and an agreement to provide private label dental HMO and
PPO/indemnity products to be sold in the marketplace by subsidiaries of Health
Net, Inc., the parent company of HN Dental, for a period of at least five years
following the closing of the transaction, subject to certain conditions. The
transaction is currently pending regulatory approval.
On June 30, 2003, the Company entered into a definitive agreement to purchase
all of the outstanding capital stock of Health Net Vision, Inc. ("HN Vision"),
which is a California vision HMO and an affiliate of HN Dental, and certain
PPO/indemnity vision business underwritten by HN Life, for $3.0 million in cash,
subject to regulatory approval. A substantial portion of the business of HN
Vision, which consists of products provided to MediCal beneficiaries, will be
transferred to a third party prior to the Company's acquisition of HN Vision,
and the remainder of the business of HN Vision, which consists of products
provided to commercial customers, will be transferred to the Company. The
transaction is currently pending regulatory approval.
The Company plans to finance the two transactions described above through the
issuance of up to approximately $18 million of unsecured convertible promissory
notes to certain of its principal stockholders. The proceeds from the
convertible notes will be used to finance the two pending transactions described
above, to satisfy the increase in the Company's regulatory net worth
requirements related to the PPO/indemnity dental and vision business to be
acquired, and to provide working capital that may be required in connection with
the integration of the acquired businesses into the Company's existing
operations.
The Company has reached an oral agreement with the stockholders referred to
above, regarding the expected amount and terms of the convertible notes. In
accordance with this agreement, the convertible notes will bear interest at 6.0%
annually, and will be convertible into the Company's common stock at the rate of
$1.75 per share, at the option of the holder. There will be no principal
payments due under the convertible notes during the first six years after
issuance, principal payments will be due during the succeeding four years
pursuant to a ten-year amortization schedule, and the remaining balance will be
payable in full ten years after the date of issuance. The convertible notes will
be payable in full upon a change in control of the Company, at the holder's
option. Provided that the Company redeems all of the outstanding convertible
10
notes at the same time, it will have the option of redeeming the convertible
notes for 229% of the face value of the notes during the first seven years after
the date of issuance, for 257% of the face value during the eighth year after
issuance, for 286% of the face value during the ninth year after issuance, and
for 323% of the face value during the tenth year after issuance. The issuance of
the convertible notes is currently pending negotiation of definitive agreements
and the completion of the acquisitions described above.
NOTE 5. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
- -----------------------------------------------------------
Long-term debt and capital lease obligations consisted of the following (in
thousands):
JUNE 30, DECEMBER 31,
2003 2002
---------- --------------
Secured convertible promissory note $ 2,038 $ 2,427
Unsecured convertible promissory note 1,539 1,798
Capital lease obligations 980 1,202
---------- --------------
Total debt and capital lease obligations 4,557 5,427
Less - Current portion (1,268) (2,430)
---------- --------------
Long-term debt and capital lease obligations $ 3,289 $ 2,997
========== ==============
Effective in August 2002, the Company issued a secured convertible promissory
note for $2,625,000 in connection with the acquisition of Paramount, which is
discussed in Note 3. The note bears interest at 7.0% annually, and was
originally payable in equal monthly installments of principal and interest
through September 2005. The terms of the note were amended during the second
quarter of 2003, and the outstanding balance is now payable in varying monthly
installments of principal and interest through September 2008. 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 Florida
dental HMO subsidiary.
In August 2002, the Company borrowed $2.0 million from one of its principal
stockholders under an unsecured convertible promissory note. The note bears
interest at 7.0% annually, and was originally payable in equal monthly
installments of principal and interest through August 2005. The terms of the
note were amended during the second quarter of 2003, and the outstanding balance
is now payable in monthly installments of interest only through May 2006, then
in monthly installments of principal and interest from June 2006 through August
2008. The outstanding balance under the unsecured convertible note is
convertible into common stock of the Company at a conversion price of $1.625 per
share.
The outstanding capital lease obligations are primarily related to the purchase
of a new telephone system for the Company's primary administrative office in
June 2003, the purchase of an updated version of the Company's primary computer
software application in June 2002, and the purchase of formerly leased furniture
for the Company's primary administrative office in June 2002. 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 June 30, 2003. Under each of the capital leases, the Company has an option
to purchase the leased assets for $1.00 at the expiration of the lease.
See Note 4 for a description of unsecured convertible promissory notes that the
Company intends to issue in connection with two pending acquisitions.
NOTE 6. EXCHANGE OF CONVERTIBLE PREFERRED STOCK
- -----------------------------------------------------
Prior to May 2002, there were 300,000 shares of convertible preferred stock
issued and outstanding. Each share had a par value of $100 and a liquidation
preference of $100, and was convertible into 100 shares of the Company's common
stock. In May 2002, each outstanding share of convertible preferred stock was
exchanged for 100 new shares of convertible preferred stock. Each new share of
11
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 condensed consolidated financial statements reflect the effects of
this exchange on a retroactive basis.
