UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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 November 1, 2003, the number of shares of registrant's common stock, par
value $0.01 per share, outstanding was 5,737,380 shares (not including 3,216,978
shares of common stock held in treasury), and the number of shares of
registrant's convertible preferred stock, par value $0.01 per share, outstanding
was 30,000,000 shares.
SAFEGUARD HEALTH ENTERPRISES, INC.
INDEX TO FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2003
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (unaudited) . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
CERTIFICATIONS BY CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER . . . . . . . . . . 26
i
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2003 2002
--------------- --------------
ASSETS
Current assets:
Cash and cash equivalents $ 4,461 $ 3,036
Investments available-for-sale, at fair value 9,602 9,668
Accounts receivable, net of allowances 1,770 2,554
Other current assets 463 853
--------------- --------------
Total current assets 16,296 16,111
Property and equipment, net of accumulated depreciation and amortization 3,686 3,532
Restricted investments available-for-sale, at fair value 3,091 3,254
Notes receivable, net of allowances 379 457
Goodwill 8,737 8,590
Intangible assets, net of accumulated amortization 2,267 2,013
Other assets 210 157
--------------- --------------
Total assets $ 34,666 $ 34,114
=============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,070 $ 1,661
Accrued expenses 3,842 3,526
Current portion of long-term debt and capital lease obligations 1,189 2,430
Claims payable and claims incurred but not reported 5,822 4,690
Deferred premium revenue 1,386 1,786
--------------- --------------
Total current liabilities 13,309 14,093
Long-term debt and capital lease obligations, net of current portion 2,785 2,997
Other long-term liabilities 937 1,013
Commitments and contingencies (Note 8)
Stockholders' equity:
Convertible preferred stock and additional paid-in capital 41,250 41,250
Common stock and additional paid-in capital 22,742 22,662
Retained earnings (accumulated deficit) (28,612) (30,170)
Accumulated other comprehensive income 81 95
Treasury stock, at cost (17,826) (17,826)
--------------- --------------
Total stockholders' equity 17,635 16,011
--------------- --------------
Total liabilities and stockholders' equity $ 34,666 $ 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 SEPTEMBER 30, 2003 AND 2002
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
2003 2002
-------- --------
Premium revenue, net $23,009 $20,682
Health care services expense 16,118 14,546
Selling, general and administrative expense 6,243 6,040
-------- --------
Operating income 648 96
Investment and other income 73 92
Interest expense (76) (84)
-------- --------
Income before income taxes 645 104
Income tax expense 81 --
-------- --------
Net income $ 564 $ 104
======== ========
Basic net income per share $ 0.02 $ 0.00
Weighted average basic shares outstanding 35,729 35,161
Diluted net income per share $ 0.02 $ 0.00
Weighted average diluted shares outstanding 36,421 35,526
See accompanying Notes to Condensed Consolidated Financial Statements.
2
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
2003 2002
-------- --------
Premium revenue, net $68,050 $61,544
Health care services expense 47,158 43,772
Selling, general and administrative expense 19,162 17,656
-------- --------
Operating income 1,730 116
Investment and other income 231 311
Interest expense (262) (115)
-------- --------
Income before income taxes 1,699 312
Income tax expense 141 --
-------- --------
Net income $ 1,558 $ 312
======== ========
Basic net income per share $ 0.04 $ 0.01
Weighted average basic shares outstanding 35,711 34,817
Diluted net income per share $ 0.04 $ 0.01
Weighted average diluted shares outstanding 36,272 35,374
See accompanying Notes to Condensed Consolidated Financial Statements.
