UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003 COMMISSION FILE NUMBER 0-12050
SAFEGUARD HEALTH ENTERPRISES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 52-1528581
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
95 ENTERPRISE, SUITE 100
ALISO VIEJO, CALIFORNIA 92656-2605
(Address of principal executive offices) (Zip Code)
949.425.4300
(Registrant's telephone number, including area code)
949.425.4586
(Registrant's fax telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $0.01 PAR VALUE
NONE
(Name of exchange on which listed)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES [X] NO [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The aggregate market value of the voting stock held by non-affiliates of the
registrant as of June 30, 2003, was $3,567,000. The number of shares of the
registrant's common stock outstanding as of March 31, 2004, was 5,770,590 (not
including 3,216,978 shares held in treasury).
SAFEGUARD HEALTH ENTERPRISES, INC.
INDEX TO FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2003
PAGE
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PART I.
Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Item 2. Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Item 3. Legal Proceedings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Item 4. Submission of Matters to a Vote of Security Holders. . . . . . . . . . . . . . . . . . 19
PART II.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. . . . . . . . . 19
Item 6. Selected Financial Data. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. 22
Item 7A. Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . 31
Item 8. Financial Statements and Supplementary Data. . . . . . . . . . . . . . . . . . . . . . 31
Item 9. Changes in and Disagreements with Independent Accountants on Accounting and
Financial Disclosures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Item 9A. Controls and Procedures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
PART III.
Item 10. Directors and Executive Officers of the Registrant . . . . . . . . . . . . . . . . . . 31
Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Item 13. Certain Relationships and Related Transactions . . . . . . . . . . . . . . . . . . . . 37
Item 14. Principal Accountant Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . 37
PART IV.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K . . . . . . . . . . . 38
Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
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PART I
ITEM 1. BUSINESS
- ------------------
In addition to historical information, the description of business below
includes certain forward-looking statements regarding SafeGuard Health
Enterprises, Inc. and its subsidiaries (the "Company"), including statements
about growth plans, business strategies, future operating results, future
financial position, and general economic and market events and trends. The
Company's actual future operating results could differ materially from the
results indicated in the forward-looking statements as a result of various
events that cannot be predicted by the Company. Those possible events include an
increase in competition, changes in health care regulations, an increase in
dental care utilization rates, new technologies, an increase in the cost of
dental care, the inability to contract with an adequate number of participating
providers, the inability to efficiently integrate the operations of acquired
businesses, the inability to realize the carrying value of goodwill, intangible
assets, and certain long-term promissory notes owed to the Company, natural
disasters, loss of key management, and other risks and uncertainties as
described below under "RISK FACTORS." The following should be read in
conjunction with the Consolidated Financial Statements of the Company and Notes
thereto.
(a) GENERAL DEVELOPMENT OF BUSINESS
The Company provides a wide range of dental benefit plans, including health
maintenance organization ("HMO") plan designs and preferred provider
organization ("PPO")/indemnity plan designs. The Company also provides vision
benefit plans, administrative services, and preferred provider network rental.
The Company conducts its business through several subsidiaries, one of which is
an insurance company that is licensed in a number of states, and several of
which are dental HMO plans that are each licensed in the state in which it
operates. The Company's operations are primarily in California, Florida and
Texas, but it also operates in a number of other states.
The Company's predecessor, SafeGuard Health Plans, Inc., a California
corporation, (the "California Plan") commenced operations in 1974 as a nonprofit
corporation. The California Plan converted to for-profit status in December 1982
and is currently a subsidiary of the Company. SafeGuard Health Enterprises, Inc.
(the "Parent") was incorporated in California in November 1982 and acquired the
California Plan in December 1982. In August 1987 the Parent reincorporated in
Delaware. Unless the context requires otherwise, all references to the "Company"
or "SafeGuard" mean SafeGuard Health Enterprises, Inc. and its subsidiaries.
The Company completed three (3) acquisitions during the last two (2) years. In
October 2003, the Company made an acquisition that included a dental HMO
company, a vision HMO company, and certain dental and vision PPO/indemnity
business, all of which was located in California, and which had aggregate
revenue of approximately $74 million in 2003. The total cost of the acquisition
was approximately $15.2 million, which was paid in cash and was financed through
the issuance of $19.0 million of convertible notes in October 2003. In March
2003, the Company acquired a dental HMO company located in California, which had
approximately $3 million of annual revenue. The total cost of the acquisition
was approximately $1.3 million. In August 2002, the Company acquired a dental
HMO company located in Florida, which had approximately $7 million of annual
revenue. The purchase price of the acquisition was approximately $6.7 million,
which consisted of a cash payment of $3.0 million, a secured convertible note
for $2,625,000, and 769,231 shares of the Company's common stock. The Company is
currently licensed as a dental HMO in four states, and as an indemnity insurance
company in 20 states. However, substantially all of its revenue is generated in
California, Florida and Texas.
The Company's executive offices are located at 95 Enterprise, Suite 100, Aliso
Viejo, California 92656-2605, and its website address is www.safeguard.net. Its
telephone number is 949.425.4300 and its fax number is 949.425.4586.
DENTAL CARE MARKETPLACE
The total market for dental care services and for dental benefit plans has grown
rapidly in recent years. The United States Centers for Medicare & Medicaid
Services (formerly known as the Health Care Financing Administration) ("CMS")
reported that total expenditures for dental care in the United States increased
from approximately $50.2 billion in 1997 to an estimated $70.3 billion in 2002.
The National Association of Dental Plans (the "NADP")
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estimated that the number of people in the United States that were enrolled in
some type of dental benefit plan increased from 139 million in 1997 to 153
million in 2002, the last year for which this information is available.
The cost of dental services has increased in recent years at a rate higher than
that for consumer goods as a whole. The United States Bureau of Labor Statistics
(the "BLS") reported that the consumer price index ("CPI") for dental services
for all urban consumers increased by 24.0% from 1997 to 2002, while the CPI for
all items for all urban consumers increased by 12.1% during the same period. CMS
reported that expenditures for dental services accounted for approximately 4.5%
of total national health care expenditures during 2002. As a result of increases
in the cost of dental services, the Company believes that employers and other
purchasers of dental care benefits have a significant interest in effectively
managing the cost of dental care benefits.
As noted above, the NADP estimated that approximately 153 million people, or
approximately 54% of the total population of the United States, were enrolled in
some type of dental benefit plan in 2002. The United States Census Bureau
estimated that approximately 242 million people, or approximately 85% of the
total population of the United States, were enrolled in some type of medical
benefit plan in 2002. The Company believes the number of people without dental
coverage represents an opportunity for dental benefits companies to increase
their enrollments.
The NADP estimated that enrollment in dental HMO plans decreased from
approximately 27 million people in 1997 to approximately 23 million people in
2002. The Company believes the primary reason that total enrollment in dental
HMOs has not increased in recent years is that most purchasers desire greater
flexibility in the choice of providers than is generally afforded by dental
HMOs, and the size of dental HMO provider networks has not kept pace with the
growth in the dental benefits market.
In recent years, there has been a significant increase in the enrollment in
dental insurance plans that include PPO networks, which typically provide
greater flexibility in the member's choice of providers than a dental HMO. Under
these plans, the insurance company creates a PPO network by negotiating reduced
fees with dentists in exchange for including the dentists in a "preferred
provider" list that is distributed to subscribers who are enrolled in the PPO
dental plan. The subscribers who are enrolled in the plan generally receive a
higher level of benefits, in the form of reduced out-of-pocket expense at the
time of service, if they choose to receive services from a dentist in the PPO
network. The NADP estimated that enrollment in fully insured PPO dental plans
has grown from approximately 15 million people in 1997 to approximately 33
million people in 2002. The Company believes that PPO dental plans have been
rapidly gaining in popularity because they provide customers with a balance of
cost-effectiveness and flexibility in the choice of providers.
The dental benefit plan business is characterized by participation of several
large national insurance companies, and numerous regional insurance companies,
regional medical HMOs, and other independent organizations. The NADP estimated
there were approximately 77 entities offering dental HMO plans, and
approximately 67 entities offering dental PPO plans, in the United States in
2002.
The average monthly cost of dental insurance coverage is much lower than medical
insurance coverage. Dental care is provided almost exclusively on an outpatient
basis, and general dentists, as opposed to specialists, perform most dental
procedures. Most dental problems are not life threatening and do not represent
serious impairments to overall health. Therefore, there is a higher degree of
discretion exercised by patients in determining when or whether to obtain dental
services, and a higher degree of sensitivity to the cost of dental services.
Many dental conditions have a range of appropriate courses of treatment, each of
which has a different out-of-pocket cost for patients who are covered by a
dental insurance plan. For example, a deteriorated filling may be replaced with
another filling (a low-cost alternative), a pin-retained crown build-up (a more
costly alternative), or a crown with associated periodontal treatment (the most
costly alternative). The design of a patient's dental insurance plan can have an
impact on the type of dental services selected by the patient or recommended by
the dentist. Dental benefit plans generally do not include coverage for
hospitalization, which is typically the most expensive component of medical
services. In addition, co-payments and co-insurance payments made by patients
under dental plans typically represent a larger share of the total cost of
dental care, compared to the share of the total cost of medical care that is
paid by patients under medical coverage plans.
Common features of dental PPO and indemnity plans include annual deductibles of
varying amounts, maximum annual benefits of $2,000 or less per person and
significant cost sharing by the patient. Patient cost sharing typically varies
by the type of dental procedure, ranging from little or no cost sharing for
preventive procedures to 50% or
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more cost-sharing for bridgework or dentures, and even greater cost-sharing for
orthodontic care. The relatively high patient cost-sharing and the relatively
predictable nature of the need for dental services substantially reduces the
underwriting risk of dental PPO and indemnity plans, compared to the
underwriting risk of a medical insurance plan, which typically covers
catastrophic illnesses and injuries.
Under a dental PPO or indemnity plan, dentists have little incentive to deliver
cost-effective treatments because they are compensated on a unit-of-service
basis. In contrast, under a dental HMO plan, each general dentist is typically
reimbursed primarily in the form of a fixed monthly payment for each member who
selects that dentist as his or her primary dental care provider (a "capitation"
payment). In some cases, the general dentist also receives supplemental payments
from the dental HMO for performing certain procedures, in addition to the
capitation payments. Under a dental HMO plan, each dentist also typically
receives co-payments from the patient for certain dental services, in addition
to the capitation and supplemental payments from the dental HMO. The co-payments
and supplemental payments mitigate the level of utilization risk assumed by the
dentist, but are typically small enough to discourage the dentist from
delivering treatments that are not cost-effective. Capitation payments create an
incentive for dentists to emphasize preventive care, to deliver cost-effective
treatments, and to develop a long-term relationship with their patients.
Capitation payments also substantially reduce the dental HMO plan's underwriting
risk associated with varying utilization of dental services.
(b) FINANCIAL INFORMATION ABOUT SEGMENTS
Management views certain geographic areas as separate operating segments, and
therefore, measures the Company's operating results separately for each of those
geographic areas. The Company provides essentially the same products and
services in all of the geographic areas in which it operates. For financial
reporting purposes, all the Company's operating segments are aggregated into one
reporting segment, which provides dental benefit plans and other related
products to employers, individuals and other purchasers.
(c) NARRATIVE DESCRIPTION OF BUSINESS
GENERAL DESCRIPTION OF THE COMPANY
The Company provides dental benefit plans, vision benefit plans and other
related products, to government and private sector employers, government
programs for low-income beneficiaries, labor unions, associations, and
individuals. The Company also provides dental benefit plans to medical HMOs,
which include the Company's dental coverage in their product offerings. The
Company currently has contracts with approximately 8,000 employers, medical
HMOs, government programs, labor unions and associations, and delivers dental or
vision benefits, or related services, to a total of approximately 1.5 million
covered individuals. Dental care is provided to covered individuals through the
Company's HMO network of approximately 6,000 dentists, and through its PPO
network of approximately 16,000 dentists. Vision care is provided to covered
individuals through the Company's HMO network of approximately 2,700
optometrists and ophthalmologists, and through its PPO network of approximately
3,700 optometrists and ophthalmologists.
Under the Company's dental benefit plans that have an HMO plan design, its
customers pay a monthly premium for each subscriber enrolled in the plan, which
is generally fixed for a period of one to two years. The amount of the monthly
premium varies depending on the dental services covered, the amount of the
member co-payments that are required for certain types of dental services, the
geographic location of the group, and the number of dependents enrolled by each
subscriber. Each subscriber and dependent is typically required to select a
general dentist from the Company's HMO provider network, and to receive all
general dental services from that dentist. Under some benefit plans with an HMO
plan design, the subscribers and dependents don't have to select a specific
general dentist, but they still have to receive services from a provider in the
Company's HMO network in order for the services to be covered by the Company's
benefit plan. A referral to a specialist must be requested by the general
dentist and approved in advance by the Company. The approval by the Company
confirms that the referral is for a service covered by the member's benefit
plan. Under HMO plan designs, subscribers and dependents are not required to pay
deductibles or file claim forms, and are not subject to a maximum annual
benefit.
Under the Company's dental benefit plans that have a PPO/indemnity plan design,
its customers also pay a monthly premium for each subscriber enrolled in the
plan, which is generally fixed for a period of one year. The amount of the
monthly premium varies depending on the dental services covered, the amount of
the annual deductible, the
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portion of the cost of dental services that is paid by the subscriber or
dependent, the maximum annual benefit amount, the geographic location of the
group, and the number of dependents enrolled by each subscriber. Under
PPO/indemnity plan designs, subscribers are required to pay deductibles and
co-insurance amounts that are typically higher than the co-payments required
under a dental HMO plan, and the benefits covered are typically subject to an
annual maximum amount. However, under PPO/indemnity plan designs, subscribers
and dependents can choose to receive dental services from any dentist of their
choice. If the subscriber or dependent chooses to receive services from a
dentist in the PPO network, the services will typically cost less than if the
services were delivered by a dentist not contracted with the Company's PPO
network.
The Company's goal is to be a leading dental benefits provider in its primary
markets of California, Florida and Texas, but it also provides dental benefit
plans in a number of other states. The Company offers a comprehensive range of
dental benefit plans that is based on a set of standard plan designs that are
generally available in each of the markets in which the Company operates.
Additionally, for large clients, the Company has the information technology and
flexibility to deliver highly customized benefit plans.
Under the Company's vision benefit plans, customers pay a monthly premium for
each subscriber enrolled in the plan, which is typically fixed for a period of
one to two years. The monthly premium varies depending on the vision services
covered, the member co-payments required for certain vision services, and the
number of dependents enrolled by each subscriber. Under the Company's vision
plans with an HMO plan design, subscribers and dependents must receive services
from a provider in the Company's HMO network in order for the services to be
covered by the Company's benefit plan. Under the Company's vision plans with a
PPO/indemnity plan design, subscribers and dependents can choose to receive
services from any licensed provider. If the subscriber or dependent chooses to
receive services from a provider in the PPO network, the amount paid by the
subscriber or dependent at the time of service is typically less than it would
be if the services were delivered by a provider outside of the PPO network.
The Company uses multiple distribution channels to sell its products. The
Company targets the large employer market by developing relationships with
benefits consulting firms that are often engaged by large employers to assist
them in selecting the best dental plans. The Company utilizes its senior
management, outside consultants, and its internal sales force to develop
relationships with benefits consulting firms and potential large customers. The
Company primarily uses its internal sales force to sell the Company's products
to mid-size employer groups, by developing relationships with independent
brokers, and to a lesser extent, by contacting potential customers directly. The
Company has a telephonic small group sales and service function in each of its
primary geographic markets, which focuses on developing the small group market
and providing quality service to existing customers in a cost-effective manner.
In addition, the Company has developed separate distribution channels for the
individual dental benefit plan market, which the Company believes has growth
potential. The Company's dental plans are also offered to medical HMOs, which
include the Company's dental plans in comprehensive medical plans offered by
those medical HMOs. In some cases, the Company utilizes general agency
relationships to market its products, which generally target small employers and
individuals.
The Company is committed to providing quality dental and vision care to its
members through its HMO and PPO networks of qualified, accessible providers. By
providing a wide range of benefit plan designs, including HMO and PPO/indemnity
plan designs, the Company is able to maintain a competitive network of providers
by delivering patients to providers under both HMO and PPO contracts. In
addition, the Company offers stand-alone administrative services and PPO access
products to its customers, which deliver additional patient volume to its
contracted providers. The Company has provider relations representatives who
maintain the provider networks in each of the Company's significant geographic
markets. The local knowledge and expertise of these representatives enables the
Company to develop and maintain competitive provider networks, which is an
important factor to employers in selecting a dental or vision benefit plan.
ACQUISITIONS
Effective October 31, 2003, the Company acquired all of the outstanding stock of
Health Net Dental, Inc. ("HN Dental"), which was a California dental HMO, and
Health Net Vision, Inc. ("HN Vision"), which was a California vision HMO, and
certain PPO/indemnity dental and vision business underwritten by Health Net Life
Insurance Company ("HN Life"), which was formerly an affiliate of HN Dental and
HN Vision. The total cost of the acquisition was approximately $15.2 million,
which was paid in cash and was financed through the issuance of
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$19.0 million of convertible notes in October 2003. HN Dental and HN Vision were
merged with the Company's preexisting dental HMO subsidiary in California
effective April 1, 2004. The combined revenue of HN Dental, HN Vision, and the
acquired PPO/indemnity business was approximately $74 million in 2003. In
connection with the acquisition of HN Dental, the Company entered into 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 former parent
company of HN Dental and HN Vision, for a period of at least five years
following the transaction, subject to certain conditions. 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. A significant
portion of the business of HN Dental consists of approximately 125,000 members
enrolled through a contract with the California Managed Risk Medical Insurance
Board, under a program known as "Healthy Families," which provides coverage to
low-income families and individuals, and approximately 60,000 members who are
enrolled under California Medi-Cal programs. These government programs represent
a new customer segment for the Company, as it has no similar business prior to
the acquisition of HN Dental. During November 2003, the Company integrated the
employees of HN Dental and HN Vision into its California operations, and in
April 2004 the Company integrated a majority of the information systems
activities and business operations of the acquired business into its primary
information systems application, moved all of the former HN Dental and HN Vision
employees to its Aliso Viego National Service Center, and is in the process of
integrating the remaining aspects of the acquired business into the Company's
operations.
In March 2003, the Company acquired all of the outstanding stock of Ameritas
Managed Dental Plan, Inc. ("Ameritas"), which was a dental HMO company with
approximately $3 million of annual revenue located in California. The total cost
of the acquisition was approximately $1.3 million. Ameritas was merged with the
Company's preexisting dental HMO subsidiary in California effective upon the
closing of the acquisition. 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 business of Ameritas, including all of its information systems activities,
was integrated into the Company's California operations in April 2003. In
connection with this acquisition, the Company entered into a five-year marketing
services agreement with Ameritas Life Insurance Corp., the former parent company
of Ameritas, ("ALIC"). Under this marketing services agreement, ALIC markets the
Company's dental HMO benefit plans to clients that purchase dental PPO and
indemnity benefit plans and other employee benefits products from ALIC.
In August 2002, the Company acquired all of the outstanding stock of Paramount
Dental Plan, Inc. ("Paramount"), which was a dental HMO company with
approximately $7 million of annual revenue located in Tampa, Florida. The
purchase price of the acquisition was approximately $6.7 million, which
consisted of a cash payment of $3.0 million, a secured convertible note for
$2,625,000, and 769,231 shares of the Company's common stock. Paramount was
merged with the Company's preexisting dental HMO subsidiary in Florida effective
upon the closing of the acquisition. The business purpose of the acquisition was
to increase the Company's market penetration in Florida, which is one of the
Company's primary geographic markets. The acquisition increased the number of
members in Florida for which the Company provides dental benefits from
approximately 50,000 members to approximately 275,000 members. During September
2002, the Company integrated the employees of Paramount into its Florida
operations, and the former chief executive officer of Paramount is currently
President of the Company's Florida operations. The Company integrated a majority
of the information systems activities of Paramount into its primary information
systems application in January 2003.
GEOGRAPHIC MARKETS
The Company operates primarily in California, Florida and Texas and its
marketing activities are currently focused on these states. It also maintains
dental HMO or dental PPO provider networks in several other states, and obtains
new business in those other states from time to time. The Company uses its
provider networks in other states primarily to serve customers in California,
Florida or Texas that have a portion of their employees located in other states.
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The Company started its business in California, and expanded to Texas and
Florida primarily through the acquisition of two dental HMO companies located in
those two states. It is possible that the Company could expand its operations to
additional states as a result of future acquisitions or new or expanded customer
contracts, although the Company has no current plans to do so.
PRODUCTS
The Company operates primarily in a single business segment, which is providing
dental benefit plans to employers, labor unions, medical HMOs, state government
agencies, individuals and other purchasers. The Company provides a broad range
of dental benefit plan designs, depending on the demands of its customers. In
addition to offering a range of benefit plan designs, the Company offers dental
benefit plans with a restricted choice of providers, through its HMO plans,
plans with financial incentives to use network providers, through its PPO plans,
and benefit plans with an unrestricted choice of providers, through its
indemnity plans. Premium rates for each benefit plan are adjusted to reflect the
benefit design, the cost of dental services in each geographic area, and whether
the covered individuals can select any provider at the time of service. In
addition to dental benefit plans, the Company also offers other related
products, as described below. The revenue currently generated by these other
related products is not significant compared to the revenue generated by the
Company's dental benefit plans.
Dental HMO Plan Designs. The Company offers a comprehensive range of dental HMO
plan designs, which typically cover basic dental procedures, such as
examinations, x-rays, cleanings and fillings, for no additional charge at the
time of service, although some benefit designs require the member to pay a small
co-payment for each office visit. Dental HMO plans also typically cover more
extensive procedures provided by the general dentist, such as root canals and
crowns, as well as procedures performed by specialists contracted with the
Company, including oral surgery, endodontics, periodontics, orthodontics, and
pedodontics, in exchange for member co-payments that vary depending on each
member's benefit plan design. In order for a member to be treated by a
specialist, the member's general dentist must initiate a referral to a
specialist, and the Company reviews each referral request prior to the member's
visit to the specialist. The Company's dental HMO plan designs also cover
emergency out-of-area treatments that are required when a member is temporarily
outside the geographic area served by his general dentist.
Under a dental HMO plan, each subscriber or dependent typically selects a
general dentist from the Company's HMO provider network, and receives all
general dental services from that dentist. The general dentist selected by each
member receives a monthly capitation payment from the Company, which is designed
to cover a majority of the total cost of the general dental services delivered
to that member. The monthly capitation payment does not vary with the nature or
the extent of dental services provided to the member by the general dentist, but
is variable based on the particular benefit plan purchased by each member. In
addition to the capitation payments, the general dentist also receives
co-payments from the members for certain types of services, and may receive
supplemental payments from the Company for certain types of services. The
Company typically pays for services delivered by a specialist based on a
negotiated fee schedule.
In addition to the dental HMO plan designs described above, the Company also
provides a dental HMO plan design in Florida that covers only semi-annual exams
and cleanings, but also provides a schedule of negotiated discounts which the
member can use when obtaining other dental services. Under this type of plan
design, the subscribers and dependents do not have to select a specific dentist,
but they must receive services from a dentist in the Company's HMO network in
order to receive the benefits of the plan.
Dental PPO/Indemnity Plan Designs. The Company offers a comprehensive range of
dental PPO/indemnity plan designs, subject to regulatory restrictions. Dental
PPO/indemnity plan designs typically cover the same dental procedures as dental
HMO plan designs. Under the Company's dental PPO/indemnity plan designs, the
covered individuals are required to make a co-insurance payment at the time of
each service, which is typically higher than the co-payments required under a
dental HMO plan design. In addition, the benefits covered under the Company's
dental PPO/indemnity plan designs are subject to annual deductibles and annual
benefit maximums, which is not the case under the Company's dental HMO plan
designs.
Under dental PPO/indemnity plan designs, subscribers and dependents can choose
to receive covered services from any licensed dentist. In the case of a benefit
plan that includes a PPO component, the co-insurance amounts paid by the covered
individual are reduced if he or she chooses to receive services from a dentist
in the Company's preferred provider network. In addition, the covered
individual's annual deductible is sometimes waived if he or she chooses
6
to receive all dental services from a dentist in the Company's preferred
provider network, depending on the specific benefit plan. The Company pays for
services delivered by dentists in its PPO network based on negotiated fee
schedules, which, together with any co-insurance payment due from the patient,
constitutes payment in full for the services delivered (i.e., there is no
"balance billing" by the provider). The Company pays for services delivered by
non-contracted providers based on usual and customary dental fees in each
geographic area, and the provider may bill the patient for any difference
between his or her standard fee and the amount paid by the Company. The Company
believes that offering an indemnity dental plan with a PPO network is an
attractive way to enter geographic areas where few dentists have agreed to
participate in HMO networks. In such areas, participation in the PPO network can
serve as a transitional step for dentists, between the traditional system of
reimbursement based on usual and customary fees, to participation in an HMO
network. Dental PPO/indemnity plan designs subject the Company to more
significant underwriting risks than dental HMO plan designs, because the Company
assumes all the risk related to varying utilization rates.
The Company believes that PPO/indemnity plan designs are attractive to employers
and other purchasers because they are a cost-effective alternative to
traditional indemnity insurance, and they offer more freedom of choice of
providers than dental HMO plan designs.
Defined Benefit Dental Plans. The Company offers a range of defined benefit
dental insurance plans. Under these plans, subscribers and dependents are
reimbursed a fixed amount for each procedure performed, regardless of which
provider performs the procedure. One innovative feature of this product is that
certain plan designs include coverage for dental implants, which are typically
excluded from other types of dental benefit plans. This product is also sold
with or without orthodontic coverage. Defined benefit plans are designed for
customers who want to avoid the restrictions of a network-based plan, while
paying a monthly premium that is significantly less than that of a typical
PPO/indemnity plan. Because this product is not dependent on a provider network,
it can be marketed to potential customers who are located outside of the
geographic areas covered by the Company's HMO and PPO provider networks.
Dual Option Product. The Company frequently combines one of its dental HMO plan
designs with one of its PPO/indemnity plan designs to create a "dual option"
product for its customers. As a result, each subscriber can choose whether to
enroll in the dental HMO plan design or the PPO/indemnity plan design. By
offering a dual option product, the Company can offer its subscribers more
flexibility, and can capture a larger portion of the total dental benefits
expenditures by each of its customers. This product allows the Company to offer
a dental HMO plan design to cost-conscious customers, while also providing a
PPO/indemnity plan design for coverage of employees located outside the
geographic area served by the Company's HMO provider network, and for employees
who are willing to pay higher premiums for greater flexibility. Certain states,
including Nevada, require that dental HMO plan designs be offered only as part
of a dual option product and other states may do so in the future.