NOTE 7. INCOME TAXES
- -----------------------
The Company's accounting for income taxes is in accordance with SFAS No. 109,
"Accounting for Income Taxes." SFAS No. 109 requires the recognition of deferred
tax assets and liabilities 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 assets and liabilities is based on current tax laws
as of the balance sheet date. The Company records a valuation allowance related
to deferred tax assets in the event that available evidence indicates that the
future tax benefits related to the deferred tax assets may not be realized. A
valuation allowance is required when it is more likely than not that the
deferred tax assets will not be realized.
The Company's net deferred tax assets have been fully reserved since September
30, 1999, due to uncertainty about whether those net assets will be realized in
the future. The uncertainty is primarily due to large losses incurred by the
Company during 1998, 1999 and 2000, relative to the amounts of income earned by
the Company during 2001, 2002 and the first six months of 2003, as well as the
existence of significant net operating loss carryforwards.
Due to the conversion of outstanding debt into convertible preferred stock in
January 2001, 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 California 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 California state net
operating loss carryforwards will begin to expire in 2020 and 2012,
respectively.
The Company had taxable income for federal income tax purposes for the six
months ended June 30, 2003 and 2002, but its taxable income in both periods was
completely offset by net operating loss carryforwards from previous years.
However, the Company recognized current federal income tax expense in 2003, due
to its tax liability under the alternative minimum tax. For California state
income tax purposes, the Company had taxable income during the first six months
of 2003, and a net loss during the same period in 2002. The State of California
suspended the use of net operating loss carryforwards to offset current taxable
income for 2003 and 2002 for all corporations. Accordingly, the Company
recognized current state income tax expense for the six months ended June 30,
2003. The Company recognized no deferred income tax expense or benefit during
the six months ended June 30, 2003 or 2002, due to the valuation allowance
against its net deferred tax assets, as discussed above.
NOTE 8. TOTAL COMPREHENSIVE INCOME
- --------------------------------------
Total comprehensive income includes the change in stockholders' equity during
the period from transactions and other events and circumstances from
non-stockholder sources. Total comprehensive income of the Company for the six
months ended June 30, 2003 and 2002, includes net income and other comprehensive
income or loss, which consists of unrealized gains and losses on marketable
securities, net of realized gains and losses that occurred during the period.
Other comprehensive income (loss) was $18,000 and $27,000 for the three months
ended June 30, 2003 and 2002, respectively, and $8,000 and $(9,000) for the six
months ended June 30, 2003 and 2002, respectively. Total comprehensive income
(loss) was $568,000 and $(173,000) for the three months ended June 30, 2003 and
2002, respectively, and $1,002,000 and $199,000 for the six months ended June
30, 2003 and 2002, respectively.
12
NOTE 9. COMMITMENTS AND CONTINGENCIES
- -----------------------------------------
LITIGATION
The Company is subject to various claims and legal actions arising in the
ordinary course of business. The Company believes all pending claims either are
covered by liability insurance maintained by the Company or by dentists in the
Company's provider network, or will not have a material adverse effect on the
Company's consolidated financial position or results of operations.
CONTINGENT LEASE OBLIGATIONS
The Company sold all of its general dental practices and orthodontic practices
in 1996, 1997 and 1998. The Company also re-sold certain of these practices in
October 2000, after the original purchaser of a number of the practices
defaulted on its obligations to the Company. The office lease agreements related
to 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 June 30, 2003, the total of the minimum annual payments under
these leases was approximately $1.3 million, and the aggregate contingent
liability of the Company related to these leases was approximately $2.5 million
over the remaining terms of the lease agreements, which expire at various dates
through 2007. The Company has not been notified of any defaults under these
leases that would materially affect the Company's consolidated financial
position.
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 also 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 condensed consolidated balance sheets, except as described
above under "Contingent Lease Obligations." The Company issued no guarantees
during the six months ended June 30, 2003.
DIRECTORS' AND OFFICERS' LIABILITY INSURANCE
The Company's directors' and officers' liability insurance policy, which
provided $5 million of coverage after a $250,000 deductible, expired on
September 30, 2002. Due to a significant increase in the cost of such insurance,
the Company elected not to purchase this insurance coverage effective October 1,
2002.
GOVERNMENT REGULATION
During the six months ended June 30, 2003 and 2002, one 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 this instance of noncompliance with
regulatory requirements will have no significant effect on its consolidated
financial statements.
