UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____ to _____
Commission file number 0-12050
SAFEGUARD HEALTH ENTERPRISES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 52-1528581
(State or other jurisdiction (I.R.S. Employer
of incorporation) Identification No.)
95 ENTERPRISE, SUITE 100
ALISO VIEJO, CALIFORNIA 92656-2605
(Address of principal executive offices)
(Zip Code)
(949) 425-4300
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--- ---
As of May 1, 2004, the number of shares of registrant's common stock, par value
$0.01 per share, outstanding was 5,770,590 shares (not including 3,216,978
shares of common stock held in treasury), and the number of shares of
registrant's convertible preferred stock, par value $0.01 per share, outstanding
was 30,000,000 shares.
SAFEGUARD HEALTH ENTERPRISES, INC.
INDEX TO FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2004
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (unaudited) . . . . . . . . . . . . . . . 1
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . 20
Item 4. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
PART II. OTHER INFORMATION
Item 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
CERTIFICATIONS BY CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER . . . . . . . . . . . . . . 23
i
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
(UNAUDITED)
MARCH 31, DECEMBER 31,
2004 2003
----------- --------------
ASSETS
Current assets:
Cash and cash equivalents $ 4,799 $ 3,201
Investments available-for-sale, at fair value 24,467 24,998
Accounts receivable, net of allowances 4,949 5,486
Deferred tax assets, net of valuation allowance 1,538 1,871
Other current assets 1,284 1,548
----------- --------------
Total current assets 37,037 37,104
Property and equipment, net of accumulated depreciation and amortization 4,869 4,823
Restricted investments available-for-sale, at fair value 2,940 2,932
Goodwill 12,347 12,365
Intangible assets, net of accumulated amortization 9,817 9,862
Deferred tax assets, net of valuation allowance 2,778 3,432
Other assets 739 720
----------- --------------
Total assets $ 70,527 $ 71,238
=========== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 2,114 $ 1,716
Accrued expenses 7,014 7,919
Current portion of long-term convertible debt and capital lease obligations 253 313
Claims payable and claims incurred but not reported 9,763 10,109
Deferred premium revenue 2,675 3,531
----------- --------------
Total current liabilities 21,819 23,588
Long-term convertible debt and capital lease obligations, net of current portion 22,502 22,537
Other long-term liabilities 1,167 1,223
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock and additional paid-in capital 41,250 41,250
Common stock and additional paid-in capital 22,798 22,766
Retained earnings (accumulated deficit) (21,248) (22,357)
Accumulated other comprehensive income 65 57
Treasury stock, at cost (17,826) (17,826)
----------- --------------
Total stockholders' equity 25,039 23,890
----------- --------------
Total liabilities and stockholders' equity $ 70,527 $ 71,238
=========== ==============
See accompanying Notes to Condensed Consolidated Financial Statements.
1
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
THREE MONTHS ENDED MARCH 31, 2004 AND 2003
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
2004 2003
-------- --------
Premium revenue, net $43,496 $21,912
Health care services expense 31,195 15,093
Selling, general and administrative expense 10,383 6,354
-------- --------
Operating income 1,918 465
Investment and other income 122 79
Interest expense (356) (100)
-------- --------
Income before income taxes 1,684 444
Income tax expense 575 --
-------- --------
Net income $ 1,109 $ 444
======== ========
Basic net income per share $ 0.03 $ 0.01
Weighted average basic shares outstanding 35,758 35,693
Diluted net income per share $ 0.03 $ 0.01
Weighted average diluted shares outstanding 49,768 35,989
See accompanying Notes to Condensed Consolidated Financial Statements.
2
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTHS ENDED MARCH 31, 2004 AND 2003
(IN THOUSANDS)
(UNAUDITED)
2004 2003
--------- --------
Cash flows from operating activities:
Net income $ 1,109 $ 444
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,073 420
Deferred income tax expense 547 --
Bad debt expense 75 39
Contribution to retirement plan in the form of common stock, at fair value 42 24
Changes in operating assets and liabilities, excluding effects of acquisition:
Accounts receivable 462 396
Other current assets 264 264
Other assets (26) 10
Accounts payable (229) (124)
Accrued expenses (915) (244)
Claims payable and claims incurred but not reported (346) 134
Deferred premium revenue (856) 82
--------- --------
Net cash provided by operating activities 1,200 1,445
Cash flows from investing activities:
Purchase of investments available-for-sale (28,027) (777)
Proceeds from sale/maturity of investments available-for-sale 28,558 760
Cash acquired in acquisition of business -- 287
Purchases of property and equipment (563) (131)
Payments received on notes receivable 7 10
Additions to intangible assets (38) --
--------- --------
Net cash (used in) provided by investing activities (63) 149
Cash flows from financing activities:
Increase in bank overdrafts 627 96
Payments on convertible debt and capital lease obligations (110) (623)
Decrease in other long-term liabilities (56) (42)
--------- --------
Net cash provided by (used in) financing activities 461 (569)
--------- --------
Net increase in cash and cash equivalents 1,598 1,025
Cash and cash equivalents at beginning of period 3,201 3,036
--------- --------
Cash and cash equivalents at end of period $ 4,799 $ 4,061
========= ========
Supplementary information:
Cash paid during the period for interest $ 265 $ 102
Supplementary disclosure of non-cash activities:
Liabilities assumed in acquisition of business:
Fair value of identifiable assets acquired, excluding cash $ -- $ 660
Goodwill related to transaction -- 699
Add - Cash received in transaction -- 287
Less - Liability for purchase price, which was paid in April 2003 -- (1,100)
Less - Liability for contingent purchase price -- (176)
--------- --------
Liabilities assumed in acquisition of business $ -- $ 370
========= ========
See accompanying Notes to Condensed Consolidated Financial Statements.