Vision Benefit Plans. The Company offers a range of vision benefit plans to
employer groups and other purchasers, which cover routine eye care in exchange
for a fixed monthly premium. In addition to routine optometric care, vision
plans offered by the Company generally cover a portion of the cost of glasses or
contact lenses. The vision plans generally cover only frames, lenses and contact
lenses if the covered individual has separate medical coverage for the cost of
routine eye exams. The vision benefit plans offered by the Company include plans
with an HMO plan design and plans with a PPO/indemnity plan design. Under the
plans with an HMO plan design, subscribers must receive services from an
optometrist or ophthalmologist in the Company's HMO network in order for the
services to be covered by the benefit plan. Under the plans with a PPO/indemnity
plan design, subscribers can choose to receive services from any licensed
optometrist or ophthalmologist, but if they choose to receive services from an
optometrist or ophthalmologist in the preferred provider network, their
co-insurance payments at the time of service would generally be reduced. The
Company's revenue from vision benefit plans was not material during the year
ended December 31, 2003. However, the acquisition of HN Vision and the related
PPO/indemnity vision business added approximately $9 million of annual vision
revenue to the Company, and the Company intends to increase its vision revenue
in the future.
Other Dental Benefits Products. For self-insured customers, the Company offers
claims administration under an administrative services only ("ASO") arrangement,
under which the Company does not assume any of the underwriting risk. The
Company receives an administrative fee to process claims and the underwriting
risk is retained by the customer sponsoring the self-insured plan. The Company
also provides access to its PPO network for a fixed monthly fee based on the
number of subscribers covered by the product. Under this product, the providers
in
7
the PPO network offer a reduced fee schedule for services provided to
participating patients. The Company makes no payments to the providers in the
PPO network under this product. In addition, in one of its primary geographic
markets, the Company sells dental PPO/indemnity benefit plans that are
underwritten by an unrelated insurance company, and provides certain
administrative services related to these plans. In exchange for its sales
efforts and administrative services, the Company receives a fixed monthly fee
for each subscriber enrolled. Currently, the Company's revenue from these other
products is not material.
MARKETING
The Company markets its products to employer groups, labor unions, individuals
and other purchasers primarily through independent brokers and consultants.
Independent brokers are typically engaged by employer groups and other
purchasers to select the dental plan that best suits the needs of the
purchaser's employees, in terms of price, benefit design, geographic coverage of
the provider network, financial stability, reputation for customer service, and
other factors. Brokers are typically paid by the Company, based on a specified
percentage of the premium revenue collected from each customer generated by the
broker. Large employers typically engage consultants, instead of brokers, to
assist them in selecting the dental plan that best suits their needs. The
consultants generally perform the same function as brokers, but are typically
paid by the employer instead of the Company. Consequently, large employers
expect to pay premium rates that have been reduced to reflect the fact that the
Company is not paying a broker commission. Brokers and consultants do not market
the Company's benefit plans on an exclusive basis.
The Company has an internal sales force that is paid through a combination of
salary and incentive compensation based on the revenue generated by each
salesperson. The function of the internal sales force is primarily to cultivate
relationships with brokers and consultants, and to help brokers and consultants
present the Company's benefit plans to their clients in the most favorable way.
A small portion of the Company's sales is generated directly by its internal
sales force. The Company generally uses the same brokers, consultants and
internal sales force to market all of its products.
After an employer group or other purchaser decides to make the Company's benefit
plan available to its employees, the Company's marketing efforts shift to the
Company's employees (potential subscribers). Typically, employees participate in
an annual open enrollment process, under which they select the employee benefit
plans they wish to use for the upcoming year. During the open enrollment
process, employees typically choose between benefit plans offered by the Company
and benefit plans offered by competitors of the Company, and in some cases,
whether to purchase any benefit plans at all. In the case of some employers, the
Company's benefit plans are offered to employees on an exclusive basis.
Generally, employees can enroll in the Company's benefit plans or cancel their
participation in the Company's benefit plans only during this annual open
enrollment process.
In addition to an internal sales force, the Company also employs account
managers who are responsible for promoting retention of the clients and
subscribers enrolled in the Company's benefit plans, and marketing additional
products to existing customers. These account managers are responsible for
supporting the customer's open enrollment process to ensure that difficulties
experienced by the customer during this process are minimized, and that the
number of subscribers who enroll in the Company's benefit plans is maximized.
The account managers perform this function for both new employer groups and
renewing employer groups. Account managers are paid a salary plus incentive
compensation for selling additional products to existing customers.
The Company markets its benefit plans to medical HMOs primarily through direct
contact between executives of the Company and the medical HMO. The Company's
existing contracts with medical HMOs typically cover a relatively large number
of subscribers, and accordingly, executives of the Company directly maintain
these relationships and provide customer service support on an ongoing basis.
The Company markets its products to government programs primarily through direct
contact between executives of the Company and the government programs. The
Company's government contracts each cover a relatively large number of
subscribers, and accordingly, executives of the Company directly maintain these
relationships and provide customer service support on an ongoing basis The
Company also has a dedicated government client service staff to provide service
to its government clients.
8
RATING AND UNDERWRITING
The Company develops the premium rates for each of its benefit plans, including
rate adjustments that depend on various group-specific underwriting variables,
based on past experience with similar products, and based on actuarial analysis
using industry claims cost information.
When the Company has the opportunity to submit a proposal for a benefit plan to
a potential customer, it first obtains certain basic underwriting information
from the prospective client. This information includes whether the potential
customer currently has dental coverage, the benefit design of the existing
dental coverage, the geographic location of the potential customer's employees,
the number of employees and dependents who are currently enrolled and the number
who are eligible for coverage, the portion of the cost of dental coverage that
is paid by the employer, whether the potential customer is considering making
the Company the exclusive provider of dental coverage, and other similar
information. The Company then evaluates this information to assess the
underwriting risk associated with providing a dental benefit plan to the
potential customer. Based on this evaluation, the Company either makes a
proposal that includes a benefit design and premium rates that take into account
the Company's risk assessment, or declines to make a proposal due to an
excessive amount of underwriting risk, or the lack of compatibility between the
Company's provider network and the location of the potential client's employees.
CLIENTS AND CUSTOMER CONTRACTS
The Company currently provides dental or vision coverage, or related services,
to an aggregate of approximately 1.5 million individuals, who participate in the
Company's benefit plans primarily through group contracts with approximately
8,000 employers, medical HMOs, state government agencies, labor unions and other
purchasers of dental or vision benefits. The Company's customers include many
large employers, including Boeing Corporation, City of Dallas, County of Los
Angeles, County of San Diego, Joint Council of Teamsters No. 42 Welfare Trust,
North Broward Hospital District, Southern California Edison, Southern California
Gas Company, and State of California, among others. A small portion of the total
covered individuals participates in the Company's benefit plans through
individual dental HMO plans purchased from the Company. The Company's contract
with the California Managed Risk Medical Insurance Board ("MRMIB"), under which
approximately 130,000 members are currently enrolled in one of the Company's
dental plans under the "Healthy Families" program, currently accounts for
approximately 10% of the Company's total premium revenue. The Company acquired
the contract with MRMIB in connection with the acquisition of HN Dental on
October 31, 2003, and accordingly, the contract did not account for a
significant portion of the Company's revenue in 2003. No other customer accounts
for five percent (5%) or more of the Company's total premium revenue.
The Company's group contracts generally provide for a specified benefit program
to be delivered to plan participants for a period of one to two years at a fixed
monthly premium rate for each subscriber type. The contracts typically provide
for termination by the customer upon 60 days written notice to the Company.
PROVIDER NETWORKS
The Company currently has approximately 6,000 providers in its dental HMO
network, and has approximately 16,000 providers in its dental PPO network. The
Company also has approximately 2,700 providers in its vision HMO network, and
has approximately 3,700 providers in its vision PPO network. The Company
believes that a key element in the success of a dental or vision benefits
company is an extensive network of participating providers in convenient
locations. The Company believes that providers who participate in its HMO and
PPO networks are willing to provide their services at reduced fees in exchange
for a steady stream of revenue from patients enrolled in the Company's benefit
plans. In addition, this revenue source for the provider is relatively free from
collection problems and administrative costs sometimes associated with other
types of patients. Therefore, qualified providers and/or provider groups have
generally been available and willing to participate in the Company's HMO and PPO
networks in order to supplement the patients for which they are paid usual and
customary fees.
The Company requires that all providers in its dental and vision HMO networks
meet certain quality assessment program standards. Those standards include
current professional license verification, adequate liability insurance
coverage, a risk management review of the provider's office facility to ensure
that Occupational Safety and Health Act ("OSHA") requirements and other
regulatory requirements are met, an inspection of a dental office's
9
sterilization practices, and a general review of the office location, including
parking availability and handicap access.
The Company compensates the general dentists in its HMO network primarily
through monthly capitation payments and supplemental payments. Each general
dentist typically receives a fixed monthly capitation payment for each
subscriber or dependent that selects that dentist as his or her primary dentist.
The amount of the capitation payment related to each member varies based on the
plan design in which the member is enrolled, but does not vary with the nature
or extent of the dental services provided to the member. In addition to
capitation payments, the general dentists may receive supplemental payments from
the Company and co-payments from the patients, depending on the plan design
purchased by each patient. The Company typically makes a fixed supplemental
payment to the general dentist each time the dentist delivers specified
procedures to members enrolled in certain benefit plans. The amount of the
supplemental payment varies depending on the specific procedure performed and
the amount of the co-payment collected from the member, which varies with the
benefit plan design. Supplemental payments are designed to mitigate the risk to
the dentist associated with procedures that require the payment of a laboratory
fee by the dentist, and members who require an extensive amount of dental
services. Supplemental payments are low enough to avoid providing an incentive
for the dentist to deliver services that are not cost-effective. The Company
believes the use of supplemental payments provides for a higher level of member
and provider satisfaction with the Company's dental HMO plan designs. The
general dentist also typically receives co-payments from members for certain
types of services, which vary based on the plan design under which each member
is covered. Although most general dentists in the Company's HMO network are
compensated through capitation and supplemental payments, in some cases, general
dentists are compensated based on a negotiated fee for each procedure performed.
No individual dental office provides services to five percent (5%) or more of
the members enrolled in the Company's dental HMO plan designs.
The Company's dental HMO network also includes specialists in the areas of
endodontics, oral surgery, orthodontics, pedodontics, and periodontics. In order
for a member to receive services from a specialist, those services must be
requested by the member's general dentist and approved in advance by the
Company. The approval by the Company confirms that the referral is for a service
covered by the member's benefit plan. Specialists are reimbursed by the Company
based on a negotiated fee schedule, and also receive co-payments from members
based on the benefit plan design under which each member is covered.
Dentists in the Company's PPO network are compensated based on a negotiated fee
schedule that is generally 20 to 40 percent less than the usual and customary
fees in that provider's geographic area. Non-contracted dentists who provide
services to subscribers and dependents enrolled in PPO plan designs are
compensated based on usual and customary fees in each geographic area, and may
bill the subscriber or dependent for any remaining balance. Under some benefit
plan designs offered by the Company, the Company compensates non-contracted
dentists based on a fixed amount for each procedure, regardless of the
geographic area, and the dentist may bill the patient for any remaining balance.
The Company compensates the providers in its vision HMO and PPO networks based
on a negotiated fee schedule that is generally 20 to 40 percent less than the
usual and customary fees in that provider's geographic area. The vision
providers in both the HMO and PPO networks also generally collect co-payments or
co-insurance amounts from the patients, depending on the plan design purchased
by each patient. Non-contracted vision providers who deliver services to
subscribers and dependents enrolled in PPO plan designs are generally
compensated based on a fixed amount for each procedure, and may bill the
subscriber or dependent for any remaining balance.
The Company employs provider relations representatives who are based in the
geographic markets served by the Company. These representatives are responsible
for developing and maintaining the Company's network of dental and vision HMO
and PPO providers. They negotiate contracts with dentists, optometrists and
ophthalmologists and also assist the network providers in the administration of
the Company's benefit plans. In the event that a network provider terminates his
relationship with the Company, the provider relations representative is
responsible for recruiting new providers to meet the needs of the members
enrolled in the Company's benefit plans.
The providers in the Company's dental and vision HMO and PPO networks are free
to contract with other dental and vision benefit plans, and both the provider
and the Company can typically terminate the contract at any time upon 60 days
prior written notice. In accordance with the contract, the Company may also
terminate the contract "for cause" upon 15 days prior written notice. The
Company can also change the reimbursement rates, member co-payments,
10
and other financial terms and conditions of the contract at any time, with ten
to fifteen days notice to the provider. The Company's contracts with providers
in its dental HMO and PPO networks require the providers to maintain
professional liability insurance with a minimum coverage of $200,000 per claim,
and $600,000 in the aggregate per year, and to indemnify the Company for claims
arising from the provider's acts or omissions.
QUALITY MANAGEMENT
The Company maintains a quality management program with respect to its dental
HMO business under the direction of its Dental Director. The Company's quality
management program includes verification of provider credentials, assessment of
each dentist's compliance with applicable state regulatory standards and
practice standards established by the Company, monitoring of patient appointment
availability and accessibility of dental care, monitoring of patient
satisfaction through member surveys and other tools, analysis of dental care
utilization data, addressing member complaints and grievances, and assessment of
other qualifications of dentists to participate in the Company's HMO network.
The Company maintains a credentialing committee for its dental HMO network,
which uses information provided by an NCQA-certified Credentialing Verification
Organization ("CVO") to verify each provider's licensing status, insurance
coverage, and compliance with applicable federal and state regulations, and to
review the National Practitioners Data Bank for complaints filed against the
provider. The Company also uses an outside contracting service to perform
on-site dental office quality assessment reviews to determine appropriateness of
care and review treatment outcomes.
The Company uses an independent outside service to conduct regular member
satisfaction surveys with respect to its dental HMO business. These surveys
monitor the level of member satisfaction with respect to the services provided
by dentists in the Company's network, the choice of providers and availability
of appointments within the Company's network, the benefits covered by the
Company's benefit plans, and the customer service provided by the Company. The
results are used by the Company to determine how it can improve its provider
network and the level of service provided to its members.
The Company also maintains a quality management program with respect to its
vision HMO business under the direction of its Vision Director. The Company's
quality management program includes verification of provider credentials,
assessment of each dentist's compliance with applicable state regulatory
standards and practice standards established by the Company, monitoring of
patient appointment availability and accessibility of dental care, monitoring of
patient satisfaction through member surveys and other tools, analysis of dental
care utilization data, addressing member complaints and grievances, and
assessment of other qualifications of optometrists and ophthalmologists to
participate in the Company's HMO network.
UTILIZATION REVIEW
The Company monitors the utilization rates for various dental procedures
provided by general dentists in its HMO network, as well as the frequency of
specialist referrals initiated by those dentists, based on paid claim
information and encounter data submitted by the dentists. The analysis of this
information, including comparisons among providers in the network, enables the
Company to determine whether any of its providers display practice patterns that
are not cost-effective, or practice patterns that are otherwise inappropriate.
When this information shows a potentially inappropriate practice pattern, the
Company conducts a more focused review of the dental practice in question.
The Company also monitors the utilization rates for various dental procedures
provided by dentists in its PPO network, based on paid claim information. The
analysis of this information, including comparisons among providers in the
network, enables the Company to focus its provider contracting efforts to
develop a more cost-effective PPO network, as well as to improve the design of
its benefit plans with a PPO/indemnity plan design. This information also allows
the Company to demonstrate savings achieved by the Company and its subscribers
and dependents, as a result of the contracting arrangements between the Company
and the providers in its network.
11
MEMBER SERVICES
The Company provides basic member services from its National Service Center in
Aliso Viejo, California through the use of toll-free telephone numbers. The
toll-free telephone numbers provide members and provider offices with access to
automated services 24 hours per day, and with access to member services
representatives from 6:00 a.m. to 7:00 p.m. Pacific Time. Automated service is
available 24 hours a day for inquiries such as selection of a network dentist,
requests for identification cards, and eligibility verification. The Company
uses an automated call distribution ("ACD") system for its management of
customer service calls.
The Company maintains Quality Management ("QM") Committees with respect to its
dental and vision HMO businesses, under the direction of its Dental Director and
Vision Director, respectively. Each QM Committee is responsible for the
disposition of all types of member grievances with respect to the Company's
dental and vision HMO plan designs. Member grievances are typically originated
through a member services call or a letter written to the Company by the member.
The Company has a standard grievance resolution process that begins with a
member services representative who attempts to resolve the grievance. In the
event this is not successful, or the grievance is related to dental or vision
care issues that are beyond the expertise of a member services representative,
the appropriate Quality Management department addresses the grievance. Each QM
Committee addresses grievances that cannot be resolved by the Quality Management
department. The Company responds to all member grievances with a written
disposition of the grievance within 30 days of receipt of the grievance. After
the QM Committee has responded to the grievance, the member has the option of
submitting the grievance to binding arbitration, which is conducted according to
the rules and regulations of the American Arbitration Association.
Each QM Committee monitors the frequency of member grievances by type, and the
average time in which the Company responds to grievances, in order to determine
ways it can improve its communications with members and network providers,
improve its customer service, and determine ways to improve the efficiency of
the grievance resolution process.
MANAGEMENT INFORMATION SYSTEMS
The Company currently uses a single primary business application for the
majority of its business. The source code for this application was purchased
from a software vendor in 2002, and the Company made extensive modifications to
it before converting substantially all of its business to this application in
September 2003. The Company anticipates that it will continue to modify this
system in the future to meet the changing needs of its business. The new
application is used for eligibility files, billing and collections, specialty
referral authorization, claims processing, commission payments, utilization
management, provider file maintenance, and other similar activities. The
application includes comprehensive information on the Company's eligibility
records, benefit plan designs, premium rates, provider payment arrangements, and
broker commission rates. This system provides the Company the ability to
maintain combined records with respect to eligibility files, billing and
collections, claim payments and other information related to all the products
purchased from the Company by a single customer. The system is also flexible
enough to accommodate a wide variety of benefit plan designs to meet the needs
of the Company's customers.
The business acquired in the acquisition of HN Dental, HN Vision and the related
dental and vision PPO/indemnity business in October 2003 used a combination of
several different business applications for different functions, all of which
were acquired by the Company in the transaction. The Company converted a
majority of the business acquired in this transaction to the primary business
application described above in April 2004, and intends to convert the remainder
of the acquired business to this system over the next several months.
Prior to September 2003, the Company used two primary business applications, one
of which was used for its dental HMO business and its vision PPO/indemnity
business, and one of which was used for its dental PPO/indemnity business. The
system used for the Company's dental HMO business and vision PPO/indemnity
business was a proprietary application that was a predecessor version of its
current primary application, and that was modified extensively by the Company.
The system used for the Company's PPO/indemnity plan designs was a standard
application purchased from a software vendor, which generally met the Company's
needs for its PPO/indemnity business. The primary reason the Company invested in
its new application was to develop a single system that could maintain combined
records for all of the products purchased from the Company by a single customer.
12
A separate primary business application is used for a portion of the business
acquired in the purchase of Paramount in August 2002, which consists of dental
HMO benefit plans delivered to certain medical HMOs. This system is a standard
application purchased from a software vendor, and generally meets the Company's
needs for the products offered to medical HMOs. The Company is currently
evaluating whether to convert this portion of its business to its primary
software application that was implemented in September 2003.
The Company is in the process of developing an enhanced web site that will allow
customers to update their eligibility files online, allow providers to verify
eligibility online, and provide other interactive features for customers,
providers and brokers.
The Company uses a personal computer network-based general ledger system that
includes reporting and analysis tools that allow the extraction and download of
data to spreadsheet programs for further analysis. The Company also makes
extensive use of its email system in coordinating the activities of employees in
various office locations and communicating with customers, brokers and
providers. During 2002, the Company implemented a Customer Relationship
Management system, as part of its long-term information systems strategic plan,
which it uses to manage customer and provider relationships. The Company also
uses a variety of other, less significant applications in various areas of its
business. All of the Company's applications are integrated into a single network
so employees can easily access any needed application from their desktop
computers.
RISK MANAGEMENT
Providers in the Company's dental HMO and dental PPO networks generally
indemnify the Company against professional liability claims and are required to
maintain professional liability insurance with specified minimum amounts of
coverage. The Company also maintains $5 million of general and professional
liability insurance coverage, which covers losses on a "claims made" basis. The
Company believes this amount of coverage is adequate to manage the ordinary
exposure of operating its business. However, there can be no assurance that this
amount of coverage would be adequate to cover potential claims against the
Company, or that adequate general and professional liability insurance coverage
will be available to the Company in the future at a reasonable cost.
Prior to October 2002, the Company maintained $5 million of officers and
directors liability insurance coverage, after a $250,000 deductible. Due to a
significant increase in the cost of such insurance, the Company elected not to
purchase this insurance coverage effective October 1, 2002.
COMPETITION
The Company operates in a highly competitive environment and faces numerous
competitors in each of its geographic markets with respect to all products
offered by the Company. The Company's competitors include several large national
insurance companies that offer dental HMO plan designs and dental PPO/indemnity
plan designs, numerous regional insurance companies and medical HMOs that offer
dental benefit plans, and numerous local or regional dental HMOs and other
companies that offer various types of dental benefit plans. Many competitors are
significantly larger than the Company, and have substantially greater financial
resources than the Company. In addition, many employers, union trust funds and
other group purchasers provide self-insured dental plans to their employees or
other constituents.
The Company believes that the key factors in a purchaser's selection of a dental
benefit plan include the premium rates charged, the comprehensiveness of the
dental benefits offered, the range of benefit designs offered, the
responsiveness related to customer service activities, and the perceived
quality, accessibility and convenience of the dental offices in the provider
network. There are competitors that compete aggressively with respect to all of
these factors in each of the geographic markets in which the Company operates,
and many employers, particularly large employers, make their selection of a
dental benefit plan through a competitive bidding process. There is significant
price competition in each of the Company's geographic markets, which could
impair the Company's ability to sell its dental benefit plans at profitable
premium rates. The Company anticipates that this price competition will continue
to exist during the foreseeable future.
Large national insurance companies that offer both dental HMO plan designs and
dental PPO/indemnity plan designs may have a competitive advantage over smaller
competitors, such as the Company, due to larger provider networks located across
the United States, the availability of multiple product lines other than dental
benefits,
13
established business relationships with large employers, better name
recognition, and greater financial and information system resources. The Company
believes it can effectively compete with these insurance companies by offering a
flexible array of benefit plan designs, and by maintaining a high level of
customer service with respect to its employer groups, members, dental service
providers, and brokers. Some medical HMOs have developed dental benefit plans
with both HMO and PPO/indemnity plan designs in-house, and others contract with
dental benefits companies, such as the Company, to provide those products. The
Company believes it can compete effectively with medical HMOs that offer dental
benefit plans. The Company currently has relationships with certain medical
HMOs, under which the medical HMOs offer the Company's dental benefit plans to
their customers, and the Company intends to form relationships with additional
medical HMOs in the future.
Other than minimum net worth requirements imposed by state regulators, and the
need to obtain a license from the applicable state regulator, which could take a
substantial period of time, there are no significant barriers to entry into the
dental benefits business by potential competitors. There can be no assurance
that the Company will be able to compete successfully with any new competitors.
Additional competition could adversely impact the Company's profitability and
growth prospects through decreases in premium rates, and the loss of customers
or dental service providers.
GOVERNMENT REGULATION
The Company's operations are subject to an extensive amount of state regulation
in each of the states in which it operates. The Company's most significant
dental and vision HMO subsidiaries are subject to regulation by the California
Department of Managed Health Care, the Florida Department of Insurance and the
Texas Department of Insurance. The Company's dental and vision insurance
subsidiary is regulated primarily by the California Department of Insurance, and
is also subject to regulation by state insurance regulatory agencies in all of
the states in which it is licensed.
The Company's dental and vision HMO subsidiaries are subject to regulations that
vary from state to state, and generally include regulations with respect to the
scope of benefits provided to members, the content of all contracts with
customers, dental and vision providers and others, advertising, the maintenance
of a minimum amount of net worth, the maintenance of restricted deposits,
procedures related to quality assurance, enrollment procedures, the maximum
percentage of premium revenue that may be spent on general and administrative
expenses, minimum loss ratios, certain "any willing provider" requirements which
may limit the Company's ability to restrict the size of its provider network,
the relationship between the Company and the providers in its dental and vision
provider networks, the Company's procedures for resolving member grievances, and
premium rates.
The Company's dental and vision insurance subsidiary is subject to state
regulations with respect to the maintenance of a minimum amount of net worth,
the maintenance of restricted deposits for the benefit of certain state
regulators, the nature of investments held by the Company, insurance policy
forms, advertising, and claims processing procedures. Insurance companies in
general are subject to extensive regulation and are typically required to have
significantly greater financial resources than dental or vision HMOs.
The Company's ability to expand its operations into states in which it is not
currently licensed is dependent on the regulatory review process conducted by
the applicable state regulatory agency in each state. Such reviews may take from
six to twenty-four months, and would have to be satisfactorily completed before
the Company could commence operations in the applicable state.
Since some states will only license full service HMO entities, the Company would
not be able to offer its dental or vision HMO plan designs in those states,
except pursuant to an arrangement with a full service medical HMO. Other states
permit only nonprofit organizations to become licensed as dental or vision HMO
plans, again limiting the Company's access to business in those states. The
heavily regulated nature of the Company's business imposes a variety of
potential obstacles to any geographic expansion by the Company, and could limit
the Company's future growth potential. This regulatory environment also governs
the conduct and expansion prospects of existing and new competitors, thereby
providing a potential barrier to entry for potential competitors.
The Company is subject to the Health Insurance Portability and Accountability
Act of 1996 ("HIPAA"). HIPAA imposes responsibilities on the Company, including
but not limited to, privacy notice requirements to members of the Company's
benefit plans, the security and privacy of individually identifiable health
information, the use of
14
unique identifiers for all of the contractual relationships the Company has with
members, providers and group and individual contract holders, the adoption of
standardized electronic transaction code sets, and prevention of unauthorized
use or disclosure of personal data maintained by the Company. The Company has
developed policies and procedures to comply with these requirements and has
provided privacy notices as required by HIPAA and the Gramm-Leach-Bliley Act.