13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor"
for forward-looking statements, as long as those statements are identified as
forward-looking and are accompanied by meaningful cautionary statements
identifying important factors that could cause actual results to differ
materially from those discussed in the statements. The Company desires to take
advantage of these safe harbor provisions. The following risk factors, as well
as the risk factors identified in the Company's Annual Report on Form 10-K for
the year ended December 31, 2002, and the Company's Current Reports on Form 8-K
filed on February 14, 2003, April 3, 2003, April 25, 2003, May 5, 2003, and July
2, 2003, all of which have been filed with the Securities and Exchange
Commission, 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.
All of the risks set forth below could negatively impact the earnings of the
Company in the future. The Company's expectations for the future are based on
current information and its evaluation of external influences. Changes in any
one factor could materially impact the Company's expectations related to premium
rates, revenue, 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.
RISK FACTORS
The Company's business and competitive environment includes numerous factors
that expose the Company to risk and uncertainty. Some risks are related to the
dental benefits industry in general and other risks are related to the Company
specifically. Due to the risks and uncertainties described below, there can be
no assurance that the Company will be able to maintain its current market
position. Some of the risk factors described below have adversely affected the
Company's operating results in the past, and all of these risk factors could
affect its future operating results.
INTEGRATION OF ACQUIRED COMPANIES
The Company completed the acquisition of Paramount effective on August 30, 2002,
and the acquisition of Ameritas effective on March 31, 2003. The Company is in
the process of integrating the business operations of both Paramount and
Ameritas into the Company's pre-existing operations. Due to the complexities
inherent in this process, there is a risk that the Company may not be able to
complete such integration in a timely and effective manner. In such case, the
Company may not be able to retain all of the customers of the acquired
companies, resulting in a loss of revenue, and the Company's health care
services or general and administrative expenses could be higher than expected,
which could have a negative impact on the Company's overall profitability.
INTEGRATION OF PENDING ACQUISITIONS
The Company expects to complete the acquisitions of HN Dental and HN Vision in
late 2003. See Note 4 to the accompanying condensed consolidated financial
statements for more information on these transactions. The combined annual
revenue of HN Dental, HN Vision, and the related group dental and vision
insurance business underwritten by HN Life was approximately $65 million for the
year ended December 31, 2002, which is material compared to the Company's
14
existing operations. After the completion of these acquisitions, the Company
expects to integrate the operations of HN Dental and HN Vision into its existing
operations. Due to the relatively large size of the business to be acquired, and
the complexities inherent in this process, there is a risk that the Company may
not be able to complete such integration in a timely and effective manner. In
such case, the Company may not be able to retain all of the customers of the
acquired companies, resulting in a loss of revenue, and the Company's health
care services or general and administrative expenses could be higher than
expected, which could have a negative impact on the Company's overall
profitability.
GOVERNMENT REGULATION
The dental benefits industry is subject to extensive state and local laws, rules
and regulations. Several of the Company's operating subsidiaries are subject to
various requirements imposed by state laws and regulations related to the
operation of a dental HMO plan or a dental insurance company, including the
maintenance of a minimum amount of net worth, and these requirements 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, which are primarily
related to protecting confidential information related to its subscribers and
their dependents. 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 June 30, 2003, the Company
is contingently liable for an aggregate of approximately $2.5 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 Company's common stock is currently
traded on the NASDAQ Over-The-Counter Bulletin Board, and 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.
15
COMPETITIVE MARKET
The Company operates in a highly competitive industry. Its ability to operate on
a profitable basis is affected by significant competition for employer groups
and for contracting dental providers. Dental providers are becoming more
sophisticated, their practices are busier, and they are less willing to join the
Company's networks under capitation arrangements or discounted fees. There can
be no assurance the Company will be able to compete successfully enough to be
profitable. Existing or new competitors could have a negative impact on the
Company's revenues, earnings and growth prospects. The Company expects the level
of competition to remain high for the foreseeable future.
ABILITY TO MAINTAIN REVENUE
The combined premium revenue of the Company, Paramount and Ameritas decreased
slightly from $46.6 million on a pro forma basis during the six months ended
June 30, 2002, to $45.9 million on a pro forma basis during the comparable
period in 2003, primarily due to the loss of a number of customers, and a net
decrease in the enrollment within retained 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
entire underwriting risk related to the frequency and cost of dental services
provided to the covered individuals. Under the Company's dental HMO plan
designs, the Company assumes a portion of the underwriting risk, primarily
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 may not be
sufficient to cover the cost of the dental services delivered to subscribers and
dependents. This could have a material adverse effect on the Company's operating
results.
EFFECT OF ADVERSE ECONOMIC CONDITIONS
The Company's business could be negatively affected by periods of general
economic slowdown, recession or terrorist activities which, among other things,
may be accompanied by layoffs by the Company's customers, which could reduce the
number of subscribers enrolled in the Company's benefit plans, and by an
increase in the pricing pressure from customers and competitors.
RELATIONSHIPS WITH DENTAL PROVIDERS
The Company's success is dependent on maintaining competitive networks of
dentists in each of the Company's geographic markets. Generally, the Company and
the network dentists enter into 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.