3
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2004
(UNAUDITED)
NOTE 1. GENERAL
- -----------------
The accompanying unaudited condensed consolidated financial statements of
SafeGuard Health Enterprises, Inc. and subsidiaries (the "Company") as of March
31, 2004, and for the three months then ended, have been prepared in accordance
with accounting principles generally accepted in the United States of America
with respect to interim periods. The accompanying financial statements reflect
all normal and recurring adjustments that, in the opinion of management, are
necessary for a fair presentation of the Company's financial position and
results of operations for the interim periods. In accordance with the
regulations of the Securities and Exchange Commission, these financial
statements omit certain footnote disclosures and other information that would be
necessary to present the Company's financial position and results of operations
in accordance with accounting principles generally accepted in the United States
of America with respect to annual periods. These condensed consolidated
financial statements should be read in conjunction with the Company's Annual
Report on Form 10-K for the year ended December 31, 2003, which includes the
Company's Consolidated Financial Statements and Notes thereto for that period.
NOTE 2. SIGNIFICANT ACCOUNTING POLICIES ANDRECENTLY ADOPTED ACCOUNTING
- -----------------------------------------------------------------------------
PRINCIPLES
- ----------
GOODWILL
The Company's accounting for goodwill is in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible
Assets." Goodwill as of March 31, 2004 is related to the following acquisitions
(in thousands):
Health Net Dental, Inc. ("HN Dental") and
Health Net Vision, Inc. ("HN Vision") - October 2003 $ 3,163
Paramount Dental Plan, Inc. ("Paramount") - August 2002 5,264
First American Dental Benefits, Inc. ("First American") - October 1996 3,920
-------
Total $12,347
=======
See Note 3 for more information on the HN Dental and HN Vision 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
previously accumulated amortization and an adjustment in 1999 to reduce the
carrying value of the goodwill to its estimated realizable value.
Changes in the carrying amount of goodwill were as follows (in thousands):
THREE MONTHS ENDED
MARCH 31,
-----------------------
2004 2003
----------- ----------
Balance at beginning of period $ 12,365 $ 8,590
Goodwill acquired -- 699
Adjustment to goodwill, related to purchase accounting (18) --
----------- ----------
Balance at end of period $ 12,347 $ 9,289
=========== ==========
SFAS No. 142 requires that all goodwill be evaluated for possible impairment on
an annual basis and any time an event that may have affected the value of the
goodwill occurs. SFAS No. 142 also established the appropriate 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 as of October 1, 2003, 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. The Company had goodwill in two of
the three reporting units as of October 1, 2003.
4
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
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
charged to each reporting unit, and the market multiple of earnings 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 resulted in impairment of the
value of its goodwill.
INTANGIBLE ASSETS
Intangible assets as of March 31, 2004 consist of customer relationships,
provider networks and other intangible assets with an aggregate net book value
of $9.8 million, all of which were acquired in connection with the acquisition
of HN Dental and HN Vision in October 2003, the acquisition of Paramount in
August 2002, and the acquisition of Ameritas Managed Dental Plan, Inc.
("Ameritas") in March 2003. See Note 3 for more information on the HN Dental, HN
Vision and Ameritas 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
is based primarily on the average historical lag time between the date of
service and the date the related claim is paid by the Company, the recent trend
in payment rates, and the recent trend in the average number of incurred claims
per covered individual. Since the liability for claims payable and claims
incurred but not reported is an actuarial estimate, the amount of claims
eventually paid for services provided prior to the balance sheet date could
differ from the estimated liability. Any such differences are included in the
consolidated statement of income for the period in which the differences are
identified.
RECOGNITION OF PREMIUM REVENUE
Premium revenue is recognized in the period during which dental and vision
coverage is provided to the covered individuals. Payments received from
customers in advance of the related period of coverage are reflected on the
accompanying condensed consolidated balance sheet as deferred premium revenue.