There is currently no other regulation of the Company's business at the federal
level.
TRADEMARKS, SERVICE MARKS AND TRADE NAMES
The Company currently markets all of its products under the brand names
"SafeGuard" and "Paramount Dental Plan." The Company has filed, received
approval, and obtained renewal protection from the United States Patent and
Trademark office for certain trademarks and trade names for names and products
used by the Company in its ordinary course of business. The Company has also
received approvals for the use of its trademarks and trade names from state
governmental agencies, as applicable. The Company has received a trademark,
service mark or trade name for the following words and phrases used with and
without distinctive logos maintained by the Company:
- - SafeGuard(R) used with a distinctive logo depicting a modified smile used
in connection with all the products offered by the Company;
- - SafeGuard Health Plans(R) used in descriptive material to describe the
products offered by the Company;
- - SafeGuard Dental Plans(TM) used to describe the various dental HMO plan
designs offered by the Company;
- - SafeHealth Life(R) used with a descriptive logo depicting a modified smile
used by the Company to describe its dental and vision PPO/indemnity plan
designs; and
- - Paramount Dental Plan with a distinctive logo of three triangles stacked on
top of each other used by the Company in the integration of its acquisition
of Paramount into the Company's Florida operations.
Collectively, these trademarks, service marks and trade names were first used in
interstate commerce in 1984 and have been continuously used thereafter. In
addition, the Company has received trademark/service mark protection from the
United States Assistant Commissioner for Trademarks of its distinctive logo
depicting a smile that the Company is currently utilizing in interstate
commerce.
EMPLOYEES
At March 31, 2004, the Company had approximately 360 employees, of which
approximately 50 were represented by a labor union. The Company considers its
relations with its employees to be satisfactory. The Company provides typical
employee benefits, including paid vacation, holiday and sick time, a portion of
the cost of health insurance, dental and vision coverage for the employee's
family, life insurance, a 401(k) plan that includes a matching contribution
consisting of the Company's common stock, and the opportunity to take advantage
of a flexible spending account under Section 125 of the Internal Revenue Code.
Employees are eligible to participate in the 401(k) plan upon completion of
three months of service with the Company. Under the 401(k) plan, an employee is
allowed to contribute up to 20% of his total compensation to the plan each pay
period, subject to the annual limit prescribed by the Internal Revenue Code, and
subject to certain anti-discrimination provisions. Effective July 1, 2001, the
Company adopted a matching contribution program, under which the Company makes a
contribution equal to a specified percentage of each employee's contribution, in
the form of common stock of the Company. The matching contribution percentage,
which was 25% for 2003, 2002 and 2001, is set in advance of each fiscal year by
the Company's board of directors, and has been set at 25% for 2004. The Company
contributed 73,000 shares, 66,000 shares and 33,000 shares of its common stock
to the 401(k) plan for the years ended December 31, 2003, 2002 and 2001,
respectively. Employees become vested in the Company's contributions to the
401(k) plan at the rate of 20% for each of the first five years of employment
with the Company, with credit given for past service. Employees are fully vested
in their contributions to the 401(k) plan at all times.
15
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 and vision benefits industries in general and other risks are related to
the Company specifically. Due to the risks and uncertainties described below, as
well as other risks described elsewhere in this Annual Report on Form 10-K,
there can be no assurance that the Company will be able to maintain its current
market position or its profitability. Some of the risk factors described below
have adversely affected the Company's operating results in the past, and all of
these risk factors could affect its future operating results.
Integration of Business Acquired in October 2003. The Company is in the process
of integrating the business operations of HN Dental, HN Vision, and the related
dental and vision PPO/indemnity business, all of which was acquired in October
2003, into the Company's operations. The revenue of the acquired business was an
aggregate of approximately $74 million in 2003, which is very significant
compared to the size of the pre-existing operations of the Company. Due to the
complexities inherent in this integration process, there is a risk that the
Company may not be able to complete such integration activities in a timely and
effective manner. In such case, the profitability of the acquired business could
be lower than expected, and the general and administrative expenses of the
Company could be higher than expected, which could have a negative impact on the
Company's overall profitability.
Government Regulation. The dental and vision benefits industries are subject to
extensive state and local laws, rules and regulations. Each of the Company's
operating subsidiaries is subject to various requirements imposed by state laws
and regulations related to the operation of a dental or vision HMO plan or a
dental and vision insurance company, including the maintenance of a minimum
amount of net worth by certain subsidiaries. In addition, regulations applicable
to dental or vision benefits companies could be changed in the future. There can
be no assurance that the Company will be able to meet all applicable regulatory
requirements in the future.
Government Sponsored Contracts. As a result of the acquisition of HN Dental, the
Company has several dental benefits contracts that are administered by state
government agencies. These contracts collectively account for approximately 15%
of the Company's total revenue. These contracts have expiration dates in 2005.
The loss of one or more of these contracts could have a material adverse affect
on the Company's operating results.
Health Insurance Portability and Accountability Act of 1996 ("HIPAA"). HIPAA
imposes various responsibilities on the Company, as described above under
"Government Regulation." The Company has developed policies and procedures to
comply with these requirements, but 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
satisfactorily comply 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. All of the office
lease agreements related to those practices either have been assigned to the
respective purchasers of the practices, or have expired. As of December 31,
2003, the Company is contingently liable for an aggregate of approximately $2.0
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
16
market price and a lack of liquidity for holders of the Company's common stock.
The fact that the Company's common stock is not listed on an exchange and is
traded on the Over The Counter Bulletin Board can have a negative influence on
the trading volume of the stock. Broad stock market fluctuations, which may be
unrelated to the Company's operating performance, could also have a negative
effect on the Company's stock price.
Competitive Market. The Company operates in a highly competitive industry. Its
ability to operate on a profitable basis is affected by significant competition
for employer groups and for contracting dental and vision 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.
Utilization of Dental Care Services. Under the Company's dental PPO/indemnity
plan designs, the Company assumes the underwriting risk related to the frequency
and cost of dental care services. If the Company does not accurately assess
these underwriting risks, the premium rates charged to its customers might not
be sufficient to cover the cost of the dental services delivered. This could
have a material adverse effect on the Company's operating results.
Under the Company's dental HMO plan designs, the Company assumes underwriting
risk related to the frequency and cost of specialist services, the cost of
supplemental payments made to general dentists, and the frequency and cost of
dental services provided by general dentists with whom the Company does not have
standard capitation arrangements. If the Company does not accurately assess
these underwriting risks, the premium rates charged to its customers might not
be sufficient to cover the cost of the dental services delivered to subscribers
and dependents. This could have a material adverse effect on the Company's
operating results.
Effect of Adverse Economic Conditions. The Company's business could be
negatively affected by periods of general economic slowdown, recession or
terrorist activities which, among other things, may be accompanied by layoffs by
the Company's customers, which could reduce the number of subscribers enrolled
in the Company's benefit plans, and by an increase in the pricing pressure from
customers and competitors.
Relationships with Providers. The Company's success is dependent on maintaining
competitive networks of dental and vision providers in each of the Company's
geographic markets. Generally, the Company and the network providers 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
providers 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.
CONVERTIBLE NOTES
The acquisition of HN Dental, HN Vision and the related dental and vision
PPO/indemnity business was financed through the issuance of $19.0 million of
unsecured convertible promissory notes to certain of the Company's principal
stockholders in October 2003. The proceeds from the convertible notes were used
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, which is estimated to be $3.8 million, to provide working
capital that may be required in connection with the integration of the acquired
businesses into the Company's pre-existing operations, and for general corporate
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
17
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, provided that it redeems all the
convertible notes held by each holder for which it redeems any of the notes.
RECAPITALIZATION TRANSACTION
On March 1, 2000, the Company entered into a recapitalization transaction with
an investor group (the "Investors"), the revolving credit facility lender (the
"Bank"), and the holder of the senior notes payable (the "Senior Note Holder").
In this transaction, the Investors loaned $8.0 million to the Company in the
form of an investor senior loan, due April 30, 2001. As part of this
transaction, the Investors, the Bank, and the Senior Note Holder agreed to
convert the $8.0 million investor senior loan, the outstanding balance of $7.0
million under the revolving credit facility plus accrued interest, and the $32.5
million of senior notes payable plus accrued interest, to convertible preferred
stock, subject to regulatory approval and an increase in the authorized shares
of the Company's common stock.
Effective as of January 31, 2001, the Company completed the conversion of this
debt into 30 million shares of convertible preferred stock. The estimated value
of the convertible preferred stock was $1.375 per share as of January 31, 2001,
which is based on the closing price of the Company's common stock on January 31,
2001, which was $1.375 per share, and the fact that each share of convertible
preferred stock is convertible into one share of common stock. Based on this
estimated value, the conversion resulted in a pre-tax gain of $11.3 million,
which is net of approximately $350,000 of transaction costs. There was no income
tax effect related to this transaction, due to the Company's net operating loss
carry-forwards for tax purposes, as discussed in Note 11 to the accompanying
consolidated financial statements. As a result of the conversion, the ownership
interest of the previously existing common stockholders of the Company was
reduced to approximately 14% of the common stock interests of the Company.
The convertible preferred stock does not accrue dividends of any kind, but
participates in any dividends paid on the Company's common stock on an
as-converted basis. Each share of convertible preferred stock is convertible
into one share of common stock at the option of the holder. The convertible
preferred stock entitles the holder to one vote for each share of common stock
into which the preferred stock is convertible, with respect to all matters voted
on by the common stockholders of the Company, except for the election of
directors. The holders of the convertible preferred stock have the right to
elect a total of five members of the board of directors, and the holders of the
common stock have the right to elect the remaining two directors. The
convertible preferred stock has a $30 million liquidation preference over the
Company's common stock.
In 1999, in connection with a previous restructuring of the senior notes
payable, the Company issued warrants to purchase 382,000 shares of its common
stock for $4.51 per share to the Senior Note Holder. The warrants were canceled
without being exercised, in connection with the conversion of the senior notes
payable into convertible preferred stock effective January 31, 2001.
ITEM 2. PROPERTIES
- --------------------
The Company leases a total of approximately 68,000 square feet of office space
in a single location in Aliso Viejo, California, under a lease agreement that
expires in 2008. Approximately 12,000 square feet of this space is not currently
used by the Company, but is subleased to unrelated third parties. The remaining
56,000 square feet of office space is used for the Company's corporate
headquarters and its National Service Center, which includes member services
activities, eligibility file maintenance, billing and collections, claims
processing and other similar customer support activities, and for its California
regional office. In addition, the Company leases office space in Irvine,
California; Walnut Creek, California; Coral Springs and Tampa, Florida; and
Dallas and Houston, Texas. The Company leased all of the office space used by
its previously owned dental and orthodontic practices. The Company remains
contingently liable for a number of these leases, which expire on various dates
through 2007, as discussed in Note 12 to the accompanying consolidated financial
statements. In the opinion of management, the Company's facilities are adequate
for its current needs.
18
ITEM 3. LEGAL PROCEEDINGS
- ----------------------------
The Company is subject to various claims and legal actions arising in the
ordinary course of business. The Company believes all pending claims either are
covered by liability insurance maintained by the Company or by providers in the
Company's dental or vision provider networks, 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, who were 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 an admission of liability.
The settlement 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 is included in selling, general and administrative
expenses in the accompanying consolidated statement of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- ---------------------------------------------------------------------
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
- ------------------------------------------------------------------------------
(a) MARKET INFORMATION
The Company's common stock is traded on the NASDAQ Over The Counter Bulletin
Board under the symbol SFGD. The following table sets forth the high and low
sale prices of the Company's common stock each calendar quarter. The prices
shown are based on transactions between market makers in the Company's stock,
and do not necessarily represent transactions between non-dealer principals.
HIGH LOW
----- -----
Year ended December 31, 2004:
First Quarter. . . . . . . . . . . . . . . $2.10 $1.78
Year ended December 31, 2003:
First Quarter. . . . . . . . . . . . . . . $1.75 $1.16
Second Quarter . . . . . . . . . . . . . . 1.80 1.23
Third Quarter. . . . . . . . . . . . . . . 1.80 1.35
Fourth Quarter . . . . . . . . . . . . . . 3.30 1.55
Year ended December 31, 2002:
First Quarter. . . . . . . . . . . . . . . $1.95 $1.19
Second Quarter . . . . . . . . . . . . . . 1.45 1.25
Third Quarter. . . . . . . . . . . . . . . 1.40 1.15
Fourth Quarter . . . . . . . . . . . . . . 1.35 1.15
(b) HOLDERS
As of March 31, 2004, there were approximately 900 holders of the Company's
common stock, including approximately 400 holders of record, and 34 holders of
the Company's convertible preferred stock.
(c) DIVIDENDS
No cash dividends have been paid on the Company's common stock, and the Company
does not expect to pay cash dividends during the foreseeable future. The
Company's convertible preferred stock does not accrue dividends of any kind.
19
STOCKHOLDER RIGHTS PLAN
In March 1996, the board of directors of the Company declared a dividend of one
right to purchase a fraction of a share of its Series A Junior Participating
Preferred Stock, having rights, preferences, privileges and restrictions as
designated, and under certain circumstances, other securities, for each
outstanding share of the Company's common stock. The dividend was distributed to
stockholders of record at the close of business on April 12, 1996. The Rights
become exercisable upon the occurrence of certain defined events related to a
possible change of control of the Company. The description and terms of the
Rights are set forth in a Rights Agreement, dated as of March 22, 1996, as
amended, between the Company and American Stock Transfer and Trust Company, as
Rights Agent. The Rights Agreement may be amended by the Company's board of
directors without the approval of the Rights holders, at any time prior to the
Rights becoming exercisable. The Rights Agreement was amended in March 2000 to
specify that the recapitalization transaction initiated in March 2000 would not
cause the Rights to become exercisable.
20
ITEM 6. SELECTED FINANCIAL DATA
- --------------------------------
The selected financial data in the following table was derived from the audited
consolidated financial statements of the Company. This data should be read in
conjunction with such consolidated financial statements and notes thereto, and
Management's Discussion and Analysis of Financial Condition and Results of
Operations.
YEARS ENDED DECEMBER 31,
--------------------------------------------------------
STATEMENT OF OPERATIONS DATA 2003 2002 2001 2000 1999
--------- ---------- ---------- ---------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA):
Premium revenue, net $104,891 $ 83,043 $ 84,822 $ 97,251 $ 96,225
Health care services expense 73,194 57,937 58,692 68,568 69,528
Selling, general and administrative expense 28,684 24,540 25,391 31,203 35,072
Loss on impairment of assets (1) -- 334 -- 450 24,576
--------- ---------- ---------- ---------- ---------
Operating income (loss) 3,013 232 739 (2,970) (32,951)
Investment and other income 490 607 1,060 1,431 2,067
Interest expense (530) (232) (504) (4,913) (5,855)
--------- ---------- ---------- ---------- ---------
Income (loss) before income taxes, discontinued
operations and extraordinary item 2,973 607 1,295 (6,452) (36,739)
Income tax expense (benefit) (2) (4,840) (820) -- -- 10,934
--------- ---------- ---------- ---------- ---------
Income (loss) before discontinued
operations and extraordinary item 7,813 1,427 1,295 (6,452) (47,673)
Discontinued operations:
Loss from assets transferred under contractual
arrangements (3) -- -- -- (2,500) (4,363)
Extraordinary item:
Gain on conversion of debt to
convertible preferred stock (4) -- -- 11,251 -- --
--------- ---------- ---------- ---------- ---------
Net income (loss) $ 7,813 $ 1,427 $ 12,546 $ (8,952) $(52,036)
========= ========== ========== ========== =========
Basic net income (loss) per share:
Income (loss) before discontinued
operations and extraordinary item $ 0.22 $ 0.04 $ 0.04 $ (1.36) $ (10.04)
Loss from discontinued operations -- -- -- (0.53) (0.92)
Extraordinary item -- -- 0.35 -- --
--------- ---------- ---------- ---------- ---------
Net income (loss) per basic share $ 0.22 $ 0.04 $ 0.39 $ (1.89) $ (10.96)
========= ========== ========== ========== =========
Weighted average basic shares outstanding (5) 35,719 35,130 32,253 4,747 4,747
Diluted net income (loss) per share:
Income (loss) before discontinued
operations and extraordinary item $ 0.20 $ 0.04 $ 0.04 $ (1.36) $ (10.04)
Loss from discontinued operations -- -- -- (0.53) (0.92)
Extraordinary item -- -- 0.34 -- --
--------- ---------- ---------- ---------- ---------
Net income (loss) per diluted share $ 0.20 $ 0.04 $ 0.38 $ (1.89) $ (10.96)
========= ========== ========== ========== =========
Weighted average diluted shares outstanding 40,244 35,638 33,009 4,747 4,747
BALANCE SHEET DATA AS OF DECEMBER 31 (IN THOUSANDS):
Cash and short-term investments $ 28,199 $ 12,704 $ 15,453 $ 16,702 $ 6,281
Current assets 37,104 16,111 19,195 21,268 10,380
Total assets 71,238 34,114 29,325 33,095 28,577
Current liabilities 23,588 14,093 14,988 72,180 18,129
Long-term debt and capital lease obligations 22,537 2,997 -- 265 39,545
Other long-term liabilities 1,223 1,013 971 1,079 2,517
Stockholders' equity (deficit) 23,890 16,011 13,366 (40,429) (31,614)
See note explanations on the following page.
21
Note explanations to Selected Financial Data:
(1) Represents reductions in the carrying value of notes receivable in 2002 and
2000, and goodwill in 1999, to their estimated realizable values.
(2) The 2003 amount primarily represents a reduction in the valuation allowance
on the Company's net deferred tax assets. The 2002 amount primarily
represents a decrease in the accrual for estimated income tax liabilities
related to certain transactions that occurred in prior years. The 1999
amount primarily represents a charge to establish a valuation allowance
against net deferred tax assets. See Note 11 to the accompanying
consolidated financial statements for more information on income taxes.
(3) Represents reductions in the carrying value of the net assets related to
certain dental practices to their estimated realizable value.
(4) Effective January 31, 2001, the Company completed the conversion of $47.5
million of debt and $5.3 million of accrued interest into 30 million shares
of convertible preferred stock, resulting in an extraordinary gain of $11.3
million, net of transaction expenses.
(5) Includes the common share equivalents of the convertible preferred stock,
because the holders of the convertible preferred stock participate in any
dividends paid on the Company's common stock on an as-converted basis, and
because the Company believes the convertible preferred stock is a
participating security that is essentially equivalent to common stock,
based on all the rights and preferences of both types of stock.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
- --------------------------------------------------------------------------------
OF OPERATIONS
-------------
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor"
for forward-looking statements, as long as those statements are identified as
forward-looking and are accompanied by meaningful cautionary statements
identifying important factors that could cause actual results to differ
materially from those discussed in the statements. The Company desires to take
advantage of these safe harbor provisions. The information in the "Risk Factors"
section of Item 1 of this Form 10-K should be read in conjunction with this
Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A").
The statements contained in this MD&A concerning expected growth, the outcome of
business strategies, future operating results and financial position, economic
and market events and trends, future premium revenue, future health care
expenses, the Company's ability to control health care, selling, general and
administrative expenses, and all other statements that are not historical facts,
are forward-looking statements. Words such as expects, projects, anticipates,
intends, plans, believes, seeks or estimates, or variations of such words and
similar expressions, are also intended to identify forward-looking statements.
These forward-looking statements are subject to significant risks, uncertainties
and contingencies, many of which are beyond the control of the Company. Actual
results may differ materially from those projected in the forward-looking
statements, which statements involve risks and uncertainties.
All of the risks set forth in the "Risk Factors" section of this Form 10-K could
negatively impact the earnings of the Company in the future. The Company's
expectations for the future are based on current information and its evaluation
of external influences. Changes in any one factor could materially impact the
Company's expectations related to revenue, premium rates, benefit plans offered,
membership enrollment, the amount of health care expenses incurred, and
profitability, and therefore, affect the forward-looking statements which may be
included in this report. In addition, past financial performance is not
necessarily a reliable indicator of future performance. An investor should not
use historical performance alone to anticipate future results or future period
trends for the Company.
CRITICAL ACCOUNTING POLICIES
The Company's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America.
Application of those accounting principles includes the use of estimates and
assumptions that are made by management, and which the Company believes are
reasonable based on the information available. These estimates and assumptions
affect the reported amounts of assets, liabilities, revenues and expenses in the
accompanying consolidated financial statements. The Company believes the most
critical accounting policies used to prepare the accompanying consolidated
financial statements are the following:
INVESTMENTS
The Company has classified all of its investments as "available-for-sale."
Accordingly, investments are carried at fair value, based on quoted market
prices, and unrealized gains and losses, net of applicable income taxes, are
reported in a separate caption of stockholders' equity. In the event there was
an unrealized loss on an investment that the Company believed to be other than
temporary, the loss would be reported in the statement of operations, instead of
in a separate caption of stockholders' equity. As of December 31, 2003, there
were no unrealized losses that the Company believed to be other than temporary.
22
ACCOUNTS RECEIVABLE
Accounts receivable represent uncollected premiums related to coverage periods
prior to the balance sheet date, and are stated at the estimated collectible
amounts, net of an allowance for bad debts. The Company continuously monitors
the timing and amount of its premium collections, and maintains a reserve for
estimated bad debt losses. The amount of the reserve is based primarily on the
Company's historical experience and any customer-specific collection issues that
are identified. The Company believes its reserve for bad debt losses is adequate
as of December 31, 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.
GOODWILL
Goodwill as of December 31, 2003 consists of $3.2 million of goodwill related to
the acquisition of Health Net Dental, Inc. ("HN Dental") and Health Net Vision,
Inc. ("HN Vision") in October 2003, $5.3 million of goodwill related to the
acquisition of Paramount Dental Plan, Inc. ("Paramount") in August 2002, and
$3.9 million of goodwill related to the acquisition of First American Dental
Benefits, Inc. ("First American") in 1996. See Note 2 to the accompanying
consolidated financial statements for more information on the acquisitions of HN
Dental, HN Vision and Paramount. In the case of each acquisition, goodwill
represents the excess of the purchase price of the acquired company over the
fair value of the net assets acquired, and in the case of the First American
acquisition, the balance is net of accumulated amortization and an adjustment in
1999 to reduce the carrying value of the goodwill to its estimated realizable
value. The Company estimated that the goodwill related to the First American
acquisition had a useful life of 40 years from the date of acquisition, and
amortized the goodwill over that period through December 31, 2001. In accordance
with Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and
Other Intangible Assets," the Company ceased amortizing its goodwill effective
January 1, 2002.
SFAS No. 142 requires that all goodwill be evaluated for possible impairment as
of January 1, 2002, on an annual basis thereafter, and any time an event that
may have affected the value of the goodwill occurs. SFAS No. 142 also
establishes a new method of testing for possible impairment. The Company has
established October 1 as the date on which it conducts its annual evaluation of
goodwill for possible impairment. In accordance with SFAS No. 142, the Company
tested its goodwill for possible impairment by estimating the fair value of each
of its reporting units that include goodwill, and comparing the fair value of
each reporting unit to the book value of the net assets of each reporting unit.
The fair value of each reporting unit was determined primarily by estimating the
discounted future cash flows of the reporting unit, and by estimating the amount
for which the reporting unit could be sold to a third party, based on a market
multiple of earnings. The Company had no impairment of its goodwill as of
January 1, 2002, or as of October 1, 2003, 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, 2003 that may have affected the value
of its goodwill. However, there can be no assurance that impairment will not
occur in the future.
INTANGIBLE ASSETS
Intangible assets as of December 31, 2003 consist of customer relationships,
provider networks, and other intangible assets with an aggregate net book value
of $9.9 million, which were acquired in connection with the acquisitions of HN
Dental and HN Vision in October 2003, Ameritas Managed Dental Plan, Inc. in
March 2003, and Paramount in August 2002. See Note 2 to the accompanying
consolidated financial statements for more information on these acquisitions.
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
23
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 or 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 consolidated balance sheet as deferred premium revenue.
INCOME TAXES
The Company's accounting for income taxes is in accordance with SFAS No. 109,
"Accounting for Income Taxes." SFAS No. 109 requires the recognition of deferred
tax liabilities and assets for the expected future tax consequences of events
that are recognized in the Company's financial statements in different periods
than those in which the events are recognized in the Company's tax returns. The
measurement of deferred tax liabilities and assets is based on current tax laws
as of the balance sheet date. The Company records a valuation allowance related
to deferred tax assets in the event that available evidence indicates that the
future tax benefits related to deferred tax assets may not be realized. A
valuation allowance is required when it is more likely than not that the
deferred tax assets will not be realized. The Company's determination of whether
a valuation allowance is required is subject to change based on future estimates
of the recoverability of its net deferred tax assets.
In 2003, the Company reduced the valuation allowance on its net deferred tax
assets by $5.7 million, primarily due to a significant improvement in its
reported operating results and its expected future operating results, compared
to previous years. The Company's net deferred tax assets were fully reserved
during the years ended December 31, 2002 and 2001, due to uncertainty about
whether those net assets would be realized in the future.
NET INCOME PER SHARE
Net income per share is presented in accordance with SFAS No. 128, "Earnings Per
Share." Basic earnings 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 holders of the
convertible preferred stock participate in any dividends paid on the Company's
common stock on an as-converted basis, and because the Company believes the
convertible preferred stock is a participating security that 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 years ended December 31, 2003, the potentially
dilutive securities of the Company that were outstanding consisted of stock
options, convertible notes, and warrants. See Note 8 to the accompanying
consolidated financial statements for information on convertible notes that were
outstanding during 2003 and 2002. The calculation of diluted net income per
share for 2003 includes the effect of all the outstanding convertible notes.
Each of these convertible notes would have an anti-dilutive effect on net income
per share in 2002, and accordingly, they are excluded from the calculation of
diluted net income per share for this period. The calculation of diluted net
income per share for 2003, 2002 and 2001 includes the effect of all outstanding
stock options with an exercise price below the average market price of the
Company's common stock during each period. The only warrants issued by the
Company were canceled without being exercised effective January 31, 2001, as
discussed in Note 9 to the accompanying consolidated financial statements.
24
SUMMARY OF RESULTS OF OPERATIONS
The following table shows the Company's results of operations as a percentage of
premium revenue, and is used in the year-to-year comparisons discussed below.