3
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(IN THOUSANDS)
(UNAUDITED)
2003 2002
-------- --------
Cash flows from operating activities:
Net income $ 1,558 $ 312
Adjustments to reconcile net income to net cash
provided by operating activities:
Bad debt expense 117 160
Depreciation and amortization 1,343 908
Contribution to retirement plan in the form of common stock, at fair value 86 68
Gains on sale of assets (25) (11)
Changes in operating assets and liabilities, excluding effects of acquisitions:
Accounts receivable 732 101
Other current assets 508 457
Other assets (53) 74
Accounts payable (51) 96
Accrued expenses 17 (740)
Claims payable and claims incurred but not reported 1,100 (968)
Deferred premium revenue (658) 270
-------- --------
Net cash provided by operating activities 4,674 727
Cash flows from investing activities:
Purchase of investments available-for-sale (8,991) (3,130)
Proceeds from sale/maturity of investments available-for-sale 9,672 6,893
Cash paid for acquisition of business, net of cash acquired (858) (2,702)
Purchases of property and equipment (741) (311)
Payments received on notes receivable 102 27
Proceeds from sale of subsidiary -- 72
-------- --------
Net cash (used in) provided by investing activities (816) 849
Cash flows from financing activities:
Borrowings on long-term debt -- 2,000
Decrease in bank overdrafts (582) (1,746)
Payments on debt and capital lease obligations (1,775) (1,099)
Exercise of stock options -- 49
(Decrease) increase in other long-term liabilities (76) 61
-------- --------
Net cash used in financing activities (2,433) (735)
-------- --------
Net increase in cash and cash equivalents 1,425 841
Cash and cash equivalents at beginning of period 3,036 1,497
-------- --------
Cash and cash equivalents at end of period $ 4,461 $ 2,338
======== ========
(Continued on next page)
4
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS -- Continued
NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(IN THOUSANDS)
(UNAUDITED)
2003 2002
-------- --------
Supplementary information:
Cash paid during the period for interest $ 267 $ 115
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, excluding cash $ 1,336 $ 408
Goodwill related to transaction 147 6,926
Less - Secured convertible note issued in transaction -- (2,625)
Less - Common stock issued in transaction -- (1,040)
Less - Cash paid in transaction, net of cash acquired (858) (2,702)
Less - Liability for contingent purchase price (293) --
-------- --------
Liabilities assumed in acquisition of business $ 332 $ 967
======== ========
See accompanying Notes to Condensed Consolidated Financial Statements.
5
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
NOTE 1. GENERAL
- -----------------
The accompanying unaudited condensed consolidated financial statements of
SafeGuard Health Enterprises, Inc. and subsidiaries (the "Company") as of
September 30, 2003, and for the three months and nine months then ended, have
been prepared in accordance with accounting principles generally accepted in the
United States of America with respect 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. In
accordance with the regulations of the Securities and Exchange Commission, these
financial statements omit certain footnote disclosures and other information
that would be necessary to present the Company's financial position and results
of operations in accordance with accounting principles generally accepted in the
United States of America with respect to annual periods. 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." Goodwill as of September 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 fair 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 estimated future cash flows, 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.
6
Changes in the carrying amount of goodwill during the nine months ended
September 30, 2003 were as follows (in thousands):
Balance at December 31, 2002 $ 8,590
Goodwill acquired (see Note 3) 147
---------
Balance at September 30, 2003 $ 8,737
=========
INTANGIBLE ASSETS
Intangible assets as of September 30, 2003 consist of customer relationships and
other intangible assets with an aggregate net book value of $2.3 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
The Company's accounting for stock options is in accordance with Accounting
Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to
Employees." 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.
7
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, "Accounting for
Stock-Based Compensation," on the Company's net income and net income per share
(in thousands, except per share amounts):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ------------------------
2003 2002 2003 2002
----------- ----------- ----------- -----------
Net income, as reported $ 564 $ 104 $ 1,558 $ 312
Less -Employee compensation expense based on
the fair value method of accounting for stock
options, net of applicable income tax effect (183) (214) (505) (642)
----------- ----------- ----------- -----------
Pro forma net income (loss) $ 381 $ (110) $ 1,053 $ (330)
=========== =========== =========== ===========
Basic net income per share, as reported $ 0.02 $ 0.00 $ 0.04 $ 0.01
Pro forma basic net income (loss) per share 0.01 (0.00) 0.03 (0.01)
Diluted net income per share, as reported $ 0.02 $ 0.00 $ 0.04 $ 0.01
Pro forma diluted net income (loss) per share 0.01 (0.00) 0.03 (0.01)
SFAS No. 123 requires an 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. The assumptions used to
determine the fair value of stock options granted were: an average expected life
of four years; expected volatility of 82%; no expected dividends; and a
risk-free annual interest rate of 2.0%. The assumptions regarding the expected
life of the options and the expected volatility of the stock price are
subjective, and these assumptions have a significant effect on the estimated
fair value amounts.