STOCK-BASED COMPENSATION
The Company's accounting for stock options is in accordance with Accounting
Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to
Employees." All stock options granted by the Company have an exercise price
equal to the market value of the Company's common stock on the date of grant,
and accordingly, there is no employee compensation expense related to stock
options reflected in the accompanying condensed consolidated statements of
income. Stock options granted generally become exercisable in equal annual
installments over a three-year period after the date of grant.
5
The following table shows the pro forma effect of using the fair value method of
accounting for stock options, as described by SFAS No. 123, "Accounting for
Stock-Based Compensation," on the Company's net income and net income per share
(in thousands, except per share amounts):
THREE MONTHS ENDED
MARCH 31,
------------------------
2004 2003
----------- -----------
Net income, as reported $ 1,109 $ 444
Less - Employee compensation expense based on
the fair value method of accounting for stock
options, net of applicable income tax effect (49) (161)
----------- -----------
Pro forma net income $ 1,060 $ 283
=========== ===========
Basic net income per share, as reported $ 0.03 $ 0.01
Pro forma basic net income per share 0.03 0.01
Diluted net income per share, as reported $ 0.03 $ 0.01
Pro forma diluted net income per share 0.03 0.01
SFAS No. 123 requires an entity to estimate the fair value of stock-based
compensation by using an option-pricing model that takes into account certain
facts and assumptions. The facts and assumptions that must be taken into account
are the exercise price, the expected life of the option, the current stock
price, the expected volatility of the stock price, the expected dividends on the
stock, and the risk-free interest rate. The option-pricing models commonly used
were developed to estimate the fair value of freely tradable, fully transferable
options without vesting restrictions, which significantly differ from the stock
options granted by the Company. The Company estimates the fair value of stock
options by using the Black-Scholes option-pricing model. The assumptions used to
determine the fair value of stock options granted in 2003 were: an average
expected life of four years; expected volatility of 75%; no expected dividends;
and a risk-free annual interest rate of 2.2%. There were no stock options
granted in 2004. The assumptions regarding the expected life of the options and
the expected volatility of the stock price are subjective, and these assumptions
have a significant effect on the estimated fair value amounts.
NET INCOME PER SHARE
Net income per share is presented in accordance with SFAS No. 128, "Earnings Per
Share." Basic net income per share is based on the weighted average common
shares outstanding, including the common shares into which the convertible
preferred stock is convertible, but excluding the effect of other potentially
dilutive securities. The number of basic common shares outstanding includes the
common share equivalents of the convertible preferred stock, because the 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 months ended March 31, 2004 and 2003, the potentially dilutive
securities outstanding consisted of stock options and convertible notes. Diluted
net income per share includes the effect of all outstanding stock options with
an exercise price below the average market price of the Company's common stock
during each applicable period. The calculation of diluted net income per share
for 2004 includes the effect of all outstanding convertible notes. All
outstanding convertible notes would have had an anti-dilutive effect on net
income per share in 2003, and accordingly, they are excluded from the
calculation of diluted net income per share for this period. See Note 4 for
information on convertible notes that were outstanding during the three months
ended March 31, 2004 and 2003.
6
The differences between weighted average basic shares outstanding and weighted
average diluted shares outstanding are as follows (in thousands):
THREE MONTHS ENDED
MARCH 31,
--------------------
2004 2003
--------- ---------
Weighted average basic shares outstanding 35,758 35,693
Effect of convertible notes 12,790 --
Effect of dilutive stock options 1,220 296
--------- ---------
Weighted average diluted shares outstanding 49,768 35,989
========= =========
For purposes of computing the net income per diluted share of common stock, the
Company's net income was adjusted as follows (in thousands):
THREE MONTHS ENDED
MARCH 31,
----------------------
2004 2003
---------- ----------
Net income, as reported $ 1,109 $ 444
Interest expense on convertible notes, net of tax effect 208 --
---------- ----------
Adjusted net income $ 1,317 $ 444
========== ==========
RECENTLY ADOPTED ACCOUNTING PRINCIPLES
In May 2003, the Financial Accounting Standards Board ("FASB") issued SFAS No.
150, "Accounting for Certain Instruments with Characteristics of Both
Liabilities and Equity." In November 2003, the FASB issued FASB Staff Position
No. 150-3 ("FSP 150-3"), which deferred indefinitely the effective dates for
applying certain provisions of SFAS No. 150 related to mandatorily redeemable
financial instruments. The adoption of SFAS No. 150 had no significant effect on
the Company's consolidated financial statements.
NOTE 3. 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 was 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. Effective October 31, 2003, the
Company also acquired all of the outstanding capital stock of HN Vision, which
was 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 subsequently, 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
7
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
170,000 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.