YEARS ENDED DECEMBER 31,
-------------------------------
2003 2002 2001
-------- ---------- ---------
Premium revenue, net 100.0% 100.0% 100.0%
Health care services expense 69.8 69.8 69.2
Selling, general and administrative expense 27.3 29.9 29.9
-------- ---------- ---------
Operating income 2.9 0.3 0.9
Investment and other income 0.4 0.7 1.2
Interest expense (0.5) (0.3) (0.6)
-------- ---------- ---------
Income before income taxes and extraordinary item 2.8 0.7 1.5
Income tax expense (benefit) (4.6) (1.0) --
-------- ---------- ---------
Income before extraordinary item 7.4 1.7 1.5
Extraordinary item -- -- 13.3
-------- ---------- ---------
Net income 7.4% 1.7% 14.8%
======== ========== =========
2003 COMPARED TO 2002
Premium revenue increased by $21.9 million, or 26.3%, from $83.0 million in 2002
to $104.9 million in 2003. The average membership for which the Company provided
dental coverage increased by 214,000 members, or 34.7%, from approximately
616,000 members during 2002 to approximately 830,000 members during 2003.
Average membership increased in 2003 by 78,000 members due to the acquisition of
HN Dental in October 2003. The HN Dental acquisition added 468,000 members to
the Company during the last two months of 2003, which resulted in an average
increase of 78,000 members for the full year. The operations of HN Dental and HN
Vision are included in the accompanying consolidated financial statements
beginning on November 1, 2003. Average membership also increased in 2003 by
133,000 members due to the Paramount acquisition in August 2002. The Paramount
acquisition added 200,000 members to the Company, which resulted in an average
increase of 133,000 members in 2003, compared to 2002. The operations of
Paramount are included in the accompanying consolidated financial statements
beginning on September 1, 2002. Premium revenue increased by only 26.3% in 2003
even though average membership increased by 34.7%. 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. 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 $15.3 million, or 26.3%, from $57.9
million in 2002 to $73.2 million in 2003. Health care services expense as a
percentage of premium revenue (the "loss ratio") was 69.8% in both 2003 and
2002. In 2003, the Company's mix of business shifted towards a higher proportion
of HMO benefit plan designs, which was primarily due to the HN Dental, HN Vision
and Paramount acquisitions. HMO benefit plan designs generally have lower loss
ratios than PPO/indemnity benefit plan designs, and accordingly, this shift in
the mix of business resulted in a slight decrease in the overall loss ratio.
However, the effect of this shift was offset by a slight increase in the loss
ratio on products with a PPO/indemnity plan design.
Selling, general and administrative ("SG&A") expense increased by $3.8 million,
or 15.3%, from $24.9 million in 2002 to $28.7 million in 2003. SG&A expense as a
percentage of premium revenue decreased from 29.9% in 2002 to 27.3% in 2003. The
increase in SG&A expense is primarily due to increases in salaries and benefits,
broker commissions, premium taxes, and amortization of intangible assets, all of
which are directly related to the acquisitions of HN Dental, HN Vision and
Paramount. The decrease in SG&A expense as a percentage of premium revenue is
primarily due economies of scale that resulted from the acquisitions of HN
Dental, HN Vision and Paramount.
25
Investment and other income decreased by $0.1 million, from $0.6 million in 2002
to $0.5 million in 2003. This decrease is primarily due to a decrease in
interest rates on short-term fixed-income investments during the past year.
Interest expense increased by $0.3 million, from $0.2 million in 2002 to $0.5
million in 2003, primarily due to the borrowings made by the Company to finance
the acquisition of HN Dental and HN Vision in October 2003 and the acquisition
of Paramount in August 2002. See Notes 2 and 8 to the accompanying consolidated
financial statements for information on outstanding debt.
Income before income taxes increased by $2.4 million, from $0.6 million in 2002
to $3.0 million in 2003. Income before income taxes as a percentage of premium
revenue increased from 0.7% in 2002 to 2.8% in 2003. This increase was primarily
due to a decrease in SG&A expense as a percentage of premium revenue, which was
primarily due to the acquisitions of HN Dental, HN Vision and Paramount, as
discussed above.
There was an income tax benefit of $4.8 million in 2003, which primarily
represents a decrease in the valuation allowance on the Company's net deferred
tax assets. The Company reduced the valuation allowance primarily due to a
significant improvement in its reported operating results and its expected
future operating results. There was an income tax benefit of $820,000 in 2002,
which primarily represents a decrease in the Company's accrual for estimated
income tax liabilities related to certain transactions that occurred in prior
years. There was no other current income tax expense in 2002, due to temporary
differences between income before income taxes for accounting purposes and
taxable income for tax purposes, which resulted in a loss for tax purposes in
2002. See Note 11 to the accompanying consolidated financial statements for more
information on income taxes.
2002 COMPARED TO 2001
Premium revenue decreased by $1.8 million, or 2.1%, from $84.8 million in 2001
to $83.0 million in 2002. The average membership for which the Company provided
dental coverage was approximately 616,000 members during 2002, compared to
615,000 members during 2001. Average membership increased in 2002 by
approximately 80,000 members due to the Paramount acquisition, but this increase
was offset by the loss of a number of the Company's customers, and a net
decrease in its enrollment within retained customers. The Paramount acquisition
added approximately 240,000 members to the Company during the last four months
of 2002, which resulted in an average increase of 80,000 members for the full
year. The operations of Paramount are included in the accompanying consolidated
financial statements beginning on September 1, 2002. 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 decreased by 2.1% in 2002 even though average
membership was approximately the same in both years. This was primarily due to
the Paramount acquisition, as the business acquired from Paramount consists
largely of products that have significantly lower premium rates than the
Company's pre-existing business. Substantially all of the Company's premium
revenue was derived from dental benefit plans in 2002 and 2001. Premium revenue
from vision benefit plans and other products was not material in 2002 or 2001.
Health care services expense decreased by $0.8 million, or 1.3%, from $58.7
million in 2001 to $57.9 million in 2002. The loss ratio increased slightly from
69.2% in 2001 to 69.8% in 2002. The business acquired from Paramount has a
significantly lower loss ratio than the Company's pre-existing business, which
is primarily due to the type of benefit plan designs sold by Paramount. The
effect of the Paramount acquisition on the loss ratio was offset by increases in
specialty referral services, supplemental payments, and discounted
fee-for-service payments to dental HMO providers. The increase in the cost of
specialty referral services was due to an increase in the utilization rate for
those services in 2002. Supplemental payments are additional payments made to
dentists who are compensated primarily through capitation payments, in
connection with the delivery of certain dental procedures by those dentists. The
increases in supplemental and discounted fee-for-service payments were partially
due to high-cost arrangements with certain providers, which were started early
in 2002, and which were terminated prior to the end of 2002. These arrangements
resulted in an unusually large amount of supplemental payments and discounted
fee-for-service payments in 2002. There was also a general increase in
supplemental payments in 2002, which the Company believes is due to more
comprehensive submission of claims information by the dentists in its HMO
network.
26
SG&A expense decreased by $0.5 million, or 2.0%, from $25.4 million in 2001 to
$24.9 million in 2002. SG&A expense as a percentage of premium revenue was 29.9%
in both 2002 and 2001. The decrease in SG&A expense is primarily due to
decreases in depreciation expense and furniture rent, and a $350,000 refund of
maintenance fees from one of the Company's vendors, which were partially offset
by a $250,000 expense in 2002 related to the settlement of stockholder
litigation, as described in Note 12 to the accompanying consolidated financial
statements, and a $334,000 loss on impairment of notes receivable in 2002. The
decrease in depreciation expense is primarily due to the fact that a significant
component of the Company's computer software became fully depreciated during
2002. The decrease in furniture rent was due to the purchase of the office
furniture used in the Company's primary administrative office through a new
capital lease during the second quarter of 2002. The related furniture was
formerly leased under an operating lease with relatively expensive terms,
compared to the new capital lease. The new capital lease caused an increase in
depreciation expense, but this was more than offset by other decreases in
depreciation, as noted above. The refund of maintenance fees was primarily due
to the settlement of a dispute over the amount of equipment maintenance fees
paid by the Company in several prior years. The impairment loss in 2002 is due
to an increase in the reserve related to notes receivable, based on the
Company's estimate of the net realizable value of the promissory notes.
Investment and other income decreased by $0.5 million, from $1.1 million in 2001
to $0.6 million in 2002. This decrease is primarily due to realized gains on the
sale of investments in 2001, a decrease in interest rates on short-term
fixed-income investments, a decrease in interest income from notes receivable,
due to the liquidation of a portion of the Company's notes receivable during
2001, and a decrease in the amount of investments held by the Company, compared
to the prior year. The decrease in the Company's investments was primarily due
to significant reductions in accrued expenses and claims payable and IBNR during
both 2002 and 2001. By intentionally accelerating its payment of claims, the
Company intends to enhance its image among dental providers.
Interest expense decreased by $0.3 million, from $0.5 million in 2001 to $0.2
million in 2002, primarily due to the conversion of substantially all of the
Company's debt into convertible preferred stock effective January 31, 2001,
which eliminated nearly all of the Company's interest expense.
Income before income taxes decreased by $0.7 million, from $1.3 million in 2001
to $0.6 million in 2002. Income before income taxes as a percentage of premium
revenue decreased from 1.5% in 2001 to 0.7% in 2002. This decrease was primarily
due to an increase in the loss ratio, which was partially offset by a decrease
in SG&A expense as a percentage of premium revenue, both as discussed above.
There was an income tax benefit of $820,000 in 2002, which primarily represents
a decrease in the Company's accrual for estimated income tax liabilities related
to certain transactions that occurred in prior years, as discussed in Note 11 to
the accompanying consolidated financial statements. There was no current income
tax expense in 2002, due to temporary differences between income before income
taxes for accounting purposes and taxable income for tax purposes. Those
temporary differences resulted in a loss for tax purposes in 2002. There was
also no deferred income tax expense in 2002, due to the valuation allowance
against the Company's net deferred tax assets, as discussed in Note 11 to the
accompanying consolidated financial statements.
LIQUIDITY AND CAPITAL RESOURCES
The Company's net working capital increased from $2.0 million as of December 31,
2002 to $13.5 million as of December 31, 2003, primarily due to the Company's
earnings during 2003, the acquisition of HN Dental and HN Vision in October
2003, and the issuance of $19.0 million of convertible notes in October 2003.
Net income less net deferred income tax benefits, plus depreciation and
amortization expense, added approximately $5.0 million of working capital during
2003. HN Dental and HN Vision had an aggregate of $3.0 million of working
capital as of the acquisition date, which added $3.0 million to the Company's
working capital. In addition, the Company borrowed $19.0 million in connection
with the acquisition of HN Dental and HN Vision, and the total cost of the
acquisition was $15.2 million, resulting in a $3.8 million addition to working
capital. See Note 2 to the accompanying consolidated financial statements for
more information on the acquisition of HN Dental and HN Vision, and the $19.0
million of convertible notes.
The Company's total debt increased from $5.4 million as of December 31, 2002 to
$22.9 million as of December 31, 2003, primarily due to $19.0 million of
convertible notes issued in October 2003, in connection with the acquisition
27
of HN Dental and HN Vision, which was partially offset by $2.1 million of
principal payments on debt and capital lease obligations during 2003.
In October 2003, the Company acquired all of the outstanding capital stock of HN
Dental, which is a California dental HMO, and certain PPO/indemnity dental
business underwritten by Health Net Life Insurance Company ("HN Life"), which
was formerly an affiliate of HN Dental, for $10.7 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 former parent
company of HN Dental, for a period of at least five years following the
transaction, subject to certain conditions. In October 2003, the Company also
acquired all of the outstanding capital stock of 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 $4.5 million in cash. The combined
revenue of the acquired businesses was approximately $61 million during the ten
months ended October 31, 2003. The operations of HN Dental, HN Vision, and the
related dental and vision PPO/indemnity business are included in the Company's
consolidated financial statements beginning on November 1, 2003.
The acquisition of HN Dental and HN Vision was financed through the issuance of
$19.0 million of unsecured convertible promissory notes to certain of the
Company's principal stockholders in October 2003. The proceeds from the
convertible notes were used 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, to provide working capital that
may be required in connection with the integration of the acquired businesses
into the Company's pre-existing operations, and for general corporate 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, provided that it redeems all
the convertible notes held by each holder for which it redeems any of the notes.
In March 2003, the Company acquired all of the outstanding capital stock of
Ameritas Managed Dental Plan, Inc. ("Ameritas") for $1.0 million in cash, plus
contingent monthly payments during the five years following the acquisition
date. Based on the amount of premium revenue during the period from April 1,
2003 to December 31, 2003, from customers of Ameritas that existed as of March
31, 2003, the maximum aggregate amount of the contingent monthly payments would
be approximately $1.5 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. The operations of Ameritas are included in the
Company's consolidated financial statements beginning on April 1, 2003.
In August 2002, the Company acquired all of the outstanding capital stock of
Paramount for approximately $6.7 million, consisting of $3.0 million in cash, a
secured convertible note for $2,625,000, and 769,231 shares of the Company's
common stock. The secured convertible note bears interest at 7.0% annually, and
was originally payable in 36 equal monthly installments of principal and
interest, beginning in October 2002. The terms of the note were amended in the
fourth quarter of 2003, and the outstanding balance is now payable in monthly
installments of interest only until a date to be specified by the holder of the
convertible note at least 90 days in advance of such date, which must be no
earlier than January 1, 2005, and no later than January 1, 2007. Effective on
the date specified by the holder, the convertible note will be payable in 21
equal monthly installments of principal and interest. 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 accompanying consolidated financial
statements beginning on September 1, 2002.
In August 2002, the Company borrowed $2.0 million from one of its principal
stockholders, which was used to increase the Company's working capital, to
provide for the payments due under certain capital leases entered into in June
2002, and to provide for the payments due under the settlement of the
stockholder litigation discussed in Note
28
12 to the accompanying consolidated financial statements. The borrowing was made
under an unsecured convertible note that 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 convertible note is convertible into common stock of the
Company at a conversion price of $1.625 per share.
Net cash provided by operating activities increased from $1.2 million during
2002 to $6.4 million in 2003, which was primarily due to increases in accrued
expenses and claims payable and claims incurred but not reported ("IBNR") in
2003, compared to significant decreases in these liabilities in 2002, and an
increase in net income, excluding the non-cash deferred income tax benefit in
2003. The increase in accrued expenses in 2003 was primarily due to an increase
in accrued incentive compensation, which was related to the improvement in the
Company's operating results in 2003. The decrease in accrued expenses in 2002
was primarily due to payments made to reduce accrued lease obligations related
to equipment that was no longer used by the Company, and to reduce certain
obligations related to discontinued operations that were disposed of prior to
2001. The increase in claims payable and claims IBNR in 2003 was primarily due
to an increase in the number of members covered under PPO/indemnity benefit plan
designs, which account for a majority of the total claims payable and claims
IBNR liability. The decrease in claims payable and claims IBNR in 2002 was
primarily due to intentional decreases in the processing time for payment of
provider claims. Due in part to the recent 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.
Net cash used by investing activities was $22.9 million in 2003, compared to
$0.8 million of net cash provided in 2002. In 2003, there was $10.1 million of
net cash used for acquisitions, and an $11.4 million net increase in
investments. The increase in investments was due to the fact that the acquired
entities had an aggregate of $5.9 million of cash as of the respective closing
dates, and the fact that there was $6.4 million of cash provided by operating
activities in 2003, as discussed above, all of which was used to purchase
investments.
Net cash provided by financing activities was $16.7 million in 2003, compared to
$0.5 million of net cash used in 2002. The change was due to $19.0 million of
borrowings in 2003, compared to $2.0 million of borrowings in 2002.
CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS
A summary of the Company's future commitments is as follows (in thousands):
PAYMENTS DUE IN
----------------------------------------
LESS THAN 1 TO 3 3 TO 5 MORE THAN
ONE YEAR YEARS YEARS FIVE YEARS TOTAL
--------- ------- -------- ---------- -------
CONTRACTUAL OBLIGATIONS:
Long-term debt $ -- $ 2,659 $ 481 $ 19,000 $22,140
Capital lease obligations 313 364 33 -- 710
Other long-term liabilities -- 903 308 12 1,223
Operating lease commitments, net 2,098 5,778 1,226 -- 9,102
--------- ------- -------- ---------- -------
Total contractual obligations $ 2,411 $ 9,704 2,048 $ 19,012 $33,175
========= ======= ======== ========== =======
OTHER COMMITMENTS:
Contingent liability for dental office
leases assigned to other entities $ 1,053 $ 891 14 -- $ 1,958
Contingent liability for subleased
office space 183 9 -- -- 192
--------- ------- -------- ---------- -------
Total other commitments $ 1,236 $ 900 $ 14 $ -- $ 2,150
========= ======= ======== ========== =======
29
If the entities to which the dental office leases have been assigned fail to
make a significant amount of the lease payments, this could have a material
adverse affect on the Company. See Note 10 to the accompanying consolidated
financial statements for more information on other long-term liabilities, and
see Note 12 for more information on operating lease commitments and contingent
lease obligations.
Several of the Company's subsidiaries are subject to state regulations that
require them to maintain restricted deposits in the form of cash or investments.
The Company had total restricted deposits of $2.9 million and $3.3 million as of
December 31, 2003 and 2002, respectively.
In addition, several of the Company's subsidiaries are subject to state
regulations that require them to maintain minimum amounts of statutory capital
and surplus, and that otherwise restrict the Company's access to the assets of
its regulated subsidiaries. As a result of these regulatory restrictions,
substantially all of the Company's consolidated stockholders' equity as of
December 31, 2003, was not available for distribution to the Company's
stockholders.
The Company's primary source of funds is cash flows from operations and
investment income. The Company believes that cash flows from operations and
investment income will be adequate to meet the Company's cash requirements for
at least the next twelve months, except for financing that may be required to
complete potential acquisitions. The Company does not expect any significant
changes in its cash requirements in the foreseeable future, except for any
financing that may be required in connection with potential acquisitions.
The Company believes it has adequate financial resources to continue its current
operations for the foreseeable future, and that it will be able to meet its
financial obligations from its existing financial resources and future cash
flows from its operations. However, there can be no assurance that there will
not be unforeseen events that could prevent the Company from doing so.
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 1 to the accompanying consolidated financial statements for information
on recent accounting pronouncements.
IMPACT OF INFLATION
The Company's operations are potentially impacted by inflation, which can affect
premium rates, health care services expense, and selling, general and
administrative expense. The Company expects that its earnings will be positively
impacted by inflation in premium rates, because premium rates for dental benefit
plans in general have been increasing due to inflation in recent years. The
Company expects that its earnings will be negatively impacted by inflation in
health care costs, because fees charged by dentists and other dental providers
have been increasing due to inflation in recent years. The impact of inflation
on the Company's health care services expense is mitigated in the short-term by
the fact that approximately 32% 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.
OFF-BALANCE SHEET ARRANGEMENTS
The Company is not a party to off-balance sheet arrangements as defined by the
Securities and Exchange Commission. However, from time to time the Company
enters into certain types of contracts that contingently require the Company to
indemnify parties against third party claims. The contracts primarily relate to:
(i) certain asset purchase agreements, under which the Company may provide
customary indemnification to the seller of the business being acquired; (ii)
certain real estate leases, under which the Company may be required to indemnify
property owners for environmental and other liabilities, and other claims
arising from the Company's use of the applicable premises; and (iii) certain
agreements with the Company's officers, directors, and employees, under which
the Company may be required to indemnify such persons for liabilities arising
out of their employment relationship.
The terms of such obligations vary by contract and in most instances a specific
or maximum dollar amount is not explicitly stated therein. Generally, amounts
under these contracts cannot be reasonably estimated until a specific claim is
asserted. Consequently, no liabilities have been recorded for these obligations
on the Company's consolidated balance sheets for any of the periods presented.
30
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- ---------------------------------------------------------------------------
The Company is subject to risk related to changes in short-term interest rates,
due to its investments in interest-bearing securities. As of December 31, 2003,
the Company's total investments were approximately $27.9 million. Therefore, a
one percentage-point change in short-term interest rates would have a $279,000
impact on the Company's annual investment income. The Company is not subject to
a material amount of risk related to changes in foreign currency exchange rates.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
- ---------------------------------------------------------
The Consolidated Financial Statements and the related Notes and Schedule thereto
filed as part of this 2003 Annual Report on Form 10-K are listed on the
accompanying Index to Financial Statements on page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT ACCOUNTANTS ON ACCOUNTING
- --------------------------------------------------------------------------------
AND FINANCIAL DISCLOSURES
---------------------------
None.
ITEM 9A. CONTROLS AND PROCEDURES
- ------------------------------------
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
As of the end of period covered by 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. 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.
During the period covered by this report, there have been no changes to the
Company's internal control over financial reporting that have materially
affected, or are reasonably likely to materially affect, the Company's internal
control over financial reporting.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
- ------------------------------------------------------------
The current directors and executive officers of the Company are as follows:
NAME AGE POSITION
- ------------------------ --- ---------------------------------------------------------------
James E. Buncher 67 President, Chief Executive Officer and Director
Stephen J. Baker 46 Executive Vice President and Chief Operating Officer
Ronald I. Brendzel, JD 54 Senior Vice President, General Counsel, Secretary and Director
Dennis L. Gates, CPA 48 Senior Vice President, Chief Financial Officer and Director
Kenneth E. Keating 40 Vice President, Marketing and Chief Marketing Officer
Michael J. Lauffenburger 43 Vice President, Chief Information Officer
Steven J. Baileys, DDS 50 Chairman of the Board of Directors
Neil R. Anderson 48 Director (1)
Stephen J. Blewitt 44 Director (2)
Leslie B. Daniels 56 Director (2)
(1) Member, Audit Committee.
(2) Member, Compensation and Stock Option Committee, and Audit Committee.
31
All directors of the Company are elected annually. Officers of the Company serve
at the pleasure of the board of directors. See Item 11. - Executive Compensation
below for a description of severance agreements with certain executive officers.
Mr. Buncher has been President and Chief Executive Officer, and a director of
the Company, since March 2000. From July 1998 to February 2000, he was a private
investor. Mr. Buncher was President and Chief Executive Officer of Community
Dental Services, Inc., a corporation operating dental practices in California,
from October 1997 until July 1998. Mr. Buncher was President of the Health
Plans Group of Value Health, Inc., a national specialty managed care company,
from September 1995 to September 1997. He served as Chairman, President and
Chief Executive Officer of Community Care Network, Inc., a Value Health
subsidiary, from August 1992 to September 1997, when Value Health was acquired
by a third party and Mr. Buncher resigned his positions with that company. Mr.
Buncher currently serves on the board of directors of Horizon Health Corporation
and one other non-public health care company.
Mr. Baker has been Executive Vice President and Chief Operating Officer since
April 2001, when he joined the Company. Prior to joining the Company, he was a
consultant to the senior management of the Company from September 2000 to March
2001. Mr. Baker was Vice President, Chief Operating Officer and Chief
Information Officer for Novaeon, Inc., a national health and disability
management company, from September 1999 to August 2000. He was an independent
management consultant from September 1997 to August 1999. Mr. Baker was Vice
President, Developing Businesses for Community Care Network, Inc., a group
health and workers' compensation managed care company from January 1997 to
August 1997.
Mr. Brendzel has been Senior Vice President, General Counsel, Secretary since
1985 and a director of the Company since 1989. He joined the Company in 1978 and
was Chief Financial Officer from April 1988 to May 1996. Mr. Brendzel is
licensed to practice law in the state of California. Mr. Brendzel is the
brother-in-law of Dr. Baileys.
Mr. Gates has been Senior Vice President and Chief Financial Officer since
November 1999, when he joined the Company, and has been a director of the
Company since March 2000. From June 1995 to February 1999, he was Chief
Financial Officer, then Treasurer, of Sheridan Healthcare, Inc., a physician
practice management company.
Mr. Keating has been Vice President, Marketing and Chief Marketing Officer since
May 2001, and was Vice President, Sales and Marketing from February 2000 to May
2001. He was Western Regional Vice President of the Company from October 1997
to February 2000. He joined the Company in 1995 and was Vice President-Imprimis
and Guards Office Operations for the Company from October 1995 until October
1997.
Mr. Lauffenburger has been Chief Information Officer since November 2002. He
served as Director, Information Services from January 2001, when he joined the
Company, to November 2002. From November 1998 to January 2001, he was IS
Manager, Year 2000, then Senior Project Manager, at Scripps Health. Mr.
Lauffenburger was Senior Programmer, then Project Manager, then Director,
Electronic Data Interchange of Community Care Network, Inc., from April 1991 to
November 1998.
Dr. Baileys has been Chairman of the Board of Directors since September 1995. He
joined the Company in 1975 and served as President of the Company from 1981 to
March 1997, and Chief Executive Officer from May 1995 to February 2000. Dr.
Baileys is licensed to practice dentistry in the state of California currently
practices dentistry full-time. Dr. Baileys is currently a director of SunLink
Health Systems, Inc.
Mr. Anderson has been President of Calver Fund, a healthcare investment and
consulting firm, since 1988. He currently serves on the board of directors of a
non-public health care company, and has been a director of several other private
health care companies.
Mr. Blewitt is a Senior Managing Director in the Bond & Corporate Finance Group
of John Hancock Life Insurance Company and has been employed by John Hancock
since 1982. Mr. Blewitt is also President of Hancock Mezzanine Advisors LLC, a
subsidiary of John Hancock, and the managing member of the general partners of
three related investment funds that invest primarily in mezzanine debt
securities. Mr. Blewitt is currently a director of NSP Holdings, L.L.C. and
Medical Resources, Inc.
32
Mr. Daniels was a founder of CAI Advisors & Co., an investment management firm,
in 1989 and has been a principal of that entity and its related investment fund
vehicles since then. Mr. Daniels is currently a director of Bioanalytical
Systems, Inc. He was a past Chairman of Zenith Laboratories, Inc. and has been a
director of several other public and private companies.
ITEM 11. EXECUTIVE COMPENSATION
- ----------------------------------
The following table shows the compensation paid to the Company's Chief Executive
Officer as of December 31, 2003, and the other four most highly compensated
executive officers as of December 31, 2003 who received total compensation in
excess of $100,000 during the year ended December 31, 2003 (the "Named Executive
Officers"). The compensation disclosed is for the three years ended December 31,
2003.