16
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 have been made by management, and which the Company believes
are reasonable based on the information available. These estimates and
assumptions affect the reported amounts of assets, liabilities, revenues and
expenses in the accompanying condensed consolidated financial statements. The
Company believes the most critical accounting policies used to prepare the
accompanying condensed consolidated financial statements are the following:
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 June 30, 2003. 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 June 30,
2003. However, there can be no assurance that the Company will realize the
carrying amount of its notes receivable.
GOODWILL
The Company's accounting for goodwill is in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible
Assets," which the Company adopted as of January 1, 2002. Goodwill as of June
30, 2003 consists of $4.7 million of goodwill related to the acquisition of
Paramount in August 2002, $3.9 million of goodwill related to the acquisition of
a Texas-based dental HMO company in 1996, and $0.1 million of goodwill related
to the acquisition of Ameritas in March 2003. See Note 3 to the accompanying
condensed consolidated financial statements for more information on the
Paramount and Ameritas acquisitions. In the case of each acquisition, goodwill
represents the excess of the purchase price of the acquired company over the
fair value of the net assets acquired. In the case of the 1996 acquisition, the
balance is net of an adjustment in 1999 to reduce the carrying value of the
goodwill to its estimated realizable value. The Company has not yet completed
its identification of the intangible assets that were acquired in the Ameritas
acquisition, or its determination of the fair values and amortization periods of
those intangible assets. The accompanying condensed consolidated financial
statements reflect the Company's preliminary estimate of the aggregate fair
value of the intangible assets acquired, and the amortization periods of those
assets, pending its final determination.
SFAS No. 142 requires that goodwill be evaluated for possible impairment on an
annual basis and any time an event occurs that may have affected the value of
the goodwill. 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 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 amounts of shared administrative expenses that are charged to
17
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 Company is not aware of any events that have
occurred since October 1, 2002, that represent an indication of a possible
impairment. However, there can be no assurance that impairment will not occur in
the future.
INTANGIBLE ASSETS
Intangible assets as of June 30, 2003 consist of customer relationships and
other intangible assets with an aggregate net book value of $2.4 million, all of
which were acquired in connection with the acquisitions of Paramount in August
2002 and Ameritas in March 2003, as discussed in Note 3 to the accompanying
condensed 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 condensed
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 assets and liabilities 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 assets and liabilities 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 large losses incurred by the
Company during 1998, 1999 and 2000, relative to the amounts of income earned by
the Company during 2001, 2002 and the first six months of 2003, as well as the
existence of significant net operating loss carryforwards.
18
RESULTS OF OPERATIONS
The following table shows the Company's results of operations as a percentage of
premium revenue, and is used in the period-to-period comparisons discussed
below.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- --------------------
2003 2002 2003 2002
---------- ---------- -------- ----------
Premium revenue, net 100.0% 100.0% 100.0% 100.0%
Health care services expense 68.9 72.8 68.9 71.5
Selling, general and administrative expense 28.4 28.6 28.7 28.4
---------- ---------- -------- ----------
Operating income 2.7 (1.4) 2.4 0.1
Investment and other income 0.3 0.5 0.3 0.5
Interest expense (0.4) (0.1) (0.4) (0.1)
---------- ---------- -------- ----------
Income before income taxes 2.6 (1.0) 2.3 0.5
Income tax expense (0.2) -- (0.1) --
---------- ---------- -------- ----------
Net income 2.4% (1.0)% 2.2% 0.5%
========== ========== ======== ==========
THREE MONTHS ENDED JUNE 30, 2003 COMPARED TO THREE MONTHS ENDED JUNE 30, 2002
Premium revenue increased by $2.9 million, or 14.7%, from $20.2 million in 2002
to $23.1 million in 2003. The average membership for which the Company provided
dental coverage increased by approximately 216,000 members, or 39.7%, from
544,000 members in 2002 to 760,000 members in 2003. The operations of Paramount
are included in the Company's financial statements beginning on September 1,
2002, and the operations of Ameritas are included beginning on April 1, 2003.
Average membership increased in 2003 by approximately 220,000 members due to the
Paramount acquisition, and by approximately 25,000 members due to the Ameritas
acquisition, but these increases were partially offset, primarily due to a net
decrease in its enrollment within retained customers, and some lost customers.
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, which may cause employers and employees to allocate less spending for
the purchase of dental coverage, which is usually viewed as being more
discretionary than medical coverage. Premium revenue increased by only 14.7%
even though average membership increased 39.7%. 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. This is because the dental plan designs offered by
Paramount include a significantly lower level of benefits than the benefit plans
offered by the Company prior to the acquisition of Paramount. Substantially all
of the Company's premium revenue was derived from dental benefit plans in 2003
and 2002. Premium revenue from vision benefit plans and other products was not
material in 2003 or 2002.