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
==========
8
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, 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 March 31, 2004,
the Company has accrued a total of $341,000 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 March 31, 2004, plus the estimated contingent monthly
payments related to the remaining portion of annual customer contracts that are
in force as of April 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
March 31, 2004, from customers of Ameritas that existed as of March 31, 2003,
the maximum aggregate amount of the contingent monthly payments would be
approximately $1.2 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 the twelve months ended March 31, 2004. 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 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 March 31, 2004 341
------
Total cost $1,375
======
Fair value of net assets acquired (liabilities assumed):
Cash and cash equivalents $ 276
Investments 465
Intangible assets 1,308
Other assets 150
Deferred income tax liability (458)
Deferred premium revenue (258)
Other current liabilities (108)
------
Total cost of acquisition $1,375
======
The intangible assets acquired consist of the following (in thousands):
WEIGHTED
AVERAGE
AMOUNT AMORTIZATION
ALLOCATED PERIOD
---------- ------------
Customer relationships $ 1,079 9.5 years
Other intangible assets 229 10.8 years
----------
Total $ 1,308 9.8 years
==========
9
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.
PRO FORMA RESULTS OF OPERATIONS
Following is certain pro forma statement of income information, which reflects
adjustments to the Company's historical financial statements for the three
months ended March 31, 2003, as if the acquisition of HN Dental and HN Vision
had been completed as of the beginning of that period (in thousands):
Premium revenue, net $35,434
Operating income 247
Net income 120
Basic net income per share $ 0.00
Diluted net income per share 0.00
The above pro forma statement of income information is not intended to indicate
the results that would have occurred if the acquisition had actually been
completed on the date indicated, or the results that may occur in any future
period. The above pro forma information does not reflect any adjustments related
to the acquisition of Ameritas, because any such pro forma adjustments would not
be significant.
NOTE 4. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
- -----------------------------------------------------------
Long-term debt and capital lease obligations consisted of the following (in
thousands):
MARCH 31, DECEMBER 31,
2004 2003
---------- -------------
Unsecured convertible promissory notes - October 2003 $ 19,000 $ 19,000
Secured convertible promissory note - September 2002 1,602 1,602
Unsecured convertible promissory note - August 2002 1,538 1,538
Capital lease obligations 615 710
---------- -------------
Total debt 22,755 22,850
Less - short-term portion (253) (313)
---------- -------------
Long-term debt and capital lease obligations $ 22,502 $ 22,537
========== =============
See Note 3 for a description of $19.0 million of unsecured convertible
promissory notes that were issued in October 2003, in connection with the
acquisitions of HN Dental and HN Vision. None of the outstanding convertible
notes include any financial covenants or similar restrictions.
In September 2002, the Company issued a secured convertible promissory note for
$2,625,000. 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
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.
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
10
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.
NOTE 5. INCOME TAXES
- -----------------------
The Company's accounting for income taxes is in accordance with SFAS No. 109,
"Accounting for Income Taxes." SFAS No. 109 requires the recognition of deferred
tax assets and liabilities for the expected future tax consequences of events
that are recognized in the Company's financial statements in different periods
than those in which the events are recognized in the Company's tax returns. The
measurement of deferred tax assets and liabilities is based on current tax laws
as of the balance sheet date. The Company records a valuation allowance related
to deferred tax assets in the event that available evidence indicates that the
future tax benefits related to the deferred tax assets may not be realized. A
valuation allowance is required when it is more likely than not that the
deferred tax assets will not be realized.
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 income tax expenses and benefits in 2004.
The Company incurred a net loss for income tax purposes during the three months
ended March 31, 2003, primarily due to temporary differences that reduced the
Company's income for tax purposes. Accordingly, the Company recognized no
current income tax expense for this period. The Company's net deferred tax
assets were fully reserved during the period from the third quarter of 1999
through the third quarter of 2003, as the Company believed at the 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 2003 was completely
offset by adjustments to the valuation allowance against its net deferred tax
assets.
Due to the conversion of outstanding debt into convertible preferred stock in
January 2001, there was a "change of control" of the Company for purposes of
Internal Revenue Code Section 382, effective January 31, 2001. As a result,
effective January 31, 2001, the amount of pre-existing net operating loss
carryforwards that can be used to offset current taxable income on the Company's
federal income tax return is limited to approximately $350,000 per year. As of
December 31, 2003, the Company had net operating loss carryforwards for federal
and California 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 California state net
operating loss carryforwards will begin to expire in 2020 and 2012,
respectively.
NOTE 6. TOTAL COMPREHENSIVE INCOME
- --------------------------------------
Total comprehensive income includes the change in stockholders' equity during
the period from transactions and other events and circumstances from
non-stockholder sources. Total comprehensive income of the Company for the
three months ended March 31, 2004 and 2003, includes net income and other
comprehensive income or loss, which consists of unrealized gains and losses on
marketable securities, net of realized gains and losses that occurred during the
period. Other comprehensive income (loss) was $8,000 and $(10,000) for the three
months ended March 31, 2004 and 2003, respectively. Total comprehensive income
was $1,117,000 and $434,000 for the three months ended March 31, 2004 and 2003,
respectively.