LONG-TERM
COMPENSATION
AWARDS
ANNUAL COMPENSATION -------------
------------------------ OTHER COM- STOCK OPTIONS
NAME PRINCIPAL POSITION YEAR SALARY BONUS PENSATION(1) GRANTED
- ------------------ ------------------------- ------ ------- ------- ------------ -------------
James E. Buncher President and Chief 2003 259,000 382,000 3,500 --
Executive Officer 2002 250,000 25,000 2,750 --
2001 246,000 -- 928 100,000
Stephen J. Baker Executive Vice President 2003 250,000 176,000 -- 50,000
and Chief Operating 2002 220,000 20,000 -- --
Officer (2) 2001 152,000 -- -- 300,000
Dennis L. Gates Senior Vice President 2003 204,000 122,000 3,000 --
and Chief Financial 2002 204,000 15,000 2,750 20,000
Officer 2001 197,000 -- -- --
Ronald I. Brendzel Senior Vice President, 2003 191,000 106,000 3,500 --
General Counsel and 2002 191,000 15,000 2,738 207,500
Secretary 2001 193,000 -- -- --
Kenneth E. Keating Vice President, 2003 171,000 79,000 2,337 --
Marketing and Chief 2002 186,000 -- 2,319 2,500
Marketing Officer (3) 2001 180,000 -- 938 --
_________________________________
(1) Other compensation consists of matching contributions to the Company's
401(k) plan.
(2) Mr. Baker joined the Company as Executive Vice President and Chief
Operating Officer in April 2001.
(3) Mr. Keating became Vice President, Marketing and Chief Marketing Officer in
May 2001. He was Vice President, Sales and Marketing from February 2000 to
May 2001.
During 2002, the Company entered into a Severance Agreement with each of the
Named Executive Officers, which continues until the officer's employment by the
Company terminates for any reason. Pursuant to each of these agreements, either
the Company or the officer can terminate the officer's employment with the
Company at any time. In the event the Company terminates the officer's
employment, or implements a substantial diminution of the officer's
responsibilities, and as a result, the officer resigns, within one year and as a
result of a "change in control" as defined below, the Company is obligated to
pay the officer an amount equal to the officer's annual salary then in effect,
plus an amount equal to the bonus earned by the officer during the last calendar
year. A "change in control" is defined as the acquisition of the Company by
another entity, a sale of substantially all of the assets of the Company, a
merger of the Company with another entity, the acquisition by any person or
group of persons of 50% or more of the combined voting power of the Company's
then outstanding securities, or a change of 50% or more of the directors of the
Company within a one-year period.
During 2003, the Company implemented a Retention Bonus Plan with respect to each
of the Named Executive Officers, which continues until the officer's employment
by the Company terminates for any reason. The purpose of the Retention Bonus
Plan is to provide an incentive for the senior management of the Company to
remain employed
33
during a reasonable transition period in the event of the sale of the Company to
a third party. In the event that more than 50% of the Company is sold to an
entity that is not a current stockholder of the Company, each of the Named
Executive Officers would receive a variable retention bonus that is based on the
amount of proceeds from the sale transaction. The retention bonus amounts to be
paid by the Company are the following amounts for each $1.00 per share of common
stock that is realized in a sale transaction: $325,000 to Mr. Buncher, $250,000
to Mr. Baker, $150,000 to Mr. Gates, $150,000 to Mr. Brendzel, and $75,000 to
Mr. Keating. Of the total amount of each officer's retention bonus, 25% would be
paid at the closing of the transaction, provided the officer is still employed
at that time, and 75% would be paid in monthly installments over the nine months
following the closing of the transaction, provided the officer is still employed
by the purchaser at the time each payment is due. Notwithstanding the previous
sentence, the entire retention bonus would be paid in the event the purchaser
reduces the officer's compensation rate or terminates the officer's employment.
STOCK OPTION GRANTS DURING THE YEAR ENDED DECEMBER 31, 2003
Stock options granted to the Named Executive Officers during the year ended
December 31, 2003 were as follows.
INDIVIDUAL STOCK OPTION GRANTS
- ------------------------------------------------------------------------------ POTENTIAL REALIZABLE VALUE
NUMBER OF % OF TOTAL AT ASSUMED ANNUAL RATES
SHARES OPTIONS OF STOCK PRICE APPRECIATION
UNDERLYING GRANTED TO EXERCISE FOR OPTION TERM(3)
OPTIONS EMPLOYEES PRICE PER EXPIRATION ----------------------------------
NAME GRANTED IN 2003 SHARE(1) DATE(2) 5% 10%
- ------------------ ---------------- -------------- ----------- ----------- ---------------- ----------------
James E. Buncher -- -- $ -- -- $ -- $ --
Stephen J. Baker 50,000 22.7% 1.60 Jul 2013 50,312 127,499
Dennis L. Gates -- -- -- -- -- --
Ronald I. Brendzel -- -- -- -- -- --
Kenneth E. Keating -- -- -- -- -- --
_________________________
(1) The exercise price per share of each of the options is equal to or greater
than the market price of the Company's common stock on the date of the
grant. Subject to the terms of each option agreement, the exercise price
may be paid in cash or in shares of common stock owned by the option
holder, or by a combination of the foregoing.
(2) Each of the options becomes exercisable in three equal annual installments.
The dates on which the options can be exercised may be accelerated in the
event of a commencement of a tender offer for shares of the Company, the
signing of an agreement for certain mergers or consolidations involving the
Company, the sale of all or substantially all of the assets of the Company,
a change of control, or certain other extraordinary corporate transactions.
The options are subject to early termination in the event the option
holder's employment is terminated.
(3) There is no assurance that the actual stock appreciation over the term of
the options will be at the assumed five percent (5%) or ten percent (10%)
levels or at any other assumed level. Unless the market price of the common
stock does in fact appreciate over the option term, the Named Executive
Officers will realize no value from the option grants.
STOCK OPTION EXERCISES AND YEAR-END STOCK OPTION VALUES
There were no stock options exercised by any of the Named Executive Officers
during the year ended December 31, 2003. Stock options held by the Named
Executive Officers at December 31, 2003 are shown in the following table. There
were no stock appreciation rights outstanding as of December 31, 2003.
STOCK OPTIONS EXERCISED NUMBER OF SECURITIES VALUE OF UNEXERCISED
-------------------------- UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS
SHARES OPTIONS AT FISCAL YEAR-END AT FISCAL YEAR-END
ACQUIRED VALUE ------------------------------ ----------------------------
NAME ON EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ------------------ ------------ ------------ --------------- ------------- ------------ --------------
James E. Buncher -- $ -- 666,667 33,333 $ 553,334 $ 21,666
Stephen J. Baker -- -- 200,000 150,000 121,667 73,333
Dennis L. Gates -- -- 381,667 13,333 322,750 8,000
Ronald I. Brendzel -- -- 189,167 138,333 144,834 85,666
Kenneth E. Keating -- -- 120,833 1,667 102,500 1,000
34
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
- ------------------------------------------------------------------------
AND RELATED STOCKHOLDER MATTERS
-------------------------------
The following table shows the number of shares of common stock beneficially
owned as of March 31, 2004, by each director, each Named Executive Officer, each
entity that, to the Company's knowledge, beneficially owned 5% or more of the
total outstanding convertible preferred stock and/or common stock of the
Company, and all directors and Named Executive Officers as a group. The number
of shares beneficially owned includes the number of shares of common stock into
which the convertible preferred stock held by each person is convertible. To the
Company's knowledge, the named person has sole voting and investment power with
respect to all shares of common stock listed, except where indicated otherwise.
The total number of shares of common stock outstanding as of March 31, 2004 was
5,770,590 and the total number of shares of preferred stock outstanding as of
that date was 30,000,000, which is convertible into 30,000,000 shares of common
stock. The following table includes the common share equivalents of the
convertible preferred stock, because the Company believes the convertible
preferred stock is essentially equivalent to common stock, based on all the
rights and preferences of both types of stock. Each of the officers and
directors may be contacted in care of the Company at 95 Enterprise, Suite 100,
Aliso Viejo, California 92656-2605
NUMBER OF SHARES % OF TOTAL
BENEFICIALLY SHARES
OFFICER OR DIRECTOR OWNED(1) OUTSTANDING(2)
- ----------------------------------------------------------- ----------------- --------------
John Hancock Life Insurance Company (3) 17,857,143 46.2
CAI Capital Partners & Company II, Limited Partnership (4) 14,867,671 35.3
Leslie B. Daniels (5) 84,500 *
Jack R. Anderson (6) 3,887,414 10.6
The Burton Partnerships (7) 3,471,542 9.4
Steven J. Baileys (8) 2,911,267 8.1
James E. Buncher (9) 914,667 2.5
Dennis L. Gates (10) 488,333 1.4
Ronald I. Brendzel (11) 422,340 1.2
Stephen J. Baker (12) 304,533 *
Kenneth E. Keating (13) 127,667 *
Neil R. Anderson 18,000 *
Stephen J. Blewitt (3) -- *
Other officers (6 persons) (14) 1,993,842 5.4
All directors, Named Executive Officers and other officers
as a group (15 persons) 39,905,463 83.0
All principal stockholders in total 47,264,419 94.2
* Indicates less than one percent (1%)
(1) Includes the number of shares of common stock into which the convertible
preferred stock held by each person is convertible. Also includes shares
issuable pursuant to stock options and convertible notes that are
exercisable within 60 days of March 31, 2004. Some of the stockholders
included in this table reside in states having community property laws
under which the spouse of a stockholder in whose name securities are
registered may be entitled to share in the management of their community
property, which may include the right to vote or dispose of such shares.
(2) For purposes of computing all the percentages shown, the total shares
outstanding includes the shares of common stock into which all outstanding
shares of convertible preferred stock are convertible. For purposes of
computing the percentage for each individual, the total shares outstanding
includes the shares issuable to that person pursuant to stock options and
convertible notes that are exercisable within 60 days of March 31, 2004.
For purposes of computing the percentages for all other officers as a
group, and all directors and officers as a group, the total shares
outstanding includes the shares issuable to the persons in each respective
group pursuant to stock options and convertible notes that are exercisable
within 60 days of March 31, 2004. For purposes of computing the percentages
for all principal stockholders as a group, the total shares outstanding
includes all the shares issuable pursuant to stock options and convertible
notes that are included in the above table.
(3) Mr. Blewitt is employed by John Hancock Life Insurance Company, which has
beneficial ownership of 15,000,000 shares issuable upon conversion of
shares of convertible preferred stock and 2,857,143 shares issuable upon
conversion of convertible notes, all as to which Mr. Blewitt disclaims
beneficial ownership. The address of Mr. Blewitt and John Hancock Life
Insurance Company is John Hancock Place, P.O. Box 111, Boston,
Massachusetts 02117.
35
(4) Includes 84,500 shares of common stock owned directly by Mr. Daniels,
2,780,786 shares issuable upon conversion of shares of convertible
preferred stock and 2,260,198 shares issuable upon conversion of
convertible notes owned by CAI Partners & Company II, Limited Partnership,
and 5,649,293 shares issuable upon conversion of shares of convertible
preferred stock and 4,092,894 shares issuable upon conversion of
convertible notes owned by CAI Capital Partners & Company II, Limited
Partnership (collectively "CAI"). Mr. Daniels is a principal of both
entities. The address of CAI and Mr. Daniels is 540 Madison Avenue, 22nd
Floor, New York, New York 10022.
(5) Represents 84,500 shares of common stock owned directly by Mr. Daniels.
Does not include 2,780,786 shares issuable upon conversion of shares of
convertible preferred stock and 2,260,198 shares issuable upon conversion
of convertible notes owned by CAI Partners & Company II, Limited
Partnership, and 5,649,293 shares issuable upon conversion of shares of
convertible preferred stock and 4,092,894 shares issuable upon conversion
of convertible notes owned by CAI Capital Partners & Company II, Limited
Partnership (collectively "CAI"). Mr. Daniels is a principal of both
entities. The address of Mr. Daniels is 540 Madison Avenue, 22nd Floor, New
York, New York 10022.
(6) Includes 1,532,885 shares issuable upon conversion of shares of convertible
preferred stock, 226,000 shares of common stock, and 946,799 shares
issuable upon conversion of convertible notes, all owned by Mr. Anderson.
Also includes 1,081,730 shares issuable upon conversion of shares of
convertible preferred stock and 100,000 shares of common stock owned by Mr.
Anderson's spouse as separate property, as to which Mr. Anderson disclaims
beneficial ownership. The address of Mr. Anderson is 16475 Dallas Parkway,
Suite 735, Addison, Texas 77001.
(7) Includes 162,700 shares of common stock, 419,470 shares issuable upon
conversion of shares of convertible preferred stock, and 285,714 shares
issuable upon conversion of convertible notes, all owned by the Burton
Partnership, Limited Partnership ("BPLP"), and 488,100 shares of common
stock, 1,258,415 shares issuable upon conversion of shares of convertible
preferred stock, and 857,143 shares issuable upon conversion of convertible
notes, all owned by the Burton Partnership (QP), Limited Partnership
("QP"). Mr. Donald W. Burton is a principal of both entities. The address
of BPLP, QP and Mr. Burton is P.O. Box 4643, Jackson, Wyoming 83001.
(8) Includes 645,000 shares of common stock held by Dr. Baileys directly,
912,500 shares issuable upon conversion of shares of convertible preferred
stock held by the Baileys Family Trust and affiliated trusts for the
benefit of various relatives of Dr. Baileys, 700,767 shares of common stock
owned by the Baileys Family Trust, 303,000 shares of common stock held in
various trusts for relatives of Dr. Baileys, as to all of which Dr. Baileys
is trustee and for which Dr. Baileys has sole power to vote the securities,
150,000 shares of common stock held by the Alvin and Geraldine Baileys
Foundation, for which Dr. Baileys is an officer and director and for which
Dr. Baileys has shared power to vote the securities, and options to
purchase 200,000 shares of common stock. Dr. Baileys disclaims beneficial
ownership of any of the shares in the trusts or the foundation referenced
above.
(9) Includes 48,000 shares of common stock, 200,000 shares issuable upon
conversion of shares of convertible preferred stock, and options to
purchase 666,667 shares of common stock.
(10) Includes 100,000 shares issuable upon conversion of shares of convertible
preferred stock, and options to purchase 388,333 shares of common stock.
(11) Includes 130,673 shares of common stock, 100,000 shares issuable upon
conversion of shares of convertible preferred stock, and options to
purchase 191,667 shares of common stock.
(12) Includes 21,200 shares of common stock and options to purchase 283,333
shares of common stock.
(13) Includes 6,000 shares of common stock and options to purchase 121,667
shares of common stock.
(14) Includes 724,557 shares of common stock, 985,618 shares issuable upon
conversion of a convertible note, and options to purchase 283,667 shares of
common stock.
36
The following is a summary of the Company's equity compensation plans as of
December 31, 2003:
SHARES OF WEIGHTED NUMBER
STOCK TO BE AVERAGE OF SHARES
ISSUED UPON EXERCISE AVAILABLE
EXERCISE OF PRICE OF FOR ISSUANCE
OUTSTANDING OUTSTANDING UNDER STOCK
STOCK OPTIONS STOCK OPTIONS OPTION PLAN
------------- -------------- ------------
Equity compensation plans approved by stockholders 2,940,334 $ 1.17 1,059,666
Equity compensation plans not approved by
stockholders -- -- --
------------- -------------- ------------
Total 2,940,334 $ 1.17 1,059,666
============= ============== ============
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
- -------------------------------------------------------------
CERTAIN AGREEMENTS
As of January 31, 2001, in connection with the completion of a recapitalization
transaction, the Company and certain stockholders, including CAI Partners and
Company II, L.P., CAI Capital Partners and Company II, L.P., Jack R. Anderson,
John Hancock Life Insurance Company and the Baileys Family Trust (collectively,
the "Investors"), entered into an Agreement Among Stockholders which, among
other things, provides that the Investors will vote their shares of capital
stock of the Company to maintain the size of the board of directors of the
Company at seven (7) members and also contains provisions requiring the
Investors to sell their shares of capital stock in the Company under certain
conditions applicable to an acquisition of all outstanding shares of capital
stock of the Company by a third party. In addition, as of January 31, 2001, the
Company entered into a Registration Rights Agreement with the Investors, under
which it granted certain registration rights to the Investors with respect to
all shares of common stock owned by the Investors and into which the convertible
preferred stock owned by the Investors is convertible. See Note 9 to the
accompanying consolidated financial statements for more information on the
recapitalization transaction.
CONSULTING SERVICES
The Company paid $10,000, $153,000 and $200,000 of consulting fees to the
chairman of its board of directors during the years ended December 31, 2003,
2002 and 2001, respectively. This consulting arrangement terminated effective
January 31, 2003.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
- ------------------------------------------------
The Company's principal accountant is Deloitte & Touche LLP ("Deloitte"). The
aggregate fees billed by Deloitte, the member firms of Deloitte Touche Tohmatsu,
and their respective affiliates, for professional services rendered for the
years ended December 31, 2003 and 2002 are as shown below.
2003 2002
-------- --------
Audit fees $309,500 $232,000
Audit related fees, which consist of fees for the audit
of the Company's 401(k) plan 15,000 14,600
Tax services 22,500 20,000
-------- --------
Total fees $347,000 $266,600
======== ========
The Audit Committee must approve in advance any significant audit or non-audit
engagement or relationship between the Company and its independent public
accountants. As a result, the Audit Committee pre-approved the provision of
audit related services and tax services provided by Deloitte as described above.
The
37
Audit Committee has determined that the provision of certain non-audit services
by Deloitte is compatible with maintaining Deloitte's independence.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
- --------------------------------------------------------------------------
(a) FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, AND EXHIBITS
The consolidated financial statements and financial statement schedule of
SafeGuard Health Enterprises, Inc. filed as part of this 2003 Annual Report on
Form 10-K are listed in the accompanying Index to Financial Statements on Page
F-1. An "Exhibit Index" is included in this 2003 Annual Report on Form 10-K
beginning on Page E-1. All Exhibits are either attached hereto or are on file
with the Securities and Exchange Commission.
(b) REPORTS ON FORM 8-K
The Company filed a Current Report on Form 8-K/A on January 13, 2004, which
amended the Current Report on Form 8-K filed on November 7, 2003, which reported
the completion of the acquisition of HN Dental, HN Vision and the related dental
and vision PPO/indemnity business effective October 31, 2003. The report on Form
8-K/A included the financial information required under Item 7 of Form 8-K.
38
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
SAFEGUARD HEALTH ENTERPRISES, INC.
By: /s/ James E. Buncher Date: April 12, 2004
----------------------- --------------------
James E. Buncher
President, Chief Executive Officer and Director
(Principal Executive Officer)
By: /s/ Dennis L. Gates Date: April 12, 2004
----------------------- --------------------
Dennis L. Gates
Senior Vice President, Chief Financial Officer and Director
(Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, the
following persons have signed this report below on behalf of the registrant and
in the capacities and on the dates indicated.
By: /s/ James E. Buncher Date: April 12, 2004
----------------------- --------------------
James E. Buncher
President, Chief Executive Officer
and Director
By: /s/ Steven J. Baileys Date: April 12, 2004
------------------------ --------------------
Steven J. Baileys
Chairman of the Board of Directors
By: /s/ Ronald I. Brendzel Date: April 12, 2004
------------------------- --------------------
Ronald I. Brendzel
Senior Vice President, General Counsel,
Secretary and Director
By: /s/ Dennis L. Gates Date: April 12, 2004
---------------------- --------------------
Dennis L. Gates
Senior Vice President, Chief Financial
Officer and Director
By: /s/ Neil R. Anderson Date: April 12, 2004
----------------------- --------------------
Neil R. Anderson
Director
By: /s/ Stephen J. Blewitt Date: April 12, 2004
------------------------- --------------------
Stephen J. Blewitt
Director
By: /s/ Leslie B. Daniels Date: April 12, 2004
------------------------ --------------------
Leslie B. Daniels
Director
39
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------- ----------------------------------------------------------------------------------------------------
2.1 Plans of Acquisition (5)
3.1 Articles of Incorporation (3)
3.1.1 Amended and Restated Certificate of Incorporation (11)
3.1.2 Amended and Restated Certificate of Incorporation (15)
3.1.3 Amended and Restated Certificate of Incorporation (17)
3.1.4 Certificate of Designation of Preferred Stock (11)
3.1.5 2002 Certificate of Designation of Preferred Stock
3.1.6 Amendment to Restated Certificate of Incorporation (22)
3.2 Amended and Restated Bylaws (19)
10.1 1984 Stock Option Plan (2)
10.2 Stock Option Plan Amendment (1)
10.3 Stock Option Plan Amendment (3)
10.4 Stock Option Plan Amendment (4)
10.5 2000 Stock Option Plan Amendment (12)
10.5.1 Amended and Restated Stock Option Plan (17)
10.5.2 2003 Stock Option Plan Amendment (22)
10.6 Form of Employment Agreement between the Company and the Named Executive Officers (12)
10.7 Form of Rights Agreement, dated as of March 22, 1996, between the Company and American
StockTransfer and Trust Company, as Rights Agent (5)
10.8 Default Forbearance Agreement and Irrevocable Power of Attorney (6)
10.9 First Waiver and Amendment to Note Purchase Agreement (7)
10.10 Amended and Restated Loan and Security Agreement (7)
10.11 Debenture and Note Purchase Agreement (8)
10.12 Stockholder Agreement (8)
10.13 First Amendment to Debenture and Note Purchase Agreement (9)
10.14 Second Amendment to Debenture and Note Purchase Agreement (9)
10.15 Term Sheet Agreement dated as of March 1, 2000 (10)
10.16 Loan Document and Purchase Agreement (11)
10.17 Agreement among Stockholders and the Company (11)
10.18 Registration Rights Agreement between certain Stockholders and the Company (11)
10.19 Consulting Agreement between the Company and Steven J. Baileys (12)
10.20 Asset Purchase Agreement between the Company and Total Dental Administrators Health Plan, Inc.
(13)
10.21 Administrative Services Agreement between the Company and Total Dental Administrators Health
Plan, Inc. (13)
10.22 Stock Purchase Agreement between the Company and Total Dental Administrators, Inc. (13)
10.23 Promissory Note and Security Interest given by Total Dental Administrators, Inc. to the Company (13)
10.24 Administrative Services Agreement between the Company and Total Dental Administrators, Inc. (13)
10.25 Stock Purchase Agreement between the Company and Dental Source of Missouri and Kansas, Inc. (13)
10.26 First Amendment to Stock Purchase Agreement between the Company and Dental Source of Missouri
and Kansas, Inc. (13)
10.27 Administrative Services Agreement between the Company and Dental Source of Missouri and Kansas,
Inc. (13)
10.28 Amended and Restated 401(k) Plan (13)
10.29 First Amendment to Amended and Restated 401(k) Plan (13)
10.30 Stock Purchase Agreement dated as of April 24, 2002 by and between the Company and Nicholas M.
Kavouklis (14)
10.31 First Amendment to Stock Purchase Agreement dated as of June 17, 2002 between the Company and
Nicholas M. Kavouklis (16)
10.32 Secured Convertible Promissory Note dated as of August 30, 2002 issued by the Company to Nicholas
M. Kavouklis in connection with Exhibit 10.31 above (16)
E-1
10.33 Registration Rights Agreement dated as of August 30, 2002 between the Company and Nicholas M.
Kavouklis in connection with Exhibit 10.31 above (16)
10.34 Employment Agreement dated as of August 30, 2002 between the Company and Nicholas M.
Kavouklis (16)
10.35 Lease Agreement dated as of August 30, 2002 between the Company and an affiliate of Nicholas M.
Kavouklis (16)
10.36 Pledge Agreement dated as of August 30, 2002 between the Company and Nicholas M. Kavouklis in
connection with Exhibit 10.31 above (16)
10.37 Guarantee Agreement dated as of August 30, 2002 between the Company and an affiliate of Nicholas
M. Kavouklis in connection with Exhibit 10.35 above (16)
10.38 Stipulation and Settlement dated as of September 17, 2002 of stockholder class action lawsuit filed
against the Company in 1999 (17)
10.39 Order Preliminarily Approving Settlement, providing for notice to the class, and scheduling final
approval of settlement dated as of September 19, 2002 (17)
10.40 Convertible Promissory Note dated as of August 8, 2002 issued by the Company to Jack R. Anderson
(18)
10.41 Registration Rights Agreement dated as of August 8, 2002 between the Company and Jack R.
Anderson (18)
10.42 Stock Purchase Agreement dated as of January 15, 2003 between a subsidiary of the Company and
Ameritas Life Insurance Company for the purchase of Ameritas Managed Dental Plan, Inc. (20)
10.43 Purchase and Sale Agreement dated as of April 7, 2003 between the Company and Health Net, Inc.
relating to the sale of Health Net Dental, Inc. (21)
10.44 Network Access Agreement dated as of April 7, 2003 between the Company and Health Net, Inc. (21)
10.45 Assumption and Indemnity Reinsurance Agreement dated as of April 7, 2003 between the Company
and a subsidiary of Health Net, Inc. (21)
10.46 Strategic Relationship Agreement dated as of April 7, 2003 between the Company and Health Net, Inc.
(21)
10.47 Amendment to Promissory Note dated as of May 6, 2003 between the Company and Jack R. Anderson
(22)
10.48 Purchase and Sale Agreement dated as of June 30, 2003, between the Company and Health Net, Inc.
relating to the sale of Health Net Vision, Inc. (23)
10.49 Assumption and Indemnity Reinsurance Agreement dated as of June 30, 2003 between the Company
and a subsidiary of Health Net, Inc. (23)
10.50 Network Access Agreement dated as of June 30, 2003 between the Company and Health Net, Inc. (23)
10.51 Administrative Services Agreement dated as of June 30, 2003 between the Company and Health Net,
Inc. (23)
10.54 Amendment to Purchase and Sale Agreement dated as of October 31, 2003 between the Company and
Health Net, Inc. relating to the sale of Health Net Dental, Inc. (24)
10.55 Amendment to Assumption and Indemnity Reinsurance Agreement dated as of October 31, 2003
between the Company and Health Net, Inc. relating to the sale of Health Net Dental, Inc. (24)
10.56 Amendment to Purchase and Sale Agreement dated as of October 31, 2003 between the Company and
Health Net, Inc. relating to the sale of Health Net Vision, Inc. (24)
10.57 Amendment to Assumption and Indemnity Reinsurance Agreement dated as of October 31, 2003
between the Company and Health Net, Inc. relating to the sale of Health Net Vision, Inc. (24)
10.58 Form of 6% Promissory Note used by the Company in connection with the financing of the acquisition
of Health Net Dental, Inc., and Health Net Vision, Inc. (24)
10.59 Amended Credit Agreement and Termination of Registration Rights Agreement dated as of December
3, 2003 between the Company and Nicholas M. Kavouklis
10.60 Amended and Restated Promissory Note dated as of December 3, 2003 between the Company and
Nicholas M. Kavouklis
21.1 Subsidiaries of the Company
23.1 Independent Auditors' Consent
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32 Certification Pursuant to 18 U.S.C. Section 1350
_________________________________________
(1) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Registration Statement on Form S- 1 filed as of September 12,
1983 (File No. 2-86472).