Health care services expense increased by $1.3 million, or 8.7%, from $14.6
million in 2002 to $15.9 million in 2003. Health care services expense as a
percentage of premium revenue (the "loss ratio") decreased from 72.8% in 2002 to
68.9% in 2003, which is primarily related to the Company's products with an HMO
plan design. The Company believes the decrease is primarily due to premium rate
increases that slightly exceeded the increases in the cost of providing dental
services to its members. The decrease in the loss ratio is also partially due
to a significantly lower loss ratio in the business acquired from Paramount,
compared to the loss ratio in the Company's pre-existing business. The lower
loss ratio in the Paramount business is primarily due to the type of benefit
plan designs sold by Paramount, as discussed above.
Selling, general and administrative ("SG&A") expense as a percentage of premium
revenue decreased from 28.6% in 2002 to 28.4% in 2003, although the amount of
SG&A expense increased by $0.8 million, or 13.6%, from $5.8 million in 2002 to
$6.6 million in 2003. The increase in SG&A expenses is primarily due to
increases in broker commissions, amortization expense, and salaries and internal
sales commissions, and a $350,000 refund of maintenance fees from one of the
Company's vendors in 2002, which were partially offset by a $250,000 expense in
19
2002 related to the settlement of a stockholder litigation matter. The increase
in broker commissions is primarily related to a 14.7% increase in premium
revenue, as discussed above. The increase in amortization expense is due to
amortization of the intangible assets acquired in the Paramount acquisition in
August 2002, as there was no amortization expense in 2002. The increase in
salaries and internal sales commissions are primarily related to the Company's
efforts to increase its new sales activity in 2003. The refund of maintenance
fees in 2002 was primarily due to the settlement of a dispute over the amount of
equipment maintenance fees paid by the Company in several prior years. See the
Company's Annual Report on Form 10-K for the year ended December 31, 2002 for
more information on the settlement of the stockholder litigation matter in 2002.
Investment and other income decreased from $103,000 in 2002 to $79,000 in 2003,
which was primarily due to a decrease in the amount of investments held by the
Company. The decrease in the amount of the Company's investments is primarily
due to a total of $3.6 million of net cash used in the acquisitions of Paramount
and Ameritas, and to $2.4 million of principal payments on debt and capital
lease obligations during the twelve months ended June 30, 2003, which were
partially offset by a $2.0 million borrowing in August 2002.
Interest expense increased from $24,000 in 2002 to $86,000 in 2003, which was
primarily due to the fact that most of the Company's existing debt was incurred
after June 30, 2002, as discussed in more detail in Note 5 to the accompanying
condensed consolidated financial statements.
Income before income taxes improved significantly, from a $200,000 loss in 2002
to income of $610,000 in 2003, which was primarily due to a decrease in the loss
ratio from 72.8% in 2002 to 68.9% in 2003, as discussed above.
SIX MONTHS ENDED JUNE 30, 2003 COMPARED TO SIX MONTHS ENDED JUNE 30, 2002
Premium revenue increased by $4.2 million, or 10.2%, from $40.8 million in 2002
to $45.0 million in 2003. The average membership for which the Company provided
dental coverage increased by approximately 201,000 members, or 36.7%, from
548,000 members in 2002 to 749,000 members in 2003. The operations of Paramount
are included in the Company's financial statements beginning on September 1,
2002, and the operations of Ameritas are included beginning on April 1, 2003.
Average membership increased in 2003 by approximately 220,000 members due to the
Paramount acquisition, and by approximately 13,000 members due to the Ameritas
acquisition, but these increases were partially offset by the loss of a number
of the Company's customers, and a net decrease in its enrollment within retained
customers. 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, which may cause employers and employees to allocate less
spending for the purchase of dental coverage, which is usually viewed as being
more discretionary than medical coverage. Premium revenue increased by only
10.2% even though average membership increased 36.7%. 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. This is because the dental plan designs offered
by Paramount include a significantly lower level of benefits than the benefit
plans offered by the Company prior to the acquisition of Paramount.
Substantially all of the Company's premium revenue was derived from dental
benefit plans in 2003 and 2002. Premium revenue from vision benefit plans and
other products was not material in 2003 or 2002.
Health care services expense increased by $1.8 million, or 6.2%, from $29.2
million in 2002 to $31.0 million in 2003. The loss ratio decreased from 71.5% in
2002 to 68.9% in 2003, which is primarily related to the Company's products with
an HMO plan design. The Company believes the decrease is partially due to
premium rate increases that slightly exceeded the increases in the cost of
providing dental services to its members. The decrease in the loss ratio is
also partially due to a significantly lower loss ratio in the business acquired
from Paramount, compared to the loss ratio in the Company's pre-existing
business. The lower loss ratio in the Paramount business is primarily due to the
type of benefit plan designs sold by Paramount, as discussed above.