NOTE 7. COMMITMENTS AND CONTINGENCIES
- -----------------------------------------
LITIGATION
The Company is subject to various claims and legal actions arising in the
ordinary course of business. The Company believes all pending claims either are
covered by liability insurance maintained by the Company or by providers in
11
the Company's network, or will not have a material adverse effect on the
Company's consolidated financial position or results of operations.
CONTINGENT LEASE OBLIGATIONS
The Company sold all of its general dental practices and orthodontic practices
in 1996, 1997 and 1998. The 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 March 31, 2004, the total of the minimum annual payments under
these leases was approximately $0.9 million, and the aggregate contingent
liability of the Company related to these leases was approximately $1.6 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 $1.6 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 $1.6
million excludes $337,000 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 condensed
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
make the lease payments, the Company could be obligated to make the lease
payments itself. The Company has also purchased a letter of credit for $250,000
in connection with a customer agreement. In the event the Company fails to meet
its financial obligations to the customer, the customer would be able to use the
letter of credit to satisfy the Company's obligations, in which case the Company
would be obligated to repay the issuer of the letter of credit. The Company also
indemnifies its directors and officers to the maximum extent permitted by
Delaware law. In addition, the Company makes indemnities to its customers in
connection with the sale of dental and vision benefit plans in the ordinary
course of business. The maximum amount of potential future payments under all of
the preceding guarantees and indemnities cannot be determined. The Company has
recorded no liabilities related to these guarantees and indemnities in the
accompanying condensed consolidated balance sheets, except as described above
under "Contingent Lease Obligations." The Company issued no guarantees during
the three months ended March 31, 2004.
GOVERNMENT REGULATION
During the three months ended March 31, 2004 and 2003, 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.
NOTE 8. CAPITAL STOCK
- ------------------------
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
12
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.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor"
for forward-looking statements, as long as those statements are identified as
forward-looking and are accompanied by meaningful cautionary statements
identifying important factors that could cause actual results to differ
materially from those discussed in the statements. The Company desires to take
advantage of these safe harbor provisions. The following risk factors, as well
as the risk factors identified in the Company's Annual Report on Form 10-K for
the year ended December 31, 2003, which has been filed with the Securities and
Exchange Commission, should be read in conjunction with this Management's
Discussion and Analysis of Financial Condition and Results of Operations
("MD&A").
The statements contained in this MD&A concerning expected growth, the outcome of
business strategies, future operating results and financial position, economic
and market events and trends, future premium revenue, future health care
expenses, the Company's ability to control health care, selling, general and
administrative expenses, and all other statements that are not historical facts,
are forward-looking statements. Words such as expects, projects, anticipates,
intends, plans, believes, seeks or estimates, or variations of such words and
similar expressions, are also intended to identify forward-looking statements.
These forward-looking statements are subject to significant risks, uncertainties
and contingencies, many of which are beyond the control of the Company. Actual
results may differ materially from those projected in the forward-looking
statements.
All of the risks set forth below could negatively impact the earnings of the
Company in the future. The Company's expectations for the future are based on
current information and its evaluation of external influences. Changes in any
one factor could materially impact the Company's expectations related to premium
rates, revenue, benefit plans offered, membership enrollment, the amount of
health care expenses incurred, and profitability, and therefore, affect the
forward-looking statements which may be included in this report. In addition,
past financial performance is not necessarily a reliable indicator of future
performance. An investor should not use historical performance alone to
anticipate future results or future period trends for the Company.
RISK FACTORS
- -------------
The Company's business and competitive environment includes numerous factors
that expose the Company to risk and uncertainty. Some risks are related to the
dental or vision benefits industry in general and other risks are related to the
Company specifically. Due to the risks and uncertainties described below, there
can be no assurance that the Company will be able to maintain its current market
position. Some of the risk factors described below have adversely affected the
Company's operating results in the past, and all of these risk factors could
affect the Company's future operating results.
INTEGRATION OF ACQUIRED BUSINESS
The Company completed the acquisition of HN Dental, HN Vision, and certain
PPO/indemnity dental and vision business underwritten by HN Life in the fourth
quarter of 2003. See Note 3 to the accompanying condensed
13
consolidated financial statements for more information on these transactions.
The combined revenue of the acquired businesses was approximately $74 million
for the year ended December 31, 2003, which is significant compared to the size
of the Company's pre-existing operations. The Company is in the process of
integrating the acquired business into its pre-existing operations. Due to the
relatively large size of the business acquired, and the complexities inherent in
this process, there is a risk that the Company may not be able to complete such
integration in a timely and effective manner. In such case, the Company may not
be able to retain all of the customers of the acquired companies, resulting in a
loss of revenue, and the Company's health care services or general and
administrative expenses could be higher than expected, which could have a
negative impact on the Company's overall profitability.
GOVERNMENT REGULATION
The dental and vision benefits industries are 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 a dental
insurance company, including the maintenance of a minimum amount of net worth,
and these requirements could be changed in the future. There can be no assurance
that the Company will be able to meet all applicable regulatory requirements in
the future.