(2) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Registration Statement on Form S-1 filed as of July 3, 1984
(File No. 2-92013).
E-2
(3) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Annual Report of Form 10-K for the year ended December 31,
1989.
(4) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Annual Report of Form 10-K for the year ended December 31,
1992.
(5) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of September 27, 1996.
(6) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Annual Report on Form 10-K for the year ended December 31,
1998.
(7) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of June 4, 1999.
(8) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of June 30, 1999.
(9) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of October 5, 1999.
(10) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of March 16, 2000.
(11) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of March 6, 2001.
(12) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Annual Report on Form 10-K for the year ended December 31,
2000.
(13) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Annual Report on Form 10-K for the year ended December 31,
2001.
(14) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of April 24, 2002.
(15) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Registration Statement on Form S-8 filed as of August 30,
2002 (File No. 33-2226).
(16) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of August 30, 2002.
(17) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of September 19, 2002.
(18) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Quarterly Report on Form 10-Q for the quarter ended September
30, 2002.
(19) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Annual Report on Form 10-K for the year ended December 31,
2002.
(20) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of February 14, 2003.
(21) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of April 25, 2003.
(22) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Quarterly Report on Form 10-Q for the quarter ended June 30,
2003.
(23) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of June 30, 2003.
(24) Incorporated by reference herein and disclosed and filed as an exhibit to
the Company's Current Report on Form 8-K dated as of November 1, 2003.
E-3
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 2003
PAGE
-----------
Independent Auditors' Report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . F-2
Financial Statements:
Consolidated Balance Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . F-3
Consolidated Statements of Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . F-4
Consolidated Statements of Stockholders' Equity (Deficit) and Other Comprehensive Income F-5
Consolidated Statements of Cash Flows. . . . . . . . . . . . . . . . . . . . . . . . . . F-6
Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . F-8 to F-33
Financial Statement Schedule:
Schedule II - Valuation and Qualifying Accounts. . . . . . . . . . . . . . . . . . . . . F-34
F-1
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of SafeGuard Health Enterprises,
Inc.:
We have audited the accompanying consolidated balance sheets of SafeGuard Health
Enterprises, Inc. and subsidiaries (the "Company") as of December 31, 2003 and
2002, and the related consolidated statements of income, stockholders' equity
(deficit) and other comprehensive income, and cash flows for each of the three
years in the period ended December 31, 2003. Our audits also included the
consolidated financial statement schedule for the years ended December 31, 2003,
2002 and 2001, included in the Index at Item 15(a)(2). These consolidated
financial statements and consolidated financial statement schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on the consolidated financial statements and consolidated financial
statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of SafeGuard Health Enterprises, Inc.
and subsidiaries as of December 31, 2003 and 2002, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2003, in conformity with accounting principles generally accepted
in the United States of America. Also, in our opinion, such consolidated
financial statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly, in all
material respects, the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, the Company
changed its method of accounting for goodwill and other intangible assets as a
result of adopting Statement of Financial Accounting Standards No. 142, Goodwill
and Other Intangible Assets, effective January 1, 2002.
DELOITTE & TOUCHE LLP
Costa Mesa, California
March 26, 2004
F-2
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2003 AND 2002
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
2003 2002
--------- ---------
ASSETS
Current assets:
Cash and cash equivalents $ 3,201 $ 3,036
Investments available-for-sale, at fair value 24,998 9,668
Accounts receivable, net of allowances of $544 in 2003 and $325 in 2002 5,486 2,554
Deferred tax assets, net of valuation allowance of $212 in 2003 1,871 --
Other current assets 1,548 853
--------- ---------
Total current assets 37,104 16,111
Property and equipment, net of accumulated depreciation and amortization 4,823 3,532
Restricted investments available-for-sale, at fair value 2,932 3,254
Goodwill 12,365 8,590
Intangible assets, net of accumulated amortization 9,862 2,013
Deferred tax assets, net of valuation allowance of $388 in 2003 3,432 --
Other assets 720 614
--------- ---------
Total assets $ 71,238 $ 34,114
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,716 $ 1,661
Accrued expenses 7,919 3,526
Current portion of long-term debt and capital lease obligations 313 2,430
Claims payable and claims incurred but not reported 10,109 4,690
Deferred premium revenue 3,531 1,786
--------- ---------
Total current liabilities 23,588 14,093
Long-term debt and capital lease obligations 22,537 2,997
Other long-term liabilities 1,223 1,013
Commitments and contingencies (Note 12)
Stockholders' equity:
Convertible preferred stock and additional paid-in capital - $0.01 par value;
31,000,000 shares authorized; 30,000,000 shares issued and outstanding
in 2003 and 2002; liquidation preference of $30 million 41,250 41,250
Common stock and additional paid-in capital - $0.01 par value;
54,000,000 shares authorized; 8,970,000 shares and 8,900,000 shares
issued in 2003 and 2002, respectively; 5,753,000 shares and 5,683,000 shares
outstanding in 2003 and 2002, respectively 22,766 22,662
Retained earnings (accumulated deficit) (22,357) (30,170)
Accumulated other comprehensive income 57 95
Treasury stock - at cost; 3,217,000 shares in 2003 and 2002 (17,826) (17,826)
--------- ---------
Total stockholders' equity 23,890 16,011
--------- ---------
Total liabilities and stockholders' equity $ 71,238 $ 34,114
========= =========
See accompanying Notes to Consolidated Financial Statements.
F-3
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(IN THOUSANDS, EXCEPT PER SHARE DATA)
2003 2002 2001
--------- -------- --------
Premium revenue, net $104,891 $83,043 $84,822
Health care services expense 73,194 57,937 58,692
Selling, general and administrative expense 28,684 24,874 25,391
--------- -------- --------
Operating income 3,013 232 739
Investment and other income 490 607 1,060
Interest expense on debt that was converted to equity in 2001 -- -- (402)
Other interest expense (530) (232) (102)
--------- -------- --------
Income before income taxes and extraordinary item 2,973 607 1,295
Income tax benefit (4,840) (820) --
--------- -------- --------
Income before extraordinary item 7,813 1,427 1,295
Extraordinary item:
Gain on conversion of debt to convertible preferred stock -- -- 11,251
--------- -------- --------
Net income $ 7,813 $ 1,427 $12,546
========= ======== ========
Basic net income per share:
Income before extraordinary item $ 0.22 $ 0.04 $ 0.04
Extraordinary item -- -- 0.35
--------- -------- --------
Net income $ 0.22 $ 0.04 $ 0.39
========= ======== ========
Weighted average basic shares outstanding 35,719 35,130 32,253
Diluted net income per share:
Income before extraordinary item $ 0.20 $ 0.04 $ 0.04
Extraordinary item -- -- 0.34
--------- -------- --------
Net income $ 0.20 $ 0.04 $ 0.38
========= ======== ========
Weighted average diluted shares outstanding 40,244 35,638 33,009
See accompanying Notes to Consolidated Financial Statements.
F-4
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) AND
OTHER COMPREHENSIVE INCOME
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(IN THOUSANDS)
ACCUMU-
NUMBER OF SHARES PREFERRED COMMON RETAINED LATED
----------------------------- STOCK AND STOCK AND EARNINGS OTHER
COMMON ADDITIONAL ADDITIONAL (ACCUMU- COMPRE-
------------------ PAID-IN PAID-IN LATED HENSIVE TREASURY
PREFERRED ISSUED TREASURY CAPITAL CAPITAL DEFICIT) INCOME STOCK TOTAL
--------- ------- --------- ----------- ------------ ---------- --------- ---------- ---------
Balance, January 1, 2001 -- 8,022 (3,275) 21,829 (44,254) 119 (18,123) (40,429)
Net income -- -- -- -- -- 12,546 -- -- 12,546
Other comprehensive
income:
Net unrealized losses on
investments available- (56) (56)
for-sale
---------
Total comprehensive income 12,490
Issuance of preferred 30,000 -- -- 41,250 -- -- -- -- 41,250
stock
Cancellation of stock -- -- -- -- (320) 320 -- -- --
warrants (1)
Repurchase of common stock -- -- (10) -- -- -- -- (10) (10)
Reissuance of treasury
stock in
contribution to -- -- 18 -- -- (59) -- 81 22
retirement plan
Exercise of stock options -- 43 -- -- 43 -- -- -- 43
--------- ------- --------- ----------- ------------ ---------- --------- ---------- ---------
Balance, December 31, 2001 30,000 8,065 (3,267) 41,250 21,552 (31,447) 63 (18,052) 13,366
Net income -- -- -- -- -- 1,427 -- -- 1,427
Other comprehensive
income:
Net unrealized gains on
investments available- 32 32
for-sale
---------
Total comprehensive income 1,459
Issuance of common stock -- 786 -- -- 1,061 -- -- -- 1,061
Reissuance of treasury
stock in
contribution to -- -- 50 -- -- (150) -- 226 76
retirement plan
Exercise of stock options -- 49 -- -- 49 -- -- -- 49
--------- ------- --------- ----------- ------------ ---------- --------- ---------- ---------
Balance, December 31, 2002 30,000 8,900 (3,217) 41,250 22,662 (30,170) 95 (17,826) 16,011
Net income -- -- -- -- -- 7,813 -- -- 7,813
Other comprehensive
income:
Net unrealized losses on
investments available- (38) (38)
for-sale
---------
Total comprehensive income 7,775
Issuance of common stock -- 70 -- -- 104 -- -- -- 104
--------- ------- --------- ----------- ------------ ---------- --------- ---------- ---------
Balance, December 31, 2003 30,000 8,970 (3,217) $ 41,250 $ 22,766 $ (22,357) $ 57 $ (17,826) $ 23,890
========= ======= ========= =========== ============ ========== ========= ========== =========
(1) These warrants were canceled without being exercised as of January 31, 2001, in connection with the conversion
of the Senior Notes Payable to convertible preferred stock, as discussed in Note 9.
See accompanying Notes to Consolidated Financial Statements.
F-5
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(IN THOUSANDS)
2003 2002 2001
--------- -------- ---------
Cash flows from operating activities:
Net income $ 7,813 $ 1,427 $ 12,546
Adjustments to reconcile net income to net
cash provided by (used in) operating activities:
Gain on conversion of debt to convertible preferred stock -- -- (11,251)
Deferred income tax benefit (4,887) -- --
Loss on impairment of assets -- 334 --
Bad debt expense 476 220 245
Depreciation and amortization 2,110 1,474 1,862
Gain or loss on sale or disposal of assets (19) (16) (276)
Contribution to retirement plan in the form
of common stock, at fair value 118 87 51
Changes in operating assets and liabilities, net of
effects of acquisitions:
Accounts receivable (479) 103 (306)
Other current assets 203 241 685
Other assets (196) 69 58
Accounts payable (61) (653) (144)
Accrued expenses 1,126 (1,271) (2,063)
Claims payable and claims incurred but not reported 632 (1,440) (1,649)
Deferred premium revenue (421) 607 (469)
--------- -------- ---------
Net cash provided by (used in) operating activities 6,415 1,182 (711)
Cash flows from investing activities:
Purchases of investments available-for-sale (24,610) (3,448) (15,599)
Proceeds from sale/maturity of investments available-for-sale 13,177 7,334 16,878
Cash paid for acquisitions of businesses, net of cash acquired (10,028) (2,708) --
Purchases of property and equipment (1,436) (444) (1,109)
Additions to intangible assets (125) -- --
Payments received on notes receivable 114 14 1,320
Proceeds from sale of subsidiary -- 77 --
--------- -------- ---------
Net cash (used in) provided by investing activities (22,908) 825 1,490
Cash flows from financing activities:
Borrowings on long-term debt 19,000 2,000 --
Increase in accrued interest that was converted to equity in 2001 -- -- 321
Payments on debt and capital lease obligations (2,089) (1,663) (235)
Decrease in bank overdrafts (463) (896) (674)
Repurchase of common stock -- -- (10)
Exercise of stock options -- 49 43
Increase (decrease) in other long-term liabilities 210 42 (108)
--------- -------- ---------
Net cash provided by (used in) financing activities 16,658 (468) (663)
--------- -------- ---------
Net increase in cash and cash equivalents 165 1,539 116
Cash and cash equivalents at beginning of year 3,036 1,497 1,381
--------- -------- ---------
Cash and cash equivalents at end of year $ 3,201 $ 3,036 $ 1,497
========= ======== =========
(Continued on next page)
F-6
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(IN THOUSANDS)
2003 2002 2001
--------- -------- -------
Supplementary information:
Cash paid during the year for interest $ 342 $ 207 $ 315
Cash paid during the year for income taxes 125 18 --
Supplementary disclosure of non-cash activities:
Debt converted into convertible preferred stock $ -- $ -- $41,250
Purchases of property and equipment through capital leases 447 1,836 --
Liabilities assumed in acquisitions of businesses:
Fair value of assets acquired, excluding cash $ 16,700 $ 2,670 $ --
Goodwill related to transactions 4,191 4,670 --
Less - Secured convertible note issued to seller -- (2,625) --
Less - Common stock issued in transaction -- (1,040) --
Less - Cash paid in transactions, net of cash acquired (10,028) (2,708) --
--------- -------- -------
Liabilities assumed in acquisitions of businesses $ 10,863 $ 967 $ --
========= ======== =======
See accompanying Notes to Consolidated Financial Statements.
F-7
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
- ------------------------------------------------------------
SafeGuard Health Enterprises, Inc., a Delaware corporation (the "Company"),
provides a wide range of dental benefit plans, vision benefit plans, and other
related products. The Company's operations are primarily in California, Florida
and Texas, but it also operates in several other states. The Company conducts
its operations through several subsidiaries, one of which is an insurance
company that is licensed in several states, and several of which are licensed as
dental or vision health maintenance organization ("HMO") plans in the states in
which they operate. The Company provides dental benefits, vision benefits or
other related products to approximately 1.5 million individuals. The Company has
been providing dental benefit plans in California since the Company was
organized in 1974.
Over 90% of the Company's total premium revenue is derived from providing dental
benefit plans. Under the dental HMO plan designs provided by the Company, a
majority of the total health care services expense consists of capitation
payments to dental service providers, which are fixed monthly payments for each
covered individual. These capitation arrangements limit the amount of risk
assumed by the Company. Under the dental preferred provider organization
("PPO")/indemnity plan designs provided by the Company, all health care services
expense consists of claims that are paid each time a covered individual receives
dental services. Under this type of plan design, the Company assumes all of the
utilization risk. Capitation payments comprised 32%, 33% and 37% of the
Company's total health care services expense during the years ended December 31,
2003, 2002 and 2001, respectively.
BASIS OF PRESENTATION
The consolidated financial statements include all the accounts of the Company
and its subsidiaries. Intercompany accounts and transactions have been
eliminated in consolidation. The Company's consolidated financial statements
were prepared in accordance with accounting principles generally accepted in the
United States of America.
BUSINESS SEGMENT INFORMATION
Management views certain geographic areas as separate operating segments, and
therefore, measures the Company's operating results separately for each of those
geographic areas. The Company provides essentially the same services in all of
the geographic areas in which it operates. For financial reporting purposes, all
the Company's operating segments are aggregated into one reporting segment,
which provides dental benefit plans and other related products to employers,
individuals and other purchasers.
CASH AND CASH EQUIVALENTS
Investments with an original maturity of three months or less are included in
cash equivalents.
RESTRICTED DEPOSITS AND MINIMUM NET WORTH REQUIREMENTS
Several of the Company's subsidiaries are subject to state regulations that
require them to maintain restricted deposits in the form of cash or investments.
The Company had total restricted deposits of $2.9 million and $3.3 million as of
December 31, 2003 and 2002, respectively.
In addition, several of the Company's subsidiaries are subject to state
regulations that require them to maintain minimum amounts of statutory capital
and surplus, and that otherwise restrict the Company's access to the assets of
its regulated subsidiaries. As a result of these regulatory restrictions,
substantially all of the Company's consolidated stockholders' equity as of
December 31, 2003, was not available for distribution to the Company's
stockholders.
INVESTMENTS
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 115,
"Accounting for Certain Investments in Debt and Equity Securities," the Company
has classified its investments as "available-for-sale."
F-8
Investments classified as available-for-sale are carried at fair value, based on
quoted market prices, and unrealized gains and losses, net of applicable income
taxes, are reported in stockholders' equity under the caption "Accumulated other
comprehensive income." In the event there was an unrealized loss on an
investment that the Company believed to be other than temporary, the loss would
be reported in the statement of income, instead of in a separate caption of
stockholders' equity. As of December 31, 2003, there were no unrealized losses
that the Company believed to be other than temporary.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The accompanying consolidated balance sheets include the following financial
instruments as of December 31, 2003: cash and cash equivalents, investments,
accounts receivable, accounts payable, accrued expenses, short-term and
long-term debt, and other long-term liabilities. All of these financial
instruments, except for long-term debt and other long-term liabilities, are
current assets or current liabilities. The Company expects to realize the
current assets, and to pay the current liabilities, within a short period of
time. Therefore, the carrying amount of these financial instruments approximates
fair value. Long-term debt and other long-term liabilities are stated at the
estimated amount of the future payments, which approximates fair value.
PROPERTY AND EQUIPMENT
Property and equipment is recorded at cost. Depreciation and amortization are
calculated using the straight-line method over the estimated useful lives of the
assets. Depreciation of leasehold improvements is calculated based on the
shorter of the estimated useful lives of the assets, or the length of the
related lease. The Company uses the following useful lives to record
depreciation expense: leasehold improvements - 4 to 10 years; computer hardware
and software - 3 to 4 years; and furniture, fixtures and other office equipment
- - 4 to 7 years. The cost of maintenance and repairs is expensed as incurred,
while significant improvements that add functionality to an asset or extend the
estimated useful life of an asset are capitalized. Upon the sale or other
retirement of assets, the cost of any such assets and the related accumulated
depreciation are removed from the books and any resulting gain or loss is
recognized.
GOODWILL
Goodwill as of December 31, 2003 is related to the following acquisitions:
Health Net Dental, Inc. ("HN Dental") and
Health Net Vision, Inc. ("HN Vision") - October 2003 $ 3,181
Paramount Dental Plan, Inc. ("Paramount") - August 2002 5,264
First American Dental Benefits, Inc. ("First American") - October 1996 3,920
-------
Total $12,365
=======
See Note 2 for more information on the HN Dental, HN Vision, and Paramount
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, and in the case of the First American acquisition, the balance is net
of accumulated amortization and an adjustment in 1999 to reduce the carrying
value of the goodwill to its estimated realizable value. The Company estimated
that the goodwill related to the First American acquisition had a useful life of
40 years from the date of acquisition, and amortized the goodwill over that
period through December 31, 2001. See Recently Adopted Accounting Principles
below in Note 1 for information on the Company's adoption of SFAS No. 142,
"Goodwill and Other Intangible Assets," which changed the accounting for
goodwill effective January 1, 2002.
INTANGIBLE ASSETS
Intangible assets as of December 31, 2003 consist of customer relationships,
provider networks and other intangible assets with an aggregate net book value
of $9.9 million, all of which are related to the acquisitions of HN Dental, HN
Vision, Ameritas Managed Dental Plan, Inc. ("Ameritas") and Paramount, which are
discussed in Note 2. The amount of the purchase price in each acquisition that
was allocated to the intangible assets was equal to the Company's estimate of
the fair value of each intangible asset. Each intangible asset is being
amortized over its estimated useful life on a straight-line basis.
F-9
LONG-LIVED ASSETS
In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," long-lived assets are reviewed for events or changes in
circumstances that indicate that their carrying values may not be recoverable.
The Company's principal long-lived assets as of December 31, 2003 are property
and equipment and intangible assets. The Company is not aware of any events or
circumstances that may have impaired the fair value of these long-lived assets.
RECOGNITION OF PREMIUM REVENUE AND COMMISSION EXPENSE
Premium revenue is recognized in the period during which dental or 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 consolidated balance sheets as deferred premium revenue.
In connection with its acquisition of new customers, the Company pays broker and
consultant commissions, which are generally based on a percentage of premium
revenue collected. The Company also pays internal sales commissions, some of
which are based on a percentage of premium revenue collected, and some of which
consist of a one-time payment at the beginning of a customer contract.
Commissions that are based on a percentage of premium revenue collected are
recognized as expenses in the period in which the related premium revenue is
recognized. Commissions that consist of a one-time payment at the beginning of
a customer contract are recognized as expenses at the beginning of the related
customer contract. As stated in SFAS No. 60, "Accounting and Reporting by
Insurance Companies," commissions related to insurance contracts should be
capitalized and charged to expense over the term of the customer contract, in
proportion to premium revenue recognized. In the case of the PPO/indemnity
insurance policies issued by the Company, the customers have the ability to
cancel the policy at any time with 30 days advance written notice. Because of
this ability, one-time commissions paid at the beginning of a customer contract
are charged to expense at the beginning of the related customer contract.
RECOGNITION OF HEALTH CARE SERVICES EXPENSE
Capitation payments to providers are recognized as expense in the period in
which the providers are obligated to deliver the related health care services.
Other payments for health care services are recognized as expense in the period
in which the services are delivered.
The estimated liability for claims payable and claims incurred but not reported
is based primarily on the average historical lag time between the date of
service and the date the related claim is paid by the Company, 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
statements of income for the period in which the differences are identified.
ADMINISTRATIVE SERVICES ARRANGEMENTS
The Company processed approximately $5.2 million, $2.6 million, and $3.2 million
of dental and vision claims under administrative services only ("ASO")
agreements during the years ended December 31, 2003, 2002 and 2001,
respectively. The revenue recognized by the Company from ASO agreements
consists only of the ASO fees received from its clients, and the claims
processed by the Company under ASO agreements are not included in the
accompanying consolidated statements of income.
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
F-10
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 consolidated statements of income. The weighted average fair value
of stock options granted by the Company was $0.90, $0.75, and $1.13 per share
during the years ended December 31, 2003, 2002 and 2001, respectively. Stock
options granted generally become exercisable in equal annual installments over a
three-year period after the date of grant.
The following table shows the pro forma effect of using the fair value method of
accounting for stock options, as described by SFAS No. 123, on the Company's net
income and net income per share (in thousands, except per share amounts):
YEARS ENDED DECEMBER 31,
----------------------------------
2003 2002 2001
---------- ----------- ---------
Net income, as reported $ 7,813 $ 1,427 $ 12,546
Less - Employee compensation expense based on
the fair value method of accounting for stock options (416) (856) (833)
---------- ----------- ---------
Pro forma net income $ 7,397 $ 571 $ 11,713
========== =========== =========
Basic net income per share, as reported $ 0.22 $ 0.04 $ 0.39
Pro forma basic net income per share 0.21 0.02 0.36
Diluted net income per share, as reported $ 0.20 $ 0.04 $ 0.38
Pro forma diluted net income per share 0.19 0.02 0.35
SFAS No. 123 requires a publicly traded entity to estimate the fair value of
stock-based compensation by using an option-pricing model that takes into
account certain facts and assumptions. The facts and assumptions that must be
taken into account are the exercise price, the expected life of the option, the
current stock price, the expected volatility of the stock price, the expected
dividends on the stock, and the risk-free interest rate. The option-pricing
models commonly used were developed to estimate the fair value of freely
tradable, fully transferable options without vesting restrictions, which
significantly differ from the stock options granted by the Company. The Company
estimated the fair value of each stock option as of the date of grant by using
the Black-Scholes option-pricing model. The facts and assumptions used to
determine the fair value of stock options granted were: an average expected life
of four years; expected volatility of 75% in 2003, 82% in 2002, and 160% in
2001; no expected dividends; and a risk-free interest rate of approximately 2.2%
in 2003, 2.0% in 2002, and 3.8% in 2001. The assumptions regarding the expected
life of the options and the expected volatility of the stock price are
subjective, and these assumptions have a significant effect on the estimated
fair value amounts.
INCOME TAXES
The Company's accounting for income taxes is in accordance with SFAS No. 109,
"Accounting for Income Taxes." SFAS No. 109 requires the recognition of deferred
tax liabilities and assets for the expected future tax consequences of events
that are recognized in the Company's consolidated financial statements in
different periods than those in which the events are recognized in the Company's
tax returns. The measurement of deferred tax liabilities and assets is based on
current tax laws as of the balance sheet date. The Company records a valuation
allowance related to deferred tax assets in the event that available evidence
indicates that the future tax benefits related to the deferred tax assets may
not be realized. A valuation allowance is required when it is more likely than
not that the deferred tax assets will not be realized.
F-11
RELATED PARTY TRANSACTIONS
See Notes 2 and 8 for information on $19.0 million of unsecured convertible
promissory notes that were issued to certain of the Company's principal
stockholders in October 2003 in connection with the Company's acquisition of HN
Dental and HN Vision effective October 31, 2003.
See Notes 2 and 8 for information on a secured convertible promissory note
payable to a member of the Company's senior management, the outstanding balance
of which was $1.6 million as of December 31, 2003. The convertible note was
issued in September 2002 in connection with the acquisition of Paramount, and
the former owner of Paramount is currently a member of the Company's senior
management.
See Note 8 for information on an unsecured convertible promissory note payable
to one of the Company's principal stockholders, the outstanding balance of which
was $1.5 million as of December 31, 2003. The note was issued in August 2002 to
obtain working capital for various purposes.
The Company paid $10,000, $153,000 and $200,000 of consulting fees to the
chairman of its board of directors during the years ended December 31, 2003,
2002 and 2001, respectively.
ADVERTISING
Advertising expense was $148,000, $185,000, and $110,000 for the years ended
December 31, 2003, 2002 and 2001, respectively.
USE OF ESTIMATES IN FINANCIAL STATEMENTS
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities, and the
reported amounts of revenues and expenses. Actual results could differ from
those estimates.