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 nine months ended September 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 4. Each of these convertible notes would have an anti-dilutive
effect on net income per share for the three months and nine months ended
September 30, 2003 and 2002. Accordingly, the convertible notes are excluded
from the calculation of diluted net income per share for all periods. As of
September 30, 2003, these two convertible notes were convertible into an
aggregate of 2,063,000 shares of common stock.
8
The differences between weighted average basic shares outstanding and weighted
average diluted shares outstanding are as follows (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- --------------------
2003 2002 2003 2002
--------- --------- --------- ---------
Weighted average basic shares outstanding 35,729 35,161 35,711 34,817
Effect of dilutive stock options 692 365 561 557
--------- --------- --------- ---------
Weighted average diluted shares outstanding 36,421 35,526 36,272 35,374
========= ========= ========= =========
RECENTLY ADOPTED ACCOUNTING PRINCIPLES
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities." 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." 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 is effective for fiscal years ending after December 15, 2002.
The adoption of SFAS No. 148 had no significant effect on the Company's
consolidated financial statements.
In January 2003, the FASB issued FIN 46, "Consolidation of Variable Interest
Entities," an interpretation of Accounting Research Bulletin No. 51. 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 September
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." SFAS No. 150 is effective
for financial instruments created or modified after May 31, 2003, and otherwise
is effective at the beginning of the first interim period beginning after June
15, 2003. The adoption of SFAS No. 150 had no significant effect on the
Company's consolidated financial statements.
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. As a result of the
acquisition, the number of individuals in Florida for which the Company provides
dental benefits increased 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
9
to the Company's historical financial statements for the nine months ended
September 30, 2002, as if the acquisition had been completed as of the beginning
of that period (in thousands):
Premium revenue, net $ 66,823
Operating income 354
Net income 383
Basic net income per share $ 0.01
Diluted net income per share 0.01
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 September 30, 2003, the Company has accrued
a total of $293,000 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 September 30, 2003, plus the estimated contingent monthly payments
related to the remaining portion of annual customer contracts that are in force
as of October 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. Based on
the amount of premium revenue during the period from April 1, 2003 to September
30, 2003, from customers of Ameritas that existed as of March 31, 2003, the
maximum aggregate amount of the contingent monthly payments would be
approximately $1.3 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 2003.
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
penetration in California, which is one of the Company's primary geographic
markets. As a result of the acquisition, the number of individuals in California
for which the Company provides dental benefits increased from approximately
300,000 members to approximately 330,000 members.
The aggregate purchase price recorded by the Company as of September 30, 2003,
including the amount paid at closing, the contingent purchase price accrued as
of September 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 147
Other assets 196
Accounts payable and claims payable and claims incurred but not reported (74)
Deferred premium revenue (258)
----------
Total cost of acquisition $ 1,427
==========
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
estimated amount of intangible assets acquired is being amortized on a
straight-line basis over a
10
period of approximately five years. The operations of Ameritas are included in
the Company's consolidated financial statements beginning on April 1, 2003.
See Note 9 for information on the acquisitions of Health Net Dental, Inc. ("HN
Dental") and Health Net Vision, Inc. ("HN Vision"), which were completed
effective October 31, 2003.
NOTE 4. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
- -----------------------------------------------------------
Long-term debt and capital lease obligations consisted of the following (in
thousands):
SEPTEMBER 30, DECEMBER 31,
2003 2002
--------------- --------------
Secured convertible promissory note $ 1,813 $ 2,427
Unsecured convertible promissory note 1,539 1,798
Capital lease obligations 622 1,202
--------------- --------------
Total debt and capital lease obligations 3,974 5,427
Less - Current portion (1,189) (2,430)
--------------- --------------
Long-term debt and capital lease obligations $ 2,785 $ 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 is payable
in 36 equal monthly installments of principal and interest, beginning in October
2002. The outstanding balance under the secured convertible note is convertible
into common stock of the Company at a conversion price of $1.625 per share. 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, and the purchase of formerly leased furniture for the Company's
primary administrative office in June 2002. 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 9 for a description of $19.0 million of unsecured convertible
promissory notes that were issued in October 2003, in connection with the
acquisitions of HN Dental and HN Vision.