CONTINGENT LEASE OBLIGATIONS
The Company sold all of its general dental practices and orthodontic practices
in 1996, 1997 and 1998. 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 March 31, 2004, the Company is contingently
liable for an aggregate of approximately $1.6 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.
POSSIBLE VOLATILITY OF STOCK PRICE
The market price of the Company's common stock has fluctuated significantly
during the past few years. The Company's common stock is currently traded on the
NASDAQ Over-The-Counter Bulletin Board, and the fact that the Company's common
stock is not listed on an exchange can have a negative influence on the trading
volume of the stock. Stock price volatility can be caused by actual or
anticipated variations in operating results, announcements of new developments,
actions of competitors, developments in relationships with clients, and other
events or factors. Even a modest shortfall in the Company's operating results,
compared to the expectations of the investment community, can cause a
significant decline in the market price of the Company's common stock. In
addition, the trading volume of the Company's common stock is relatively low,
which can cause fluctuations in the market price and a lack of liquidity for
holders of the Company's common stock. Broad stock market fluctuations, which
may be unrelated to the Company's operating performance, could also have a
negative effect on the Company's stock price.
COMPETITIVE MARKET
The Company operates in a highly competitive industry. Its ability to operate on
a profitable basis is affected by significant competition for employer groups
and for contracting dental and vision providers. Dental and vision 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 AND VISION SERVICES
Under the Company's dental PPO/indemnity plan designs and its vision benefit
plans, the Company assumes the entire underwriting risk related to the frequency
and cost of dental or vision services provided to the covered individuals. Under
the Company's dental HMO plan designs, the Company assumes a portion of the
underwriting
14
risk, primarily related to the frequency and cost of specialist services, the
cost of supplemental payments made to general dentists, and the frequency and
cost of dental services provided by general dentists with whom the Company does
not have standard capitation arrangements. If the Company does not accurately
assess these underwriting risks, the premium rates charged to its customers may
not be sufficient to cover the cost of the dental services delivered to
subscribers and dependents. This could have a material adverse effect on the
Company's operating results.
EFFECT OF ADVERSE ECONOMIC CONDITIONS
The Company's business could be negatively affected by periods of general
economic slowdown, recession or terrorist activities which, among other things,
may be accompanied by layoffs by the Company's customers, which could reduce the
number of subscribers enrolled in the Company's benefit plans, and by an
increase in the pricing pressure from customers and competitors.
RELATIONSHIPS WITH PROVIDERS
The Company's success is dependent on maintaining competitive provider networks
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.
CRITICAL ACCOUNTING POLICIES
- ------------------------------
The Company's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America.
Application of those accounting principles includes the use of estimates and
assumptions that have been made by management, and which the Company believes
are reasonable based on the information available. These estimates and
assumptions affect the reported amounts of assets, liabilities, revenues and
expenses in the accompanying condensed consolidated financial statements. The
Company believes the most critical accounting policies used to prepare the
accompanying condensed consolidated financial statements are the following:
ACCOUNTS RECEIVABLE
Accounts receivable represent uncollected premiums related to coverage periods
prior to the balance sheet date, and are stated at the estimated collectible
amounts, net of an allowance for bad debts. The Company continuously monitors
the timing and amount of its premium collections, and maintains a reserve for
estimated bad debt losses. The amount of the reserve is based primarily on the
Company's historical experience and any customer-specific collection issues that
are identified. The Company believes its reserve for bad debt losses is adequate
as of March 31, 2004. 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
The Company's accounting for goodwill is in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible
Assets." Goodwill as of March 31, 2004 consists of $3.1 million of goodwill
related to the acquisition of HN Dental and HN Vision in October 2003, $5.3
million of goodwill related to the acquisition of Paramount in 2002, and $3.9
million of goodwill related to the acquisition of First American in 1996. See
Note 3 to the accompanying consolidated financial statements for more
information on the acquisition of HN Dental and HN Vision. 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
15
acquisition, the balance is net of previously accumulated amortization and an
adjustment in 1999 to reduce the carrying value of the goodwill to its estimated
realizable value.
SFAS No. 142 requires that all goodwill be evaluated for possible impairment on
an annual basis, and any time an event that may have affected the value of the
goodwill occurs. SFAS No. 142 also established the appropriate 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 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 March 31, 2004 consist of customer relationships,
provider networks, and other intangible assets with an aggregate net book value
of $9.8 million, all of which were acquired in connection with the acquisitions
of HN Dental and HN Vision in October 2003, Ameritas in March 2003, and
Paramount in August 2002. See Note 3 to the accompanying consolidated financial
statements for more information on the acquisitions of HN Dental, HN Vision and
Ameritas. The amount of the purchase price that was allocated to each of the
intangible assets was equal to the Company's estimate of the fair value of each
asset. Each intangible asset is being amortized over its estimated useful life
on a straight-line basis. The estimates to which the fair value of each
intangible asset are the most sensitive are the estimate of future cash flows
related to the asset, the estimated useful life of the asset, and the weighted
average cost of capital assumed. The Company believes the estimates used in
determining the fair value of each intangible asset are reasonable and
appropriate, but a significant change in any of these estimates could result in
a significant change in the fair values of the intangible assets, or the
amortization periods of those assets, or both.