SG&A expense increased by $1.3 million, or 11.2%, from $11.6 million in 2002 to
$12.9 million in 2003. SG&A expense as a percentage of premium revenue increased
slightly from 28.4% in 2002 to 28.7% in 2003. The increase in SG&A expenses is
primarily due to increases in broker commissions, amortization expense, and
salaries and internal sales commissions, and a $350,000 refund of maintenance
fees from one of the Company's vendors in 2002, which were partially offset by a
$250,000 expense in 2002 related to the settlement of a stockholder litigation
20
matter. The increase in broker commissions is primarily related to a 14.7%
increase in premium revenue, as discussed above. The increase in amortization
expense is due to amortization of the intangible assets acquired in the
Paramount acquisition in August 2002, as there was no amortization expense in
2002. The increase in salaries and internal sales commissions are primarily
related to the Company's efforts to increase its new sales activity in 2003. The
refund of maintenance fees in 2002 was primarily due to the settlement of a
dispute over the amount of equipment maintenance fees paid by the Company in
several prior years. See the Company's Annual Report on Form 10-K for the year
ended December 31, 2002 for more information on the settlement of the
stockholder litigation matter in 2002.
Investment and other income decreased from $219,000 in 2002 to $158,000 in 2003,
which was primarily due to a decrease in the amount of investments held by the
Company. The decrease in the amount of the Company's investments is primarily
due to a total of $3.6 million of net cash used in the acquisitions of Paramount
and Ameritas, and to $2.4 million of principal payments on debt and capital
lease obligations during the twelve months ended June 30, 2003, which were
partially offset by a $2.0 million borrowing in August 2002.
Interest expense increased from $31,000 in 2002 to $186,000 in 2003, which was
primarily due to the fact that most of the Company's existing debt was incurred
after June 30, 2002, as discussed in more detail in Note 5 to the accompanying
condensed consolidated financial statements.
Income before income taxes increased from $0.2 million in 2002 to $1.1 million
in 2003, which was primarily due to a decrease in the loss ratio from 71.5% in
2002 to 68.9% in 2003, as discussed above.
LIQUIDITY AND CAPITAL RESOURCES
The Company's net working capital increased from $2.0 million as of December 31,
2002, to $2.8 million as of June 30, 2003. The increase in net working capital
was primarily due to $1.9 million of net income plus depreciation and
amortization expense, and a $1.1 million reduction in the current portion of
long-term debt and capital lease obligations, which were partially offset by
$1.2 million of debt payments, and the impact of the Ameritas acquisition in
March 2003, as discussed in Note 3 to the accompanying condensed consolidated
financial statements. The Ameritas acquisition decreased working capital by a
net amount of $0.8 million, which represents the intangible assets and goodwill
acquired in the transaction. The $1.1 million decrease in the current portion of
long-term debt and capital lease obligations was the result of amendments to the
payment terms of the Company's unsecured convertible note and secured
convertible note during the second quarter of 2003, as discussed in Note 5 to
the accompanying condensed consolidated financial statements.
The Company's total debt decreased from $5.4 million as of December 31, 2002, to
$4.6 million as of June 30, 2003, primarily due to $1.2 million of debt payments
during the first six months of 2003, which were partially offset by a new
capital lease during the second quarter of 2003. The new capital lease is
related to a new telephone system for the Company's primary administrative
office. The aggregate principal payments due under all of the Company's debt,
including its capital leases, are $0.8 million during the remainder of 2003,
$0.9 million in 2004, $0.6 million in 2005, $0.6 million in 2006, $1.0 million
in 2007, and $0.7 million in 2008.
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 lease obligations entered
into in June 2002, as discussed in Note 5 to the accompanying condensed
consolidated financial statements, and to provide for the payments due under the
settlement of the stockholder litigation matter. The borrowing was made under an
unsecured convertible note that bears interest at 7.0% annually, and is payable
in monthly installments of interest only through May 2006, then in monthly
installments of principal and interest from June 2006 through August 2008. The
outstanding balance under the convertible note is convertible into common stock
of the Company at a conversion price of $1.625 per share.
Effective August 30, 2002, the Company acquired all of the outstanding capital
stock of Paramount for a total cost of approximately $6.8 million, consisting of
$3.0 million in cash, a secured convertible note for $2,625,000, 769,231 shares
of the Company's common stock, and $164,000 of transaction expenses. The secured
convertible note bears interest at 7.0% annually, and is payable in varying
monthly installments of principal and interest through September 2008. 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
21
Company's dental HMO subsidiary in Florida. The operations of Paramount are
included in the Company's consolidated financial statements beginning on
September 1, 2002.