NOTE 5. EXCHANGE OF CONVERTIBLE PREFERRED STOCK
- -----------------------------------------------------
Prior to May 2002, there were 300,000 shares of convertible preferred stock
issued and outstanding. Each share had a par value of $100 and a liquidation
preference of $100, and was convertible into 100 shares of the Company's common
stock. In May 2002, each outstanding share of convertible preferred stock was
exchanged for 100 new shares of convertible preferred stock. Each new share of
convertible preferred stock has a par value of $1.00 and a liquidation
preference of $1.00, and is convertible into one share of the Company's common
stock. All other rights and preferences of the convertible preferred stock
remained the same. All references to the convertible preferred stock in the
accompanying condensed consolidated financial statements reflect the effects of
this exchange on a retroactive basis.
11
NOTE 6. 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 nine 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 nine
months ended September 30, 2003. Its taxable income was completely offset by net
operating loss carryforwards from previous years, but the Company recognized
current federal income tax expense in 2003, due to the alternative minimum tax.
For California state income tax purposes, the Company had taxable income during
the first nine months of 2003. The State of California suspended the use of net
operating loss carryforwards to offset current taxable income for 2003 for all
corporations. Accordingly, the Company recognized current state income tax
expense for the nine months ended September 30, 2003. The Company incurred a net
loss for both federal and state income tax purposes for the nine months ended
September 30, 2002, and therefore, recognized no current income tax expense for
this period. The Company recognized no deferred income tax expense or benefit
during the nine months ended September 30, 2003 or 2002, due to the valuation
allowance against its net deferred tax assets, as discussed above.
NOTE 7. 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 nine
months ended September 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 $(22,000) and $47,000 for the
three months ended September 30, 2003 and 2002, respectively, and $(14,000) and
$38,000 for the nine months ended September 30, 2003 and 2002, respectively.
Total comprehensive income was $542,000 and $151,000 for the three months ended
September 30, 2003 and 2002, respectively, and $1,544,000 and $350,000 for the
nine months ended September 30, 2003 and 2002, respectively.
NOTE 8. 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.
12
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 September 30, 2003, the total of the minimum annual payments
under these leases was approximately $1.2 million, and the aggregate contingent
liability of the Company related to these leases was approximately $2.2 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 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 nine months ended September 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 nine months ended September 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.
NOTE 9. SUBSEQUENT EVENTS
- ----------------------------
Effective October 31, 2003, the Company acquired 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, for $10.4
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 transaction, subject to certain conditions. Effective October 31,
2003, the Company also acquired 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 $4.4 million in cash.
13
The aggregate cost of the acquisitions was approximately $16.3 million,
including estimated severance liabilities related to employees of HN Dental and
HN Vision, and other acquisition expenses. The combined annual revenue of the
acquired businesses was approximately $65 million for the year ended December
31, 2002.
The business purpose of these acquisitions was to increase the Company's market
penetration in California, which is one of the Company's primary geographic
markets, and to gain vision benefit products that are internally administered by
the Company. As a result of the acquisitions, the number of individuals in
California for which the Company provides dental benefits increased from
approximately 350,000 members to approximately 800,000 members, and the number
of individuals in California for which the Company provides vision benefits
increased from approximately 20,000 members to approximately 150,000 members.
The acquisitions were financed through the issuance of $19.0 million of
unsecured convertible promissory notes to certain of its principal stockholders
in October 2003. The proceeds from the convertible notes were used primarily to
finance the acquisitions, to satisfy the increase in the Company's regulatory
net worth requirements related to the PPO/indemnity dental and vision business
that was 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 convertible notes bear interest at 6.0% annually, and are convertible into
the Company's common stock at the rate of $1.75 per share, at the option of the
holder. There are no principal payments due under the convertible notes prior to
January 31, 2010, then principal payments are due beginning on January 31, 2010,
and each three months thereafter through July 31, 2013, pursuant to a ten-year
amortization schedule, and the remaining balance is payable in full on October
31, 2013. The convertible notes are payable in full upon a change in control of
the Company, at the holder's option. The Company has the option of redeeming the
convertible notes for 229% of face value during the first seven years after the
date of issuance, for 257% of face value during the eighth year after issuance,
for 286% of face value during the ninth year after issuance, and for 323% of
face value during the tenth year after issuance.