CLAIMS PAYABLE AND CLAIMS INCURRED BUT NOT REPORTED
The estimated liability for claims payable and claims incurred but not reported
("IBNR") is based primarily on the average historical lag time between the date
of service and the date the related claim is paid by the Company, the recent
trend in payment rates, and the recent trend in the average number of incurred
claims per covered individual. The use of average historical lag times to
estimate current lag times is dependent on the assumption that the average time
to process claims currently is consistent with the average time to process
claims historically. The Company makes adjustments to the average historical lag
times to account for any changes in claims processing times, but a significant
change in these adjustments could result in a significant change in the
estimated liability. The estimate of the liability is also dependent on the
assumption that the recent trend in payment rates and the average number of
incurred claims per covered individual has continued to the balance sheet date.
A significant change in provider payment rates or utilization rates related to
claims not yet received by the Company could result in a significant change in
the amount of the liability. Since the liability for claims payable and claims
incurred but not reported is an actuarial estimate, the amount of claims
eventually paid for services provided prior to the balance sheet date could
differ from the estimated liability. Any such differences are included in the
consolidated statement of operations for the period in which the differences are
identified.
16
RECOGNITION OF PREMIUM REVENUE
Premium revenue is recognized in the period during which dental coverage is
provided to the covered individuals. Payments received from customers in advance
of the related period of coverage are reflected on the accompanying condensed
consolidated balance sheet as deferred premium revenue.
INCOME TAXES
The Company's accounting for income taxes is in accordance with SFAS No. 109,
"Accounting for Income Taxes." SFAS No. 109 requires the recognition of deferred
tax assets and liabilities for the expected future tax consequences of events
that are recognized in the Company's financial statements in different periods
than those in which the events are recognized in the Company's tax returns. The
measurement of deferred tax assets and liabilities is based on current tax laws
as of the balance sheet date. The Company records a valuation allowance related
to deferred tax assets in the event that available evidence indicates that the
future tax benefits related to deferred tax assets may not be realized. A
valuation allowance is required when it is more likely than not that the
deferred tax assets will not be realized.
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 income tax expenses and benefits during the three
months ended March 31, 2004. The Company's net deferred tax assets were fully
reserved during the comparable period in 2003, as the Company believed at that
time that it was more likely than not that the net deferred tax assets would not
be realized.
RESULTS OF OPERATIONS
The following table shows the Company's results of operations as a percentage of
premium revenue, and is used in the period-to-period comparisons discussed
below.
THREE MONTHS ENDED
MARCH 31,
----------------------
2004 2003
---------- ----------
Premium revenue, net 100.0% 100.0%
Health care services expense 71.7 68.9
Selling, general and administrative expense 23.9 29.0
---------- ----------
Operating income 4.4 2.1
Investment and other income 0.3 0.4
Interest expense (0.8) (0.5)
---------- ----------
Income before income taxes 3.9 2.0
Income tax expense 1.3 --
---------- ----------
Net income 2.6% 2.0%
========== ==========
THREE MONTHS ENDED MARCH 31, 2004 COMPARED TO THREE MONTHS ENDED MARCH 31, 2003
Premium revenue increased by $21.6 million, or 98.5%, from $21.9 million in 2003
to $43.5 million in 2004, primarily due to the acquisition of HN Dental and HN
Vision effective October 31, 2003, and the acquisition of Ameritas effective
March 31, 2003. See Note 3 to the accompanying condensed consolidated financial
statements for more information on these acquisitions. The operations of HN
Dental and HN Vision are included in the Company's financial statements
beginning on November 1, 2003, and the operations of Ameritas are included
beginning on April 1, 2003. The average membership for which the Company
provided dental or vision coverage increased by approximately 674,000 members,
or 87.1%, from 774,000 members in 2003 to 1,448,000 members in 2004. Average
membership increased in 2004 by approximately 621,000 members due to the HN
Dental and HN
17
Vision acquisition, and by approximately 26,000 members due to the Ameritas
acquisition, and the remaining increase of 3.5% was due to net internal
membership growth.
Premium revenue increased by 98.5% while average membership increased 87.1%. The
increase in premium revenue per member was primarily due to the acquisition of
HN Dental and HN Vision, as the acquired business has higher average revenue per
member than the Company's pre-existing business. The Company believes this is
because the product mix of the acquired business includes benefit plans with
higher levels of coverage on average, compared to the Company's pre-existing
business. The increase in premium revenue per member from 2003 to 2004 is also
partially due to increases in premium rates.