Effective March 31, 2003, the Company acquired all of the outstanding capital
stock of Ameritas for a purchase price of $1.1 million in cash, plus contingent
monthly payments during the five years following the acquisition date. Each
contingent monthly payment is equal to 10% of the actual premium revenue during
the month from customers of Ameritas that existed as of March 31, 2003. As of
June 30, 2003, the Company has accrued a total of $255,000 of contingent
purchase price, which has been added to the cost of the acquisition for
accounting purposes. Ameritas had premium revenue of $3.7 million during the
year ended December 31, 2002, and accordingly, the maximum aggregate amount of
the contingent monthly payments would be approximately $1.8 million, if the
Company retained all of the existing customers of Ameritas for five years after
the acquisition date at the premium rates in effect during 2002. See Note 3 to
the accompanying condensed consolidated financial statements for more
information on this acquisition. The operations of Ameritas are included in the
Company's consolidated financial statements beginning on April 1, 2003.
On April 7, 2003, the Company entered into a definitive agreement to purchase
all of the outstanding capital stock of Health Net Dental, Inc. ("HN Dental"),
which is a California dental HMO, and certain PPO/indemnity dental business
underwritten by Health Net Life Insurance Company ("HN Life"), which is an
affiliate of HN Dental, subject to regulatory approval. The purchase price is
$9.0 million in cash and an agreement to provide private label dental HMO and
PPO/indemnity products to be sold in the marketplace by subsidiaries of Health
Net, Inc., the parent company of HN Dental, for a period of at least five years
following the closing of the transaction, subject to certain conditions. The
transaction is currently pending regulatory approval.
On June 30, 2003, the Company entered into a definitive agreement to purchase
all of the outstanding capital stock of Health Net Vision, Inc. ("HN Vision"),
which is a California vision HMO and an affiliate of HN Dental, and certain
PPO/indemnity vision business underwritten by HN Life, for $3.0 million in cash,
subject to regulatory approval. A substantial portion of the business of HN
Vision, which consists of products provided to MediCal beneficiaries, will be
transferred to a third party prior to the Company's acquisition of HN Vision,
and the remainder of the business of HN Vision, which consists of products
provided to commercial customers, will be transferred to the Company. The
transaction is currently pending regulatory approval.
The Company plans to finance the two transactions described above through the
issuance of up to approximately $18 million of unsecured convertible promissory
notes to certain of its principal stockholders. The proceeds from the
convertible notes will be used to finance the two pending transactions described
above, to satisfy the increase in the Company's regulatory net worth
requirements related to the group dental and vision insurance business to be
acquired, and to provide working capital that may be required in connection with
the integration of the acquired businesses into the Company's existing
operations.
The Company has reached an oral agreement with the stockholders referred to
above, regarding the expected amount and terms of the convertible notes. In
accordance with this agreement, the convertible notes will bear interest at 6.0%
annually, and will be convertible into the Company's common stock at the rate of
$1.75 per share, at the option of the holder. There will be no principal
payments due under the convertible notes during the first six years after
issuance, principal payments will be due during the succeeding four years
pursuant to a ten-year amortization schedule, and the remaining balance will be
payable in full ten years after the date of issuance. The convertible notes will
be payable in full upon a change in control of the Company, at the holder's
option. Provided that the Company redeems all of the outstanding convertible
notes at the same time, it will have the option of redeeming the convertible
notes for 229% of the face value of the notes during the first seven years after
the date of issuance, for 257% of the face value during the eighth year after
issuance, for 286% of the face value during the ninth year after issuance, and
for 323% of the face value during the tenth year after issuance. The issuance of
the convertible notes is currently pending negotiation of definitive agreements
and the completion of the acquisitions described above.
The Company believes it has adequate financial resources to continue its current
operations for the foreseeable future. The Company also believes it will be able
to meet all of its financial obligations from its existing financial resources
and future cash flows from its operations, except for the obligation to complete
the pending acquisitions of HN Dental, HN Vision, and the related dental
insurance and vision insurance businesses. As discussed above, the Company plans
to finance these acquisitions through the issuance of convertible notes to
22
certain of its principal stockholders. Although the Company believes it can meet
its other financial obligations from its internal resources, there can be no
assurance that the Company's future earnings will be adequate to make all of the
payments on the Company's various obligations as they become due.
Net cash provided by operating activities was $3.3 million during the six months
ended June 30, 2003, compared to $0.3 million of net cash used by operating
activities during the same period in 2002. The improvement is due to several
reasons. There was $0.2 million of net cash provided by an increase in claims
payable and claims incurred but not reported ("IBNR") during 2003, compared to
$1.2 million of net cash used by a decrease in claims payable and IBNR in 2002.