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, July 2,
2003, August 13, 2003, November 7, 2003, and November 10, 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
14
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 the Company's future operating results.
INTEGRATION OF ACQUIRED BUSINESS
The Company completed the acquisition of HN Dental, HN Vision, and certain
PPO/indemnity dental and vision business underwritten by HN Life in the fourth
quarter of 2003. See Note 9 to the accompanying condensed consolidated
financial statements for more information on these transactions. The combined
annual revenue of the acquired businesses was approximately $65 million for the
year ended December 31, 2002, which is material compared to the Company's
existing operations. The Company expects to integrate the operations of HN
Dental, HN Vision and the related PPO/indemnity business into its existing
operations during the next several months. Due to the relatively large size of
the business 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.
CONTINGENT LEASE OBLIGATIONS
The Company sold all of its general dental practices and orthodontic practices
in 1996, 1997 and 1998. The Company also re-sold certain of these practices in
October 2000, after the original purchaser of a number of the practices
defaulted on its obligations to the Company. All of the office lease agreements
related to those practices either have been assigned to the respective
purchasers of the practices, or have expired. As of September 30, 2003, the
Company is contingently liable for an aggregate of approximately $2.2 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. The net book value of the remaining
two promissory notes is $379,000 as of September 30, 2003. 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. The Company's common stock is currently traded on the
NASDAQ Over-The-Counter Bulletin Board, and the fact that
15
the Company's common stock is not listed on an exchange can have a negative
influence on the trading volume of the stock. 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. Broad stock market fluctuations, which
may be unrelated to the Company's operating performance, could also have a
negative effect on the Company's stock price.
COMPETITIVE MARKET
The Company operates in a highly competitive industry. Its ability to operate on
a profitable basis is affected by significant competition for employer groups
and for contracting dental providers. Dental providers are becoming more
sophisticated, their dental 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 $69.6 million on a pro forma basis during the nine months ended
September 30, 2002, to $68.9 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
16
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.
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 September 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 September
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." Goodwill as of September 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 First American 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
these 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 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.
17
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 of each year 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 estimates of future cash flows, the amounts 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 any 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 September 30, 2003 consist of customer relationships and
other intangible assets with an aggregate net book value of $2.3 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. The estimates
to which the fair value of each intangible asset are the most sensitive are the
estimate of future cash flows related to the asset, the estimated useful life of
the asset, and the weighted average cost of capital assumed. The Company
believes the estimates used in determining the fair value of each intangible
asset are reasonable and appropriate, but a significant change in any of these
estimates could result in a significant change in the fair values of the
intangible assets, or the amortization periods of those assets, or both.
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. The use of average historical lag times to estimate current lag
times is dependent on the assumption that the average time to process claims
currently is consistent with the average time to process claims historically.
The Company makes adjustments to the average historical lag times to account for
any changes in claims processing times, but a significant change in these
adjustments could result in a significant change in the estimated liability. The
estimate of the liability is also dependent on the assumption that the recent
trend in payment rates and the average number of incurred claims per covered
individual has continued to the balance sheet date. A significant change in
provider payment rates or utilization rates related to claims not yet received
by the Company could result in a significant change in the amount of the
liability. 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.
18
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 nine months of 2003, as well as the
existence of significant net operating loss carryforwards.