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 holders
of the convertible preferred stock participate in any dividends paid on the
Company's common stock on an as-converted basis, and because the Company
believes the convertible preferred stock is a participating security that 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 years ended December 31, 2003, the
potentially dilutive securities of the Company that were outstanding consisted
of convertible notes, stock options, and warrants. See Note 8 for information on
convertible notes that were outstanding during 2003 and 2002. The calculation of
diluted net income per share for 2003 includes the effect of all the outstanding
convertible notes. Each of these convertible notes would have an anti-dilutive
effect on net income per share in 2002, and accordingly, they are excluded from
the calculation of diluted net income per share for this period. The calculation
of diluted net income per share for 2003, 2002 and 2001 includes the effect of
all outstanding stock options with an exercise price below the average market
price of the Company's common stock during each period. The only warrants issued
by the Company were canceled without being exercised effective January 31, 2001,
as discussed in Note 9.
F-12
The differences between weighted average basic shares outstanding and weighted
average diluted shares outstanding in each of the three years ended December 31,
2003, are as follows (in thousands):
2003 2002 2001
------ ------ ------
Weighted average basic shares outstanding 35,719 35,130 32,253
Effect of convertible notes 3,806 -- --
Effect of dilutive stock options 719 508 756
------ ------ ------
Weighted average diluted shares outstanding 40,244 35,638 33,009
====== ====== ======
For purposes of computing the net income per diluted share of common stock, the
Company's net income was adjusted as follows (in thousands):
2003 2002 2001
------ ------ -------
Net income, as reported $7,813 $1,427 $12,546
Interest expense on convertible notes, net of tax effect 272 -- --
------ ------ -------
Adjusted Net Income $8,085 $1,427 $12,546
====== ====== =======
RECENTLY ADOPTED ACCOUNTING PRINCIPLES
Effective January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other
Intangible Assets." SFAS No. 142 requires that goodwill and other intangible
assets with indefinite useful lives not be amortized. SFAS No. 142 also requires
that all goodwill be evaluated for possible impairment as of January 1, 2002, on
an annual basis thereafter, and any time an event that may have affected the
value of the goodwill occurs. SFAS No. 142 also establishes a new method of
testing goodwill for possible impairment. The adoption of SFAS No. 142 had no
significant effect on the Company's consolidated financial statements. See Notes
5 and 6 for more information.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets." SFAS No. 144 supersedes SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of," and APB No. 30, "Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual, and Infrequently Occurring Events and Transactions." SFAS No. 144
establishes accounting and reporting standards for the impairment or disposal of
long-lived assets, and for reporting the results of discontinued operations. The
Company adopted SFAS No. 144 effective January 1, 2002. The adoption of SFAS No.
144 had no significant effect on the Company's consolidated financial
statements.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections."
SFAS No. 145 updates, clarifies, and simplifies existing accounting
pronouncements. 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 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 October 2002, the Emerging Issues Task Force ("EITF") of the FASB issued EITF
02-17, which addresses issues raised in the interpretation of SFAS No. 141,
"Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible
Assets," and the identification and valuation of intangible assets. EITF 02-17
provides guidance on determining when, as a result of a business combination, a
customer-related intangible asset exists that should be separately valued from
goodwill. EITF No. 02-17 is effective for business combinations consummated and
goodwill impairment tests performed after October 25, 2002. The adoption of EITF
02-17 had no significant effect on the Company's consolidated financial
statements.
F-13
In November 2002, the FASB issued FASB Interpretation ("FIN") No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others." FIN No. 45 is an interpretation
of FASB Statements No. 5, 57, and 107, and a rescission of FIN No. 34,
"Disclosure of Indirect Guarantees of Indebtedness of Others." FIN No. 45
requires that a guarantor recognize a liability for the fair value of certain
types of guarantees, at the time the guarantee is initially made. It also
elaborates on the financial statement disclosures to be made by a guarantor
about its obligations under certain types of guarantees. The initial
recognition and measurement provisions of this interpretation are applicable on
a prospective basis to guarantees issued or modified after December 31, 2002.
The disclosure requirements are effective for financial statements for periods
ending after December 15, 2002. The adoption of FIN No. 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, "Accounting for Stock-Based Compensation." 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 of SFAS No. 148 had no significant
effect on the Company's consolidated financial statements.
In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest
Entities," an interpretation of Accounting Research Bulletin No. 51. FIN No. 46
requires that variable interest entities be consolidated by the investing
company if the investing company is obligated to absorb a majority of the losses
incurred by the variable interest entity, or is entitled to receive a majority
of the profits earned by the entity, or both. The consolidation requirements of
FIN No. 46 are effective for all periods with respect variable interest entities
that are created after January 31, 2003. The consolidation requirements with
respect to variable interest entities created prior to February 1, 2003 are
effective for periods beginning after June 15, 2003. The adoption of FIN No. 46
had no significant effect on the Company's consolidated financial statements. In
December 2003, the FASB issued FIN No. 46R, which revised the implementation
date for FIN No. 46 with respect to variable interest entities created prior to
January 31, 2003, among other things. The adoption of FIN No. 46R had no
significant effect on the Company's consolidated financial statements.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 is effective for
contracts and hedging relationships entered into or modified after June 30,
2003. The adoption of SFAS No. 149 had no significant effect on the Company's
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 establishes
standards for how an issuer classifies and measures certain financial
instruments that have characteristics of both debt and equity, and requires an
issuer to classify certain instruments as liabilities in its balance sheet. 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. In November 2003, the
FASB issued FASB Staff Position No. 150-3 ("FSP 150-3"), which deferred the
effective dates for applying certain provisions of SFAS No. 150 related to
mandatorily redeemable financial instruments. The adoption of FSP 150-3 had no
significant effect on the Company's consolidated financial statements.
RECLASSIFICATION
Certain amounts in the financial statements for prior years have been
reclassified to conform to the current year presentation.
NOTE 2. ACQUISITIONS
- ----------------------
HEALTH NET DENTAL, INC. AND HEALTH NET VISION, INC.
Effective October 31, 2003, the Company acquired all of the outstanding capital
stock of HN Dental, which is a California dental HMO, and certain PPO/indemnity
dental business underwritten by Health Net Life Insurance
F-14
Company ("HN Life"), which was formerly an affiliate of HN Dental, for $10.7
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 former 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 HN Vision, which is a California vision HMO and a former affiliate of HN
Dental, and certain PPO/indemnity vision business underwritten by HN Life, for
$4.5 million in cash. The combined revenue of the acquired businesses was
approximately $61 million during the ten months ended October 31, 2003. The
operations of HN Dental, HN Vision, and the related dental and vision
PPO/indemnity business are included in the Company's consolidated financial
statements beginning on November 1, 2003.
The dental and vision PPO/indemnity business referred to above was transferred
to the Company through two Assumption and Indemnity Reinsurance Agreements with
HN Life (the "Agreements"). In connection with the Agreements, the Company
assumed an estimated amount of claims payable and claims incurred but not
reported, and certain other assets and liabilities, in exchange for a cash
payment from HN Life. Also in connection with the Agreements, the Company and HN
Life agreed to adjust the cash payment approximately six months after the
effective date of the Agreements, based on subsequent payment of claims,
subsequent collection of receivables, and other information that becomes
available to the parties during the six months after the effective date.
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 the Company's principal
stockholders in October 2003. The proceeds from the convertible notes were used
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, which is estimated to be $3.8 million, to provide working
capital that may be required in connection with the integration of the acquired
businesses into the Company's pre-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, provided that it redeems all
the convertible notes held by each holder for which it redeems any of the notes.
F-15
The aggregate cost of the acquisitions was allocated among the assets acquired
as follows (in thousands):
Cost of acquisitions:
Cash purchase price, including estimated post-closing adjustments $15,158
Transaction expenses incurred by the Company 68
--------
Total cost $15,226
========
Fair value of net assets acquired (liabilities assumed):
Cash and cash equivalents $ 5,672
Investments, including restricted investments 3,147
Accounts receivable 2,864
Property and equipment 795
Goodwill 4,191
Intangible assets 7,768
Other assets 1,110
Accounts payable (537)
Accrued expenses (3,121)
Claims payable and claims incurred but not reported (4,755)
Deferred premium revenue (1,908)
--------
Net assets acquired $15,226
========
The intangible assets acquired consist of the following (in thousands):
WEIGHTED
AVERAGE
AMOUNT AMORTIZATION
ALLOCATED PERIOD
---------- ------------
Customer relationships $ 5,237 6.2 years
Provider networks 2,230 20.0 years
Other intangible assets 301 11.7 years
----------
Total $ 7,768 10.4 years
==========
The Company plans to make an election under Section 338 of the Internal Revenue
Code to treat the acquisition of HN Dental as an asset purchase for tax
purposes. Assuming this election is made, the Company estimates that
approximately $8.9 million of goodwill and intangible assets related to the HN
Dental and HN Vision acquisitions will be amortized over 15 years on a
straight-line basis for income tax purposes.
AMERITAS MANAGED DENTAL PLAN, INC.
Effective March 31, 2003, the Company acquired all of the outstanding capital
stock of Ameritas for $1.0 million in cash, including a post-closing adjustment,
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 December 31, 2003, the Company has accrued a total of $301,000 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 December 31, 2003, plus
the estimated contingent monthly payments related to the remaining portion of
annual customer contracts that are in force as of January 1, 2004. 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 December 31, 2003, from customers of
Ameritas that existed as of March 31, 2003, the maximum aggregate amount of the
contingent monthly payments would be approximately $1.5 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. The operations of
Ameritas are included in the Company's consolidated financial statements
beginning on April 1, 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
F-16
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 cost of the acquisition was allocated among the assets acquired as follows
(in thousands):
Cost of acquisition:
Cash purchase price, net of post-closing adjustments $1,034
Contingent purchase price accrued as of December 31, 2003 301
-------
Total cost $1,335
=======
Fair value of net assets acquired (liabilities assumed):
Cash and cash equivalents $ 276
Investments 465
Intangible assets 810
Other assets 150
Deferred premium revenue (258)
Other current liabilities (108)
-------
Total cost of acquisition $1,335
=======
The intangible assets acquired consist of the following (in thousands):
WEIGHTED
AVERAGE
AMOUNT AMORTIZATION
ALLOCATED PERIOD
---------- ------------
Customer relationships $ 635 9.5 years
Other intangible assets 175 10.8 years
----------
Total $ 810 9.8 years
==========
The Company estimates that approximately $0.1 million of the intangible assets
related to the acquisition of Ameritas will be amortized over 15 years on a
straight-line basis for income tax purposes.
PARAMOUNT DENTAL PLAN, INC.
Effective August 30, 2002, the Company acquired all of the outstanding capital
stock of Paramount for approximately $6.7 million, consisting of $3.0 million in
cash, a secured convertible note for $2,625,000, and 769,231 shares of the
Company's common stock. Paramount was a dental benefits company located in
Florida, and was merged into the Company's Florida dental HMO subsidiary
effective August 30, 2002. The secured convertible note bears interest at 7.0%
annually, and was originally payable in 36 equal monthly installments of
principal and interest, beginning in October 2002. The terms of the note were
amended in the fourth quarter of 2003, and the outstanding balance is now
payable in monthly installments of interest only until a date to be specified by
the holder of the convertible note at least 90 days in advance of such date,
which must be no earlier than January 1, 2005, and no later than January 1,
2007. Effective on the date specified by the holder, the convertible note will
be payable in 21 equal monthly installments of principal and interest. 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 accompanying
consolidated financial statements beginning on September 1, 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.
In connection with this transaction, the Company entered into a three-year
employment agreement with the seller of Paramount, who is currently employed as
president of the Company's operations in Florida. Also in connection with this
transaction, the Company entered into a three-year office lease agreement with
the seller of Paramount, the term
F-17
of which started in November 2002, related to the office space that is currently
used as the Company's primary sales and administrative office in Florida.
The cost of the acquisition was allocated among the assets acquired as follows
(in thousands):
Cost of acquisition:
Cash portion of purchase price $3,000
Secured convertible note issued to seller 2,625
Common stock issued to seller 1,040
-------
Purchase price paid to seller 6,665
Transaction expenses incurred by the Company 164
-------
Total cost $6,829
=======
Fair value of net assets acquired (liabilities assumed):
Cash and cash equivalents $ 456
Restricted investment 50
Property and equipment 121
Goodwill 4,670
Intangible assets 2,270
Other assets 229
Accounts payable and accrued expenses (386)
Claims payable and claims incurred but not reported (225)
Deferred premium revenue (356)
-------
Net assets acquired $6,829
=======
The value indicated above for the Company's common stock issued in the
acquisition is based on 769,231 shares of common stock issued, and a market
value of $1.35 per share. The market value of $1.35 per share is the average
closing price of the Company's common stock during the period from five business
days prior to execution of the Stock Purchase Agreement to five business days
after execution of the agreement. The Stock Purchase Agreement was executed on
April 24, 2002.
The intangible assets acquired consist of the following (in thousands):
WEIGHTED
AVERAGE
AMOUNT AMORTIZATION
ALLOCATED PERIOD
---------- ------------
Customer relationships $ 1,926 4.5 years
Other intangible assets 344 10.1 years
----------
Total $ 2,270 5.3 years
==========
None of the goodwill or intangible assets related to the acquisition of
Paramount will be amortized for income tax purposes.
F-18
PRO FORMA RESULTS OF OPERATIONS
Following is certain unaudited pro forma statement of income information, which
reflects adjustments to the Company's historical financial statements as if the
acquisitions of HN Dental, HN Vision, and Paramount had been completed as of the
beginning of each period presented (in thousands):
YEARS ENDED DECEMBER 31,
----------------------------
2003 2002
------------ --------------
(unaudited)
Premium revenue, net $ 150,629 $ 139,521
Operating income (loss) 3,222 (3,461)
Net income (loss) 7,281 (3,171)
Basic net income (loss) per share $ 0.20 $ (0.09)
Diluted net income (loss) per share 0.17 (0.09)
The above unaudited pro forma statement of income information is not intended to
indicate the results that would have occurred if the acquisitions had actually
been completed on the dates indicated, or the results that may occur in any
future period. The above pro forma information does not reflect the pro forma
effect of the acquisition of Ameritas, because such pro forma effect is not
significant.
NOTE 3. INVESTMENTS
- ---------------------
Gross realized gains on sales of investments were $1,000, $2,000, and $101,000
for the years ended December 31, 2003, 2002, and 2001, respectively. There were
no gross realized losses on sales of investments during the three years ended
December 31, 2003. The historical cost of specific securities sold is used to
compute the gain or loss on the sale of investments. At December 31, 2003, the
Company had net unrealized gains of $57,000, which is included in stockholders'
equity under the caption "Accumulated other comprehensive income."
The Company's investments as of December 31, 2003 are summarized below (in
thousands):
COST/ ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------- ----------- ------------ ----------
Classified as available-for-sale:
U.S. government securities $ 5,842 $ 55 $ -- $ 5,897
U.S. government agency securities 6,238 2 (1) 6,239
Corporate bonds and commercial paper 3,109 3 -- 3,112
Other marketable debt securities 12,684 -- (2) 12,682
---------- ----------- ------------ ----------
Total available-for-sale $ 27,873 $ 60 $ (3) $ 27,930
========== =========== ============ ==========
The maturity dates of the Company's investments as of December 31, 2003 are
summarized below (in thousands):
COST/ ESTIMATED
AMORTIZED FAIR
COST VALUE
---------- ----------
Classified as available-for-sale:
Due in 2004 $ 23,121 $ 23,126
Due in 2005 1,544 1,581
Due in 2006 and thereafter 3,208 3,223
---------- ----------
Total available-for-sale $ 27,873 $ 27,930
========== ==========
F-19
The Company's investments as of December 31, 2002 are summarized below (in
thousands):
COST/ ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------- ----------- ----------- ----------
Classified as available-for-sale:
U.S. government and its agencies $ 2,303 $ 87 $ -- $ 2,390
State and municipal obligations 255 8 -- 263
Other marketable debt securities 10,269 -- -- 10,269
---------- ----------- ----------- ----------
Total available-for-sale $ 12,827 $ 95 $ -- $ 12,922
========== =========== =========== ==========
NOTE 4. PROPERTY AND EQUIPMENT
- ----------------------------------
The Company's property and equipment consists of the following (in thousands):
DECEMBER 31,
-------------------
2003 2002
-------- ---------
Leasehold improvements $ 950 $ 842
Furniture and office equipment 1,871 1,504
Computer hardware and software 9,957 7,767
-------- ---------
Total, at cost 12,778 10,113
Less - accumulated depreciation and amortization (7,955) (6,581)
-------- ---------
Total, net of accumulated depreciation and amortization $ 4,823 $ 3,532
======== =========
Property and equipment that was acquired through capital leases with an
outstanding balance as of the balance sheet date consists of the following,
which is included above (in thousands):
DECEMBER 31,
------------------
2003 2002
------- ---------
Furniture and office equipment $1,135 $ 950
Computer hardware and software 250 1,250
------- ---------
Total cost of property acquired through capital leases 1,385 2,200
Less - accumulated depreciation and amortization (297) (344)
------- ---------
Total, net of accumulated depreciation and amortization $1,088 $ 1,856
======= =========
NOTE 5. GOODWILL
- -----------------
Changes in the carrying amount of goodwill were as follows (in thousands):
YEARS ENDED DECEMBER 31,
----------------------------
2003 2002
------------- -------------
Balance at beginning of year $ 8,590 $ 3,920
Goodwill acquired (see Note 2) 4,191 4,670
Adjustments to goodwill (see Note 11) (416) --
------------- -------------
Balance at end of year $ 12,365 $ 8,590
============= =============
F-20
In accordance with SFAS No. 142, the Company ceased amortizing its goodwill
effective January 1, 2002. The Company recorded $113,000 of amortization expense
related to goodwill during the year ended December 31, 2001. The Company's
adjusted results of operations for the year ended December 31, 2001, which are
adjusted to assume the non-amortization provision of SFAS No. 142 was applied as
of January 1, 2001, are as follows (in thousands):
Income before extraordinary item, as reported $ 1,295
Add back - Goodwill amortization 113
-------
Income before extraordinary item, as adjusted $ 1,408
=======
Net income, as reported $12,546
Add back - Goodwill amortization 113
-------
Net income, as adjusted $12,659
=======
None of the Company's reported net income per share amounts for the year ended
December 31, 2001 would change as a result of the above adjustment for goodwill
amortization expense, due to the relatively small amount of this adjustment.
SFAS No. 142 requires that all goodwill be evaluated for possible impairment as
of January 1, 2002, on an annual basis thereafter, and any time an event that
may have affected the value of the goodwill occurs. SFAS No. 142 also
establishes a new method of testing for possible impairment. The Company has
established October 1 as the date on which it conducts its annual evaluation of
goodwill for possible impairment. In accordance with SFAS No. 142, the Company
tested its goodwill for possible impairment by estimating the fair value of each
of its reporting units that include goodwill, and comparing the fair value of
each reporting unit to the book value of the net assets of each reporting unit.
For purposes of this test, the Company has three reporting units, which are its
operations in California, Florida and Texas. As of December 31, 2003, the
Company has goodwill in each of the three reporting units. The fair value of
each reporting unit was determined primarily by estimating the discounted future
cash flows of the reporting unit, and estimating the amount for which the
reporting unit could be sold to a third party, based on a market multiple of
earnings. The Company had no impairment of its goodwill as of January 1, 2002,
or as of October 1, 2003, based on the method of testing for possible impairment
established by SFAS No. 142. The Company is not aware of any events that have
occurred since October 1, 2003, that may have resulted in impairment of the
value of its goodwill.
NOTE 6. INTANGIBLE ASSETS
- ----------------------------
The Company's intangible assets consist of the following (in thousands):
DECEMBER 31,
-------------------
2003 2002
-------- ---------
Customer relationships $ 7,798 $ 1,926
Provider networks 2,461 --
Other intangible assets 589 344
-------- ---------
Total, at cost 10,848 2,270
Less - accumulated amortization (986) (257)
-------- ---------
Total, net of accumulated amortization $ 9,862 $ 2,013
======== =========
F-21
Amortization expense related to intangible assets was $729,000 and $257,000
during the years ended December 31, 2003 and 2002, respectively. As of December
31, 2003, the Company expects future amortization expense related to intangible
assets to be as follows (in thousands):
2004 $1,909
2005 1,580
2006 1,188
2007 904
2008 755
Thereafter 3,526
NOTE 7. CLAIMS PAYABLE AND CLAIMS INCURRED BUT NOT REPORTED ("IBNR")
- ----------------------------------------------------------------------
The Company is responsible for paying claims submitted by dental and vision
providers for services provided to patients who have purchased dental or vision
coverage from the Company. The liability for claims payable and claims IBNR is
an estimate of the claims related to services delivered prior to the balance
sheet date, which have not yet been paid by the Company as of the balance sheet
date. The estimate of claims payable and claims 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, 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 IBNR 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 income for the period in which the
differences are identified.
A summary of the activity in the liability for claims payable and claims IBNR
during the two years ended December 31, 2003 is shown below (in thousands):
CLAIMS LIABILITY BY TYPEOF COVERAGE
---------------------------------------------
VISION HMO
DENTAL PPO/ DENTAL AND PPO/
INDEMNITY HMO INDEMNITY TOTAL
--------------- ------------- ------------- ---------
Balance at January 1, 2002 $ 4,252 $ 1,653 $ -- $ 5,905
Incurred claims related to:
Current year - 2002 23,133 10,566 -- 33,669
Prior years (594) (206) -- (800)
Balance assumed in acquisition -- 225 -- 225
Paid claims related to:
Current year - 2002 (20,092) (8,928) -- (29,020)
Prior years (3,658) (1,447) -- (5,105)
Balance assumed in acquisition -- (214) -- (214)
--------------- ------------- ------------- ---------
Balance at December 31, 2002 3,041 1,649 -- 4,690
Incurred claims related to:
Current year - 2003 28,134 14,492 716 43,342
Prior years (378) (371) -- (749)
Balance assumed in acquisitions 2,344 1,945 466 4,755
Paid claims related to:
Current year - 2003 (22,608) (11,798) (297) (34,703)
Prior years (2,663) (1,278) -- (3,941)
Balance assumed in acquisition (1,621) (1,360) (304) (3,285)
--------------- ------------- ------------- ---------
Balance at December 31, 2003 $ 6,249 $ 3,279 $ 581 $ 10,109
=============== ============= ============= =========
F-22
The liability for claims payable and claims IBNR is adjusted each year to
reflect any differences between claims actually paid and previous estimates of
the liability. During each of the years ended December 31, 2003 and 2002, the
aggregate adjustments to the liability to reflect these differences, which are
reflected in the above table, were not material.
NOTE 8. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
- -----------------------------------------------------------
Long-term debt and capital lease obligations consisted of the following (in
thousands):
DECEMBER 31,
-------------------
2003 2002
-------- ---------
Unsecured convertible promissory notes - October 2003 $19,000 $ --
Secured convertible promissory note - September 2002 1,602 2,427
Unsecured convertible promissory note - August 2002 1,538 1,798
Capital lease obligations 710 1,202
-------- ---------
Total debt 22,850 5,427
Less - short-term portion (313) (2,430)
-------- ---------
Long-term debt and capital lease obligations $22,537 $ 2,997
======== =========
See Note 2 for descriptions of the unsecured convertible promissory notes issued
in October 2003 in connection with the acquisition of HN Dental and HN Vision,
and the secured convertible promissory note issued in September 2002 in
connection with the acquisition of Paramount. None of the outstanding
convertible notes include any financial covenants or similar restrictions.
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 Company has several capital leases outstanding, which are related to the
purchase of certain office and computer equipment.
Annual maturities of long-term debt and future minimum lease payments under
capital lease obligations were as follows, as of December 31, 2003 (in
thousands):
CAPITAL LESS - AMOUNT
LONG-TERM LEASE REPRESENTING
DEBT OBLIGATIONS INTEREST TOTAL
---------- ------------ --------------- -------
Payable in 2004 $ -- $ 372 $ (59) $ 313
Payable in 2005 886 169 (35) 1,020
Payable in 2006 1,092 166 (22) 1,236
Payable in 2007 681 98 (12) 767
Payable in 2008 481 35 (2) 514
Payable thereafter 19,000 -- -- 19,000
---------- ------------ --------------- -------
Total balance at December 31, 2003 $ 22,140 $ 840 $ (130) $22,850
========== ============ =============== =======
NOTE 9. CONVERSION OF DEBT TO CONVERTIBLE PREFERRED STOCK
- ----------------------------------------------------------
On March 1, 2000, the Company entered into a recapitalization agreement with an
investor group (the "Investors"), the Company's revolving credit facility lender
(the "Bank"), and the holder of certain senior notes payable issued by
F-23
the Company (the "Senior Note Holder"). Pursuant to this agreement, the
Investors loaned $8.0 million to the Company in the form of an investor senior
loan, due April 30, 2001. In addition, the Investors, the Bank, and the Senior
Note Holder agreed to convert the $8.0 million investor senior loan, the
outstanding balance of $7.0 million under the revolving credit facility plus
accrued interest, and the $32.5 million of senior notes payable plus accrued
interest, to convertible preferred stock, subject to regulatory and stockholder
approval.
Effective as of January 31, 2001, the Company completed the conversion of the
investor senior loan ($8.0 million), the outstanding balance under the revolving
credit facility ($7.0 million), the senior notes payable ($32.5 million), and
the accrued interest on the revolving credit facility and the senior notes
payable ($5.3 million) into 30 million shares of convertible preferred stock.
The estimated value of the convertible preferred stock was $1.375 per share as
of January 31, 2001, which is based on the closing price of the Company's common
stock on January 31, 2001, which was $1.375 per share, and the fact that each
share of convertible preferred stock is convertible into one share of common
stock. The number of shares of convertible preferred stock, the estimated value
per share, and the conversion ratio indicated above have all been adjusted to
reflect an exchange of the Company's outstanding shares of convertible preferred
stock that was completed in May 2002. See Note 13 for more information on this
exchange.
Based on the estimated value of the convertible preferred stock as of January
31, 2001, the debt conversion resulted in an extraordinary gain of $11.3
million, which is net of approximately $350,000 of transaction costs. There was
no income tax effect related to the conversion, due to the Company's net
operating loss carryforwards for tax purposes, as discussed in Note 11.