Net cash provided by net income plus depreciation and amortization expense
increased from $0.8 million in 2002 to $1.9 million in 2003. In addition, net
cash used by a decrease in accrued expenses decreased from $0.8 million in 2002
to $0.2 million in 2003. The decrease in claims payable and IBNR in 2002 was
primarily due to an intentional acceleration in the Company's payment of
provider claims. Due in part to a decline in interest rates on investments, the
Company adopted the practice of paying all provider claims as rapidly as
possible, in order to enhance its image among dental providers. The reduced
processing times for payment of provider claims have been substantially
maintained through the first six months of 2003. The decrease in accrued
expenses in 2002 was primarily due to payments made to reduce the obligations
assumed in connection with the re-sale of certain dental practices in October
2000, and payments on equipment leases for which the future payments were
previously accrued.
Net cash used by investing activities was $0.5 million in 2003, compared to $1.1
million in 2002. The change was primarily due to $0.9 million of net cash used
in the acquisition of Ameritas, and an increase in net purchases of investments
from $1.3 million in 2002 to $0.8 million in 2003. Net cash used in financing
activities decreased from $1.1 million in 2002 to $2.0 million in 2003,
primarily due to an increase in debt payments from $0.5 million in 2002 to $1.2
million in 2003.
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 2 to the accompanying condensed consolidated financial statements for a
discussion of recently adopted accounting principles and recently issued
accounting pronouncements.
IMPACT OF INFLATION
The Company's operations are potentially impacted by inflation, which can affect
premium rates, health care services expense, and selling, general and
administrative expense. The Company expects that its earnings will be positively
impacted by inflation in premium rates, because premium rates for dental benefit
plans in general have been increasing due to inflation in recent years. The
Company expects that its earnings will be negatively impacted by inflation in
health care costs, because fees charged by dentists and other dental providers
have been increasing due to inflation in recent years. The impact of inflation
on the Company's health care expenses is partially mitigated in the short-term
by the fact that approximately 30% of total health care services expense
consists of capitation (fixed) payments to providers. In addition, most of the
Company's selling, general and administrative expenses are impacted by general
inflation in the economy.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is subject to risk related to changes in short-term interest rates,
due to its investments in interest-bearing securities. As of June 30, 2003, the
Company's total cash and investments were approximately $16.4 million.
Therefore, a one percentage-point change in short-term interest rates would have
a $164,000 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.
23
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
Within 90 days prior to the date of this report, the Company completed an
evaluation, under the supervision and with the participation of the Company's
management, including the Chief Executive Officer and the Chief Financial
Officer, of the effectiveness of the design and operation of the Company's
disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based
on that evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that the Company's disclosure controls and procedures are effective in
alerting them, on a timely basis, to material information related to the Company
required to be included in the Company's periodic filings with the Securities
and Exchange Commission.
CHANGES IN INTERNAL CONTROLS
No significant changes to the Company's internal controls were made during the
periods covered by this report.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is subject to various claims and legal actions arising in the
ordinary course of business. The Company believes all pending claims either are
covered by liability insurance maintained by the Company or by dentists in the
Company's provider network, or will not have a material adverse effect on the
Company's consolidated financial position or results of operations.
In December 1999, a stockholder lawsuit against the Company was filed, which
alleged that the Company and certain of its officers then in office violated
certain securities laws by issuing alleged false and misleading statements
concerning the Company's publicly reported revenues and earnings during a
specified class period. During 2002 the Company settled the lawsuit for a
payment of $1.25 million to the plaintiffs, without any admission of liability.
The agreement between the Company and the plaintiffs was approved by the
District Court in September 2002, and the matter has been dismissed with
prejudice. The Company's insurer paid $1.0 million of the cost of the
settlement, and the Company recorded a $250,000 expense during the three months
ended June 30, 2002, which was included in selling, general and administrative
expenses.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
EXHIBIT DESCRIPTION
------- -------------------------------------------------------
3.1.5 Amendment to Restated Certificate of Incorporation
10.5.2 Amendment to Stock Option Plan
10.52 Amendment to Convertible Promissory Note dated August
8, 2002.
(b) REPORTS ON FORM 8-K.
The Company filed a Current Report on Form 8-K on July 2, 2003, to report the
execution of a definitive agreement to purchase all of the outstanding stock of
Health Net Vision, Inc. ("HN Vision") and certain group vision insurance
business underwritten by Health Net Life Insurance Company ("HN Life"), which is
an affiliate of HN Vision, for $3.0 million in cash, subject to regulatory
approval. The Company previously filed a Current Report on Form 8-K on April 25,
2003, to report the execution of a binding letter of intent to purchase all of
the outstanding stock of HN Vision. The terms of the definitive agreement are
substantially the same as the terms of the binding letter of intent. The
transaction is currently pending regulatory approval. See Note 4 to the
accompanying condensed consolidated financial statements for more information on
this transaction.
24
The Company filed a Current Report on Form 8-K on August 12, 2003, to report the
issuance of a news release containing information on the Company's results of
operations for the quarter and six months ended June 30, 2003.
25
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized, in the City of Aliso
Viejo, State of California, on the 13th day of August 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
(Principal Accounting Officer)
26