RESULTS OF OPERATIONS
The following table shows the Company's results of operations as a percentage of
premium revenue, and is used in the period-to-period comparisons discussed
below.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ----------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Premium revenue, net 100.0% 100.0% 100.0% 100.0%
Health care services expense 70.1 70.3 69.3 71.1
Selling, general and administrative expense 27.1 29.2 28.2 28.7
---------- ---------- ---------- ----------
Operating income 2.8 0.5 2.5 0.2
Investment and other income 0.3 0.4 0.4 0.5
Interest expense (0.3) (0.4) (0.4) (0.2)
---------- ---------- ---------- ----------
Income before income taxes 2.8 0.5 2.5 0.5
Income tax expense 0.4 -- 0.2 --
---------- ---------- ---------- ----------
Net income 2.4% 0.5% 2.3% 0.5%
========== ========== ========== ==========
THREE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2002
Premium revenue increased by $2.3 million, or 11.3%, from $20.7 million in 2002
to $23.0 million in 2003. The average membership for which the Company provided
dental coverage increased by approximately 139,000 members, or 22.9%, from
607,000 members in 2002 to 746,000 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 125,000 members due to the
Paramount acquisition, and by approximately 25,000 members due to the Ameritas
acquisition, and these increases were partially offset by a small decrease in
enrollment within the Company's pre-existing business.
Premium revenue increased by only 11.3% even though average membership increased
22.9%. 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.
19
Health care services expense increased by $1.6 million, or 10.9%, from $14.5
million in 2002 to $16.1 million in 2003. Health care services expense as a
percentage of premium revenue (the "loss ratio") decreased slightly from 70.3%
in 2002 to 70.1% in 2003.
Selling, general and administrative ("SG&A") expense as a percentage of premium
revenue decreased from 29.2% in 2002 to 27.1% in 2003, while the amount of SG&A
expense increased by $0.2 million, or 3.3%, from $6.0 million in 2002 to $6.2
million in 2003. The increase in SG&A expenses is primarily due to increases in
broker commissions and amortization expense, which were partially offset by
decreases in various other expenses, including telephone, equipment rent and
maintenance and consulting. The increase in broker commissions is primarily
related to an 11.3% 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 and the Ameritas
acquisition in March 2003.
Investment and other income decreased from $92,000 in 2002 to $73,000 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 an aggregate of $3.6 million of net cash used in the acquisitions of
Paramount in August 2002 and Ameritas in March 2003, and to $2.3 million of
principal payments on debt and capital lease obligations during the twelve
months ended September 30, 2003, which were partially offset by a $2.0 million
borrowing in August 2002.
Interest expense decreased from $84,000 in 2002 to $76,000 in 2003, which was
primarily due to debt payments made during the twelve months ended September 30,
2003.
Income before income taxes improved significantly, from $104,000 in 2002 to
$609,000 in 2003, which was primarily due to a decrease in SG&A expense as a
percentage of premium revenue, from 29.2% in 2002 to 27.1% in 2003, as discussed
above.
Income tax expense increased from zero in 2002 to $81,000 in 2003. The Company's
effective tax rate was relatively low in 2003 primarily due to net operating
loss carryforwards from previous years. The Company had a loss for tax purposes
in 2002, and accordingly, recorded no income tax expense. See Note 6 to the
accompanying condensed consolidated financial statements for more information on
income tax expense.
NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2002
Premium revenue increased by $6.5 million, or 10.6%, from $61.5 million in 2002
to $68.0 million in 2003. The average membership for which the Company provided
dental coverage increased by approximately 180,000 members, or 31.7%, from
568,000 members in 2002 to 748,000 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 190,000 members due to the
Paramount acquisition, and by approximately 17,000 members due to the Ameritas
acquisition, and these increases were partially offset by a small decrease in
enrollment within the Company's pre-existing business.
Premium revenue increased by only 10.6% even though average membership increased
31.7%. 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 $3.4 million, or 7.7%, from $43.8
million in 2002 to $47.2 million in 2003. The loss ratio decreased from 71.1% in
2002 to 69.3% in 2003, which is primarily 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.
20
SG&A expense as a percentage of premium revenue decreased from 28.7% in 2002 to
28.2% in 2003, while the amount of SG&A expense increased by $1.5 million, or
8.5%, from $17.7 million in 2002 to $19.2 million in 2003. The increase in SG&A
expenses is primarily due to increases in broker commissions and amortization
expense. The increase in broker commissions is primarily related to a 10.6%
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 and the Ameritas acquisition in March 2003.
Investment and other income decreased from $311,000 in 2002 to $231,000 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 $2.3 million of principal payments on debt and capital
lease obligations during the twelve months ended September 30, 2003, which were
partially offset by a $2.0 million borrowing in August 2002.