See Note 13 for a description of the convertible preferred stock. As a result of
the debt conversion, the ownership interest of the previously existing common
stockholders of the Company was reduced to approximately 14% of the common stock
interests of the Company. The holders of the convertible preferred stock issued
to the Investors in the debt conversion (Series A convertible preferred stock)
have the right to elect four members of the Company's board of directors, voting
as a separate class, which constitutes a majority of the board of directors,
which has a total of seven members. In addition, the holders of the convertible
preferred stock issued to the Bank and the Senior Note Holder in the debt
conversion (Series B, C and D convertible preferred stock) have the right to
elect one member of the Company's board of directors, voting as a separate
class. The holders of the Company's common stock have the right to elect the
remaining two members of the Company's board of directors, voting as a separate
class.
In 1999, in connection with a previous restructuring of the senior notes
payable, the Company issued warrants to purchase 382,000 shares of its common
stock for $4.51 per share to the Senior Note Holder. The Company estimated that
the fair value of these warrants was $320,000, based on an option-pricing model.
Accordingly, this amount was charged to interest expense and credited to
additional paid-in capital during 1999. The warrants were canceled without
being exercised, in connection with the conversion of the senior notes payable
into convertible preferred stock effective January 31, 2001. Accordingly, the
estimated fair value of the warrants, which was $320,000, was debited to
additional paid-in capital and credited to retained earnings during 2001.
NOTE 10. OTHER LONG-TERM LIABILITIES
- ----------------------------------------
Other long-term liabilities consist primarily of deferred rent related to an
office lease with monthly payments that increase over the term of the lease, an
accrued lease obligation related to a dental office sold by the Company in 1998
(see Note 12), deferred compensation payments to a former employee of a dental
HMO company acquired by the Company in 1996, and certain other liabilities.
Annual maturities of other long-term liabilities as of December 31, 2003 are as
follows (in thousands):
2005 $280
2006 312
2007 311
2008 208
Thereafter 112
------
Total other long-term liabilities $1,223
======
F-24
NOTE 11. INCOME TAXES
- ------------------------
The Company's federal and state income tax expense (benefit) is as follows (in
thousands):
YEARS ENDED DECEMBER 31,
---------------------------------
2003 2002 2001
---------- ---------- ---------
Currently payable: Federal $ 64 $ (120) $ --
State (17) (700) --
Deferred: Federal 860 -- --
State (22) -- --
Decrease in valuation allowance (5,725) -- --
---------- ---------- ---------
Total income tax expense (benefit) $ (4,840) $ (820) $ --
========== ========== =========
The Company's taxable income for federal income tax purposes in 2003 was
completely offset by net operating loss carryforwards from previous years, but
the Company recognized a current federal income tax expense in 2003 due to the
alternative minimum tax. The State of California suspended the use of net
operating loss carryforwards to offset current taxable income in 2003 for all
corporations, and accordingly, the Company recognized a current state income tax
expense for 2003, which was more than offset by a decrease in the Company's
accrual for estimated income tax liabilities related to certain transactions
that occurred in prior years. The Company incurred net losses for federal and
state income tax purposes during the years ended December 31, 2002 and 2001,
primarily due to temporary differences that reduced the Company's income for tax
purposes, and the fact that the Company's gain on the conversion of debt to
equity in 2001 (see Note 9) was not taxable. The income tax benefit in 2002
primarily represents a decrease in the Company's accrual for estimated income
tax liabilities related to certain transactions that occurred in prior years.
In the fourth quarter of 2003, the Company reduced the valuation allowance on
its net deferred tax assets by $5.7 million, based on its determination that
this amount of the net deferred tax assets is more likely than not to be
realized, primarily due to a significant improvement in the Company's reported
operating results and its expected future operating results. Accordingly, the
Company recognized deferred federal income tax expense and a deferred state
income tax benefit in 2003. The Company's net deferred tax assets were fully
reserved during the years ended December 31, 2002 and 2001, as the Company
believed at that time that it was more likely than not that the net deferred tax
assets would not be realized. Accordingly, the Company's deferred income tax
expense in both of these years was completely offset by adjustments to decrease
the valuation allowance against its net deferred tax assets.
A reconciliation of the expected federal income tax expense (benefit) based on
the statutory rate to the actual income tax expense (benefit) is as follows (in
thousands):
YEARS ENDED DECEMBER 31,
------------------------------------------------------------
2003 2002 2001
------------------ -------------------- ------------------
AMOUNT % AMOUNT % AMOUNT %
-------- -------- ---------- -------- --------- -------
Expected federal income tax
expense $ 1,011 34.0% $ 206 34.0% $ 4,266 34.0%
State income tax expense, net of
effect on federal income tax 123 4.1 23 3.7 -- --
Amortization of goodwill -- -- -- -- 35 0.3
Other items (49) (1.6) 132 21.8 855 6.8
Decrease in income tax accrual (200) (6.7) (820) (135.1) -- --
Expiration of net operating loss
carryforwards due to change
of control -- -- -- -- 6,774 54.0
Change in valuation allowance (5,725) (192.6) (361) (59.5) (11,930) (95.1)
-------- -------- ---------- -------- --------- -------
Actual income tax
expense (benefit) $(4,840) (162.8)% $ (820) (135.1)% $ -- --%
======== ======== ========== ======== ========= =======
F-25
Deferred tax assets and liabilities are related to the following items (in
thousands):
DECEMBER 31,
------------------
2003 2002
------- ---------
Deferred tax assets:
Net operating loss carryforward $2,612 $ 3,690
Depreciation and amortization 960 1,498
Accrued expenses 1,720 948
Capital loss carryforward 600 610
Other items 547 166
------- ---------
Total deferred tax assets 6,439 6,912
Deferred tax liabilities:
State income taxes 253 321
Prepaid expenses 184 --
Other items 99 266
------- ---------
Total deferred tax liabilities 536 587
------- ---------
Net deferred tax assets 5,903 6,325
Valuation allowance (600) (6,325)
------- ---------
Net deferred tax assets after valuation allowance $5,303 $ --
======= =========
As noted above, the Company reduced the valuation allowance on its net deferred
tax assets by $5.7 million in 2003. The Company evaluated all the available
positive and negative evidence regarding whether it was more likely than not
that the Company would realize the value of its net deferred tax assets in the
future. As a result of this evaluation, the Company concluded that it is more
likely than not that the Company will realize its net deferred tax assets. In
reaching this conclusion, significant weight was given to the significant
improvement in the Company's operating results, including its operating results
for the two months ended December 31, 2003, during which time the Company's
results included the operations of HN Dental and HN Vision. The remaining
valuation allowance of $0.6 million as of December 31, 2003, is related to a
deferred tax asset that represents an unused capital loss carryforward. The
Company retained the valuation allowance on this deferred tax asset because the
Company can only use the capital loss carryforward by offsetting it against
capital gains, and there are no capital gains expected in the foreseeable
future.
Due to the conversion of outstanding debt into convertible preferred stock, as
described in Note 9, 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, 2003, the Company had net operating loss carryforwards for federal
and state tax purposes of approximately $6.7 million and $5.2 million,
respectively, which are net of the amounts that will expire unused due to the
change of control limitation. The federal and state net operating loss
carryforwards will begin to expire in 2020 and 2012, respectively.
In 2003, as a result of the decrease in the valuation allowance on the Company's
net deferred tax assets, the Company reduced the goodwill related to the
acquisition of HN Dental and HN Vision in October 2003 by $1,010,000, and
increased the goodwill related to the acquisition of Paramount in August 2002 by
$594,000, to recognize the deferred tax assets and liabilities that were
acquired in these transactions. See Note 5 for more information on goodwill.
NOTE 12. COMMITMENTS AND CONTINGENCIES
- ------------------------------------------
LEASE COMMITMENTS
The Company leases administrative office space and office equipment under a
number of operating leases. Rent expense was $2,632,000, $2,960,000, and
$3,465,000 in 2003, 2002, and 2001, respectively. The Company has subleased
certain of its office space to unrelated third parties, which office space is
subject to lease agreements for
F-26
which the Company remains contingently liable in the event the sublessees fail
to make the lease payments. Future minimum rental payments required under
non-cancelable operating leases are as follows, net of payments the Company
expects to receive pursuant to subleases (in thousands):
TOTAL EXPECTED NET
LEASE SUBLEASE LEASE
OBLIGATION PAYMENTS OBLIGATION
----------- ---------- -----------
2004 $ 2,281 $ (183) $ 2,098
2005 2,093 (9) 2,084
2006 1,853 -- 1,853
2007 1,841 -- 1,841
2008 1,226 -- 1,226
Thereafter -- -- --
----------- ---------- -----------
Total minimum payments $ 9,294 $ (192) $ 9,102
=========== ========== ===========
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 providers in the
Company's 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, who were 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 an admission of liability.
The settlement 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 is included in selling, general and administrative
expenses in the accompanying consolidated statement of income.
CONTINGENT LEASE OBLIGATIONS
The Company sold all of its general dental practices and orthodontic practices
in 1996, 1997 and 1998. The office lease agreements related to all of the
practices sold by the Company either have been assigned to the respective
purchasers of the practices, or have expired.
In the case of the assigned leases, the Company is secondarily liable for the
lease payments in the event the purchasers of those practices fail to make the
payments. As of December 31, 2003, the total of the minimum annual payments
under these leases was approximately $1.1 million, and the aggregate contingent
liability of the Company related to these leases was approximately $2.0 million
over the terms of the lease agreements, which expire at various dates through
2009. In the event the parties to which these lease agreements have been
assigned defaulted on the leases, the aggregate contingent liability of
approximately $2.0 million could be mitigated by the Company by subleasing the
related office space to other parties, although there can be no assurance it
would be able to do so. The aggregate contingent lease obligation of $2.0
million excludes $350,000 of estimated lease obligations that have been accrued
as of December 31, 2003, due to the failure by one of the entities to make the
lease payments under a lease that was assigned to that entity by the Company.
This estimated lease obligation is included in the accompanying consolidated
balance sheet under the caption "Accrued expenses." The Company has not been
notified of any other defaults under these leases that would have a material
effect on 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
F-27
make the lease payments, the Company could be obligated to make the lease
payments itself. The Company has purchased a letter of credit for $250,000 in
connection with a certain customer agreement. In the event the Company fails to
meet its financial obligations to the customer, the customer would be able to
use the letter of credit to satisfy the Company's obligations, in which case the
Company would be obligated to repay the issuer of the letter of credit. The
Company also indemnifies its directors and officers to the maximum extent
permitted by Delaware law. In addition, the Company makes indemnities to its
customers in connection with the sale of dental and vision benefit plans in the
ordinary course of business. The maximum amount of potential future payments
under all of the preceding guarantees and indemnities cannot be determined. The
Company has recorded no liabilities related to these guarantees and indemnities
in the accompanying consolidated balance sheets, except as described above under
"Contingent Lease Obligations."
EMPLOYMENT AGREEMENT COMMITMENTS
The Company has an employment agreement with one of its senior officers, which
expires on August 30, 2005, and has severance agreements with certain other
officers of the Company, which continue for as long as each officer remains
employed by the Company. In the event there is a change in control of the
Company, each officer with a severance agreement would receive a severance
payment under certain circumstances, which is equal to that officer's annual
salary then in effect, plus the amount of the bonus, if any, earned by the
officer for the previous calendar year. The maximum aggregate commitment under
the employment agreement and the severance agreements is approximately $3.2
million as of December 31, 2003. None of the future commitments under the
employment agreement or the severance agreements are accrued as of December 31,
2003, as these commitments are all related to services to be performed by the
officers subsequent to 2003.
RETENTION BONUS PLAN
In January 2003, the Company implemented a Retention Bonus Plan (the "Plan")
with respect to certain senior executives of the Company. The purpose of the
Plan is to provide an incentive for the senior management of the Company to
remain employed during a reasonable transition period in the event of the sale
of the Company to a third party. In the event that more than 50% of the Company
is sold to an entity that is not otherwise a current stockholder of the Company,
each eligible officer would receive a variable retention bonus that is based on
the amount of proceeds from the sale transaction, subject to the officer
remaining an employee of the Company for a specified period of time. The
aggregate amount of retention bonuses paid by the Company under the Plan would
be approximately $1.3 million for each $1.00 of proceeds per share of common
stock realized by the Company's stockholders in a sale of the Company.
EMPLOYEE RETIREMENT PLAN
The Company maintains a retirement plan under Section 401(k) of the Internal
Revenue Code (the "Plan"). Under the Plan, employees are permitted to make
contributions to a retirement account through payroll deductions from pre-tax
earnings. Employees are fully vested in contributions made from payroll
deductions. In addition, the Company may, at its discretion, make additional
contributions to the Plan. The Company made $118,000, $87,000 and $51,000 of
matching contributions to the Plan for the years ended December 31, 2003, 2002
and 2001, respectively, in the form of 73,000 shares, 66,000 shares and 33,000
shares of its common stock, respectively. Of the total of 73,000 shares of
common stock related to 2003, 55,000 shares were contributed in 2003, and an
additional 18,000 shares were contributed in 2004, the value of which is
included in accrued expenses as of December 31, 2003. Employees become vested in
the matching contributions at the rate of 20% per year during the first five
years of employment with the Company, with employees receiving credit for past
years of service. There are no restrictions on the ability of employees to
liquidate the Company's common stock that is credited to their account, except
for vesting requirements.
PROFESSIONAL LIABILITY INSURANCE
The Company maintains professional liability insurance that covers losses on a
claims-made basis. The Company's professional liability insurance policy
provides $5 million of coverage and has an aggregate deductible of $250,000.
F-28
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 or vision HMO plan or an insurance company, including the
maintenance of a minimum amount of net worth and compliance with numerous other
financial requirements. In addition, regulations applicable to dental or vision
benefit plans could be changed in the future. There can be no assurance that the
Company will be able to meet all applicable regulatory requirements in the
future.
During the years ended December 31, 2003, 2002 and 2001, certain of the
Company's subsidiaries were not in compliance with regulatory requirements that
limit the amount of the subsidiary's administrative expenses as a percentage of
its premium revenue. The Company has discussed this noncompliance with the
applicable regulatory agencies, and those agencies have taken no action with
respect to this noncompliance. The Company believes these instances of
noncompliance with regulatory requirements will have no significant effect on
its consolidated financial statements.
HEALTH INSURANCE PORTABILITY AND ACCOUNTABILITY ACT OF 1996 ("HIPAA")
HIPAA imposes various responsibilities on the Company, including but not limited
to, the issuance of privacy notices to members of the Company's benefit plans,
the security and privacy of individually identifiable health information, the
use of unique identifiers for all of the contractual relationships the Company
has with members, providers and group and individual contract holders, the
adoption of standardized electronic transaction code sets, and prevention of
unauthorized use or disclosure of personal data maintained by the Company. The
Company has developed policies and procedures to comply with these requirements
and has provided privacy notices as required by HIPAA and the Gramm-Leach-Bliley
Act.
CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject the Company to concentrations of
credit risk consist primarily of bank deposits, investments and accounts
receivable. As of December 31, 2003, the Company had bank deposits that were
approximately $7.0 million in excess of the amounts insured by the Federal
Deposit Insurance Corporation. The Company's investments consist entirely of
high-quality marketable securities.
NOTE 13. CAPITAL STOCK
- -------------------------
CONVERTIBLE PREFERRED STOCK
The convertible preferred stock does not accrue dividends of any kind, but
participates in any dividends paid on the Company's common stock on an
as-converted basis. Each share of convertible preferred stock is convertible
into one share of common stock at the option of the holder. The convertible
preferred stock entitles the holder to one vote for each share of common stock
into which the preferred stock is convertible, with respect to all matters voted
on by the common stockholders of the Company, except for the election of
directors. The holders of the convertible preferred stock have the right to
elect a total of five members of the board of directors, and the holders of the
common stock have the right to elect the remaining two directors. In the
aggregate, the convertible preferred stock has a $30 million liquidation
preference over the Company's common stock.
Prior to May 2002, there were 300,000 shares of convertible preferred stock
issued and outstanding. Each share had a par value of $100 and a liquidation
preference of $100, and was convertible into 100 shares of the Company's common
stock. In May 2002, each outstanding share of convertible preferred stock was
exchanged for 100 new shares of convertible preferred stock. Each new share of
convertible preferred stock has a par value of $1.00 and a liquidation
preference of $1.00, and is convertible into one share of the Company's common
stock. All other rights and preferences of the convertible preferred stock
remained the same. All references to the convertible preferred stock in the
accompanying consolidated financial statements reflect the effects of this
exchange on a retroactive basis.
F-29
TREASURY STOCK AND STOCK REPURCHASES
As of December 31, 2003 and 2002, the Company had 3,216,978 shares of treasury
stock, which were acquired by the Company for an aggregate of $17.8 million. In
December 2000, the board of directors of the Company authorized management to
repurchase up to 500,000 shares of the Company's outstanding common stock, of
which 10,000 shares had been repurchased as of December 31, 2003.
PENDING REVERSE STOCK SPLIT
In November 2003 the Company's board of directors approved a reverse stock split
and certain related transactions, pursuant to which: (i) each 1,500 shares of
the Company's outstanding common stock would be converted into one share of new
common stock; (ii) the Company would pay cash for fractional shares that result
from the reverse stock split at the rate of $2.25 per share of existing common
stock; (iii) the Company would acquire all the shares of its common stock that
are held by the Company's 401(k) retirement plan (approximately 172,000 shares)
for a price of $2.25 per share of existing common stock; (iv) each outstanding
option to purchase 1,500 shares of common stock would be converted into an
option to purchase one share of new common stock, at an exercise price per share
that is equal to 1,500 times the existing exercise price per share; and (v) the
Company would pay cash equal to the excess, if any, of $2.25 per existing share
over the existing exercise price per share, for the fractional options that
result from the reverse split.
The purpose of the reverse stock split is to reduce the number of the Company's
stockholders below 300, after which the Company intends to de-register its
common stock with the United States Securities and Exchange Commission and cease
being a publicly traded company. The Company estimates the aggregate cost of the
reverse stock split and related transactions to be approximately $1.2 million,
including the cost of acquiring shares of stock and fractional stock options and
transaction expenses. The reverse stock split and related transactions are
currently pending stockholder approval.
STOCKHOLDER RIGHTS PLAN
In March 1996, the board of directors of the Company declared a dividend of one
right to purchase a fraction of a share of its Series A Junior Participating
Preferred Stock, having rights, preferences, privileges and restrictions as
designated, and under certain circumstances, other securities, for each
outstanding share of the Company's common stock (the "Rights"). The dividend was
distributed to stockholders of record at the close of business on April 12,
1996. The Rights become exercisable upon the occurrence of certain defined
events related to a possible change of control of the Company. The description
and terms of the Rights are set forth in a Rights Agreement, dated as of March
22, 1996, as amended, between the Company and American Stock Transfer and Trust
Company, as Rights Agent. The Rights Agreement may be amended by the Company's
board of directors without the approval of the Rights holders, at any time prior
to the Rights becoming exercisable. The Rights Agreement was amended in March
2000 to specify that the recapitalization transaction initiated in March 2000
would not cause the Rights to become exercisable.
STOCK OPTION PLAN
The Company has a stock option plan (the "Plan") that authorizes the granting of
both incentive and non-qualified stock options to purchase an aggregate of
4,000,000 shares of common stock. Either incentive or non-qualified stock
options may be granted to executive officers and other employees of the Company.
Only non-qualified stock options may be granted to non-employee directors of the
Company. Under the Plan, the exercise price of any stock option granted must be
at least equal to the market value of the Company's common stock on the date the
option is granted. The Compensation and Stock Option Committee of the board of
directors of the Company administers the Plan.
F-30
The following is a summary of stock options outstanding as of December 31, 2003:
TOTAL STOCK OPTIONS OUTSTANDING STOCK OPTIONS EXERCISABLE
-------------------------------------------- -----------------------------
RANGE OF WEIGHTED WEIGHTED WEIGHTED
EXERCISE NUMBER AVERAGE AVERAGE NUMBER AVERAGE
PRICES OF SHARES REMAINING LIFE EXERCISE PRICE OF SHARES EXERCISE PRICE
- ---------------- ----------- -------------- --------------- ------------ ---------------
$ 1.00 - 1.46 2,642,334 6.9 years $ 1.09 2,130,228 $ 1.06
1.50 - 2.00 290,000 8.7 years 1.58 80,004 1.50
9.00 - 15.75 8,000 3.5 years 10.64 8,000 10.64
----------- ------------
Total 2,940,334 7.1 years $ 1.17 2,218,232 $ 1.11
=========== ============
The following is a summary of activity in stock options:
YEARS ENDED DECEMBER 31,
-------------------------------------
2003 2002 2001
----------- ----------- -----------
Outstanding at beginning of year 2,725,834 2,614,500 2,216,300
Stock options granted 220,000 404,500 805,000
Stock options exercised -- (48,332) (43,332)
Stock options canceled (5,500) (244,834) (363,468)
----------- ----------- -----------
Outstanding at end of year 2,940,334 2,725,834 2,614,500
=========== =========== ===========
Exercisable at end of year 2,218,232 1,319,142 616,107
Available to issue 1,059,666 874,166 385,500
Weighted average exercise price of options granted $ 1.59 $ 1.24 $ 1.26
Weighted average exercise price of options exercised -- 1.00 1.00
Weighted average exercise price of options canceled 10.91 1.16 3.81
Weighted average exercise price of options outstanding 1.17 1.15 1.14
Weighted average exercise price of options exercisable 1.11 1.15 1.23
NOTE 14. INVESTMENT AND OTHER INCOME
- -----------------------------------------
Investment and other income consists of the following (in thousands):
YEARS ENDED DECEMBER 31,
-------------------------------
2003 2002 2001
--------- --------- ---------
Investment income, including realized gains $ 226 $ 318 $ 1,046
Other income, net 264 289 14
--------- --------- ---------
Total investment and other income $ 490 $ 607 $ 1,060
========= ========= =========
F-31
NOTE 15. UNAUDITED SELECTED QUARTERLY INFORMATION
- ----------------------------------------------------
QUARTERLY RESULTS OF OPERATIONS
Unaudited quarterly results of operations for the years ended December 31, 2003
and 2002 are shown below (in thousands, except per share data). This information
was derived from the Company's unaudited interim financial statements, which
were prepared on the same basis as the accompanying consolidated financial
statements for the years ended December 31, 2003 and 2002, and include all
necessary adjustments, which consist only of normal recurring adjustments. The
unaudited quarterly results should be read in conjunction with the accompanying
audited consolidated financial statements.
YEAR ENDED DECEMBER 31, 2003
-------------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
--------- --------- --------- ----------
Premium revenue, net $ 21,912 $ 23,129 $ 23,009 $ 36,841
Health care services expense 15,093 15,947 16,118 26,036
Selling, general and administrative expense 6,354 6,565 6,243 9,522
--------- --------- --------- ----------
Operating income 465 617 648 1,283
Investment and other income 79 79 73 259
Interest expense (100) (86) (76) (268)
--------- --------- --------- ----------
Income before income taxes 444 610 645 1,274
Income tax expense -- 60 81 (4,981)
--------- --------- --------- ----------
Net income $ 444 $ 550 $ 564 $ 6,255
========= ========= ========= ==========
Basic net income per share $ 0.01 $ 0.02 $ 0.02 $ 0.18
Weighted average basic shares outstanding 35,693 35,711 35,729 35,741
Diluted net income per share $ 0.01 $ 0.02 $ 0.02 $ 0.14
Weighted average diluted shares outstanding 35,989 36,366 36,421 46,228
FOURTH QUARTER ADJUSTMENTS IN 2003
During the fourth quarter of 2003, the Company recorded a $5.0 million income
tax benefit, which primarily represents a decrease in the valuation allowance
for the Company's net deferred tax assets and a decrease in the Company's
accrual for estimated income tax liabilities related to certain transactions
that occurred in prior years, as discussed in Note 11.
F-32
YEAR ENDED DECEMBER 31, 2002
--------------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
--------- --------- ---------- ----------
Premium revenue, net $ 20,688 $ 20,174 $ 20,682 $ 21,499
Health care services expense 14,550 14,676 14,546 14,165
Selling, general and administrative expense 5,839 5,777 6,040 6,884
Loss on impairment of assets -- -- -- 334
--------- --------- ---------- ----------
Operating income (loss) 299 (279) 96 116
Investment and other income 116 103 92 296
Interest expense (7) (24) (84) (117)
--------- --------- ---------- ----------
Income (loss) before income taxes 408 (200) 104 295
Income tax expense -- -- -- (820)
--------- --------- ---------- ----------
Net income (loss) $ 408 $ (200) $ 104 $ 1,115
========= ========= ========== ==========
Basic net income (loss) per share $ 0.01 $ (0.01) $ 0.00 $ 0.03
Weighted average basic shares outstanding 34,812 34,857 35,161 35,677
Diluted net income (loss) per share $ 0.01 $ (0.01) $ 0.00 $ 0.03
Weighted average diluted shares outstanding 35,568 34,857 35,526 36,010
FOURTH QUARTER ADJUSTMENTS IN 2002
During the fourth quarter of 2002, the Company recorded an $820,000 income tax
benefit, which primarily represents a decrease in the Company's accrual for
estimated income tax liabilities related to certain transactions that occurred
in prior years, as discussed in Note 11. During the fourth quarter of 2002, the
Company also increased the bad debt reserve on its notes receivable by $334,000
to reduce the carrying value of those notes to their estimated realizable
values.
F-33
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(IN THOUSANDS)
BALANCE AT CHARGED TO CHARGED TO BALANCE AT
BEGINNING COSTS AND OTHER END
OF YEAR EXPENSES ACCOUNTS WRITE-OFFS OF YEAR
----------- ----------- ----------- ------------ -----------
YEAR ENDED DECEMBER 31, 2001:
Allowance for doubtful accounts:
Accounts receivable $ 868 $ 245 $ -- $ (605) $ 508
Long-term notes receivable $ 2,806 $ -- $ -- $ (2,339) $ 467
YEAR ENDED DECEMBER 31, 2002:
Allowance for doubtful accounts:
Accounts receivable $ 508 $ 220 $ -- $ (403) $ 325
Long-term notes receivable $ 467 $ 334 $ -- $ -- $ 801
YEAR ENDED DECEMBER 31, 2003:
Allowance for doubtful accounts:
Accounts receivable $ 325 $ 476 $ -- $ (257) $ 544
Long-term notes receivable $ 801 $ -- $ -- $ (21) $ 780
F-34