Health care services expense increased by $16.1 million, or 106.7%, from $15.1
million in 2003 to $31.2 million in 2004, primarily due to the acquisitions of
HN Dental, HN Vision and Ameritas, as discussed above. Health care services
expense as a percentage of premium revenue (the "loss ratio") increased from
68.9% in 2003 to 71.7% in 2004. The increase in the loss ratio was primarily due
to the acquisition of HN Dental and HN Vision, as the acquired business had a
higher loss ratio than the pre-existing operations of the Company.
Selling, general and administrative ("SG&A") expense increased by $4.0 million,
or 63.4%, from $6.4 million in 2003 to $10.4 million in 2004, primarily due to
the acquisitions of HN Dental, HN Vision and Ameritas, as discussed above. SG&A
expense as a percentage of premium revenue decreased from 29.0% in 2003 to 23.9%
in 2004. The increase in SG&A expenses is primarily due to the increase in
membership and premium revenue, as discussed above, while the decrease in SG&A
expense as a percentage of premium revenue is primarily due to economies of
scale that were realized by the Company as a result of the acquisition of HN
Dental and HN Vision.
Investment and other income decreased from $79,000 in 2003 to $122,000 in 2004,
which was primarily due to an increase in the amount of investments held by the
Company. The increase in the amount of investments held by the Company was
primarily due to the investments of HN Dental and HN Vision, and the increase in
investments held by the Company's insurance subsidiary, which was necessary to
support the PPO/indemnity dental and vision business acquired in connection with
the acquisition of HN Dental and HN Vision. See Note 3 to the accompanying
condensed consolidated financial statements for more information on the
acquisition of HN Dental and HN Vision. The increase in investments held by the
Company's insurance subsidiary was financed by the issuance of convertible notes
in October 2003, as discussed in Note 3 to the accompanying condensed
consolidated financial statements.
Interest expense increased from $100,000 in 2003 to $356,000 in 2004, which was
primarily due to the issuance of $19.0 million of convertible notes in October
2003, as discussed in Note 3 to the accompanying condensed consolidated
financial statements.
Income before income taxes improved significantly, from $444,000 in 2003 to $1.7
million in 2004, which was primarily due to a 98.5% increase in premium revenue,
and a decrease in SG&A expense as a percentage of premium revenue, from 29.0% in
2002 to 23.9% in 2003, as discussed above.
Income tax expense increased from zero in 2003 to $575,000 in 2004. The Company
had a loss for tax purposes in 2003, and its net deferred tax assets were fully
reserved at the time, and accordingly, the Company recorded no income tax
expense in 2003. See Note 5 to the accompanying condensed consolidated financial
statements for more information on income tax expense.
LIQUIDITY AND CAPITAL RESOURCES
The Company's net working capital increased from $13.5 million as of December
31, 2003, to $15.2 million as of March 31, 2004. The increase in net working
capital was primarily due to $1.1 million of net income plus $0.5 million of
deferred income tax expense.
The Company's total debt decreased slightly from $22.9 million as of December
31, 2003, to $22.8 million as of March 31, 2004, as there were no principal
payments due on any of its debt during the first quarter of 2004, except for the
capital lease obligations. The aggregate principal payments due under all of the
Company's debt, including
18
its capital leases, are $0.2 million during the remainder of 2004, $0.1 million
in 2005, $0.5 million in 2006, $1.7 million in 2007, $1.2 million in 2008, and
$19.0 million from 2009 through 2013.
Effective March 31, 2003, the Company acquired all of the outstanding capital
stock of Ameritas for $1.0 million in cash, plus contingent monthly payments
during the five years following the acquisition date. Each contingent monthly
payment is equal to 10% of the actual premium revenue during the month from
customers of Ameritas that existed as of March 31, 2003. As of March 31, 2004,
the Company has accrued a total of $341,000 of contingent purchase price, which
has been added to the cost of the acquisition for accounting purposes. Based on
the amount of premium revenue during the period from April 1, 2003 to March 31,
2004, from customers of Ameritas that existed as of March 31, 2003, the maximum
aggregate amount of the contingent monthly payments would be approximately $1.2
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 the
twelve months ended March 31, 2004. See Note 3 to the accompanying condensed
consolidated financial statements for more information on this acquisition. The
operations of Ameritas are included in the Company's consolidated financial
statements beginning on April 1, 2003.
Effective October 31, 2003, the Company acquired all of the outstanding capital
stock of HN Dental, which was 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. Effective October 31, 2003, the
Company also acquired all of the outstanding capital stock of HN Vision, which
was 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.
HN Dental and HN Vision were merged into the Company's pre-existing California
dental HMO subsidiary effective April 1, 2004.
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 170,000 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 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.
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 additional 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.
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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.
Net cash provided by operating activities decreased from $1.4 million in 2003 to
$1.2 million in 2004. Net cash provided by net income plus depreciation,
amortization and deferred income tax expense increased from $