Interest expense increased from $115,000 in 2002 to $262,000 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 4 to the accompanying
condensed consolidated financial statements.
Income before income taxes improved significantly, from $312,000 in 2002 to $1.7
million in 2003, which was primarily due to a decrease in the loss ratio from
71.1% in 2002 to 69.3% in 2003, and a decrease in SG&A expense as a percentage
of premium revenue, from 28.7% in 2002 to 28.1% in 2003, as discussed above.
Income tax expense increased from zero in 2002 to $141,000 in 2003. The
Company's effective tax rate was relatively low in 2003 primarily due to net
operating loss carryforwards from previous years. The Company had a loss for tax
purposes in 2002, and accordingly, recorded no income tax expense. See Note 6 to
the accompanying condensed consolidated financial statements for more
information on income tax expense.
LIQUIDITY AND CAPITAL RESOURCES
The Company's net working capital increased from $2.0 million as of December 31,
2002, to $3.0 million as of September 30, 2003. The increase in net working
capital was primarily due to $2.9 million of net income plus depreciation and
amortization expense, and a $1.2 million reduction in the current portion of
long-term debt and capital lease obligations, which were partially offset by
$1.8 million of debt payments, and $0.9 million of net cash used in the
acquisition of Ameritas in March 2003, as discussed in Note 3 to the
accompanying condensed consolidated financial statements. The $1.2 million
decrease in the current portion of long-term debt and capital lease obligations
was primarily due to an amendment to the payment terms of the Company's
unsecured convertible note during the second quarter of 2003, as discussed in
Note 4 to the accompanying condensed consolidated financial statements, and the
payment in full of one of the Company's capital lease obligations during 2003.
The Company's total debt decreased from $5.4 million as of December 31, 2002, to
$4.0 million as of September 30, 2003, primarily due to $1.8 million of debt
payments during the first nine 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 $0.3 million during the remainder of 2003,
$1.1 million in 2004, $0.8 million in 2005, $0.5 million in 2006, $0.8 million
in 2007, and $0.5 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 4 to the accompanying condensed
consolidated financial statements, and to provide for the payments due under the
settlement of a 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
21
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. The
convertible note is secured by the stock of the Company's dental HMO subsidiary
in Florida. The operations of Paramount are included in the 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
September 30, 2003, the Company has accrued a total of $293,000 of contingent
purchase price, which has been added to the cost of the acquisition for
accounting purposes. Based on the amount of premium revenue during the period
from April 1, 2003 to September 30, 2003, from customers of Ameritas that
existed as of March 31, 2003, the maximum aggregate amount of the contingent
monthly payments would be approximately $1.3 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 2003. 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.
Effective October 31, 2003, the Company acquired 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, for $10.4
million in cash and an agreement to provide private label dental HMO and
PPO/indemnity products to be sold in the marketplace in conjunction with Health
Net medical products by subsidiaries of Health Net, Inc., the parent company of
HN Dental, for a period of at least five years following the transaction,
subject to certain conditions. Effective October 31, 2003, the Company also
acquired 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 $4.4 million
in cash. The aggregate cost of the acquisitions was approximately $16.3 million,
including estimated severance liabilities related to employees of HN Dental and
HN Vision, and other acquisition expenses.
The business purpose of these acquisitions was to increase the Company's market
penetration in California, which is one of the Company's primary geographic
markets, and to gain vision benefit products that are internally administered by
the Company. The acquisitions increased the number of individuals in California
for which the Company provides dental benefits from approximately 350,000
members to approximately 800,000 members, and increased the number of
individuals in California for which the Company provides vision benefits from
approximately 20,000 members to approximately 150,000 members.
The acquisitions were financed through the issuance of $19.0 million of
unsecured convertible promissory notes to certain of its principal stockholders.
The proceeds from the convertible notes were used primarily to finance the
acquisitions, to satisfy the increase in the Company's regulatory net worth
requirements related to the PPO/indemnity dental and vision business that was
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 and other purposes.
The convertible notes bear interest at 6.0% annually, and are convertible into
the Company's common stock at the rate of $1.75 per share, at the option of the
holder. There are no principal payments due under the convertible notes prior to
January 31, 2010, then principal payments are due beginning on January 31, 2010,
and each three months thereafter through July 31, 2013, pursuant to a ten-year
amortization schedule, and the remaining balance is payable in full on October
31, 2013. The convertible notes are payable in full upon a change in control of
the Company, at the holder's option. The Company has the option of redeeming the
convertible notes for 229% of face value during the first seven years after the
date of issuance, for 257% of face value during the eighth year after issuance,
for 286% of face value during the ninth year after issuance, and for 323% of
face value during the tenth year after issuance.
22
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. Although the Company believes it can
meet all of its 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 increased significantly from $0.7
million during the nine months ended September 30, 2002, to $4.7 million in the
same period in 2003. This was primarily due to an increase in net cash provided
by net income plus depreciation and amortization expense, and by an increase in
claims payable and claims incurred but not reported ("IBNR"). Net cash provided
by net income plus depreciation and amortization expense increased from $1.2
million in 2002 to $2.9 million in 2003, which is discussed above under Results
from Operations. There was $1.1 million of net cash provided by an increase in
claims payable and IBNR in 2003, compared to $1.0 million of net cash used by a
decrease in claims payable and IBNR in 2002. The increase in claims payable and
IBNR in 2003 was primarily due to a temporary decrease in the amount of claims
paid during September 2003, in connection with the Company's conversion of its
business to a new primary software application during September. The decrease in
claims payable and IBNR in 2002 was primarily due to an intentional acceleration
in the Company's payment of provider claims, which continued during 2003, except
during the month of September, as noted above.
Net cash used by investing activities was $0.8 million in 2003, compared to $0.8
million of net cash provided by investing activities in 2002. The change was
primarily due to a decrease in net sales of investments from $3.8 million in
2002 to $0.7 million in 2003. The net sales of investments in 2002 were
completed primarily to raise cash that was needed to finance the acquisition of
Paramount, a $1.7 million decrease in bank overdrafts, and $1.1 million of debt
payments. Net cash used in financing activities increased from $0.7 million in
2002 to $2.4 million in 2003, primarily due to the $2.0 million borrowing that
was completed in August 2002, as discussed in Note 4 to the accompanying
condensed consolidated financial statements.
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 2 to the accompanying condensed consolidated financial statements for a
discussion of recently adopted accounting principles and recently issued
accounting pronouncements.
IMPACT OF INFLATION
The Company's operations are potentially impacted by inflation, which can affect
premium rates, health care services expense, and selling, general and
administrative expense. The Company expects that its earnings will be positively
impacted by inflation in premium rates, because premium rates for dental benefit
plans in general have been increasing due to inflation in recent years. The
Company expects that its earnings will be negatively impacted by inflation in
health care costs, because fees charged by dentists and other dental providers
have been increasing due to inflation in recent years. The impact of inflation
on the Company's health care expenses is partially mitigated in the short-term
by the fact that approximately 30% of total health care services expense
consists of capitation (fixed) payments to providers. In addition, most of the
Company's selling, general and administrative expenses are impacted by general
inflation in the economy.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is subject to risk related to changes in short-term interest rates,
due to its investments in interest-bearing securities. As of September 30, 2003,
the Company's total cash and investments were approximately $17.2 million.
Therefore, a one percentage-point change in short-term interest rates would have
a $172,000 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
The Company completed an evaluation as of September 30, 2003, 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 lawsuit 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 2002, which was
included in selling, general and administrative expenses.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
None.
(b) REPORTS ON FORM 8-K.
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.
The Company filed a Current Report on Form 8-K on November 7, 2003, to report
the completion of the acquisition of HN Dental and HN Vision effective October
31, 2003, and the issuance of $19.0 million of unsecured convertible promissory
notes to certain of its principal stockholders in October 2003. See Note 9 to
the accompanying condensed consolidated financial statements for more
information on these events.
The Company filed a Current Report on Form 8-K on November 10, 2003, to report
the issuance of a news release containing information on the Company's results
of operations for the quarter and nine months ended September 30, 2003.
24
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 10th day of November 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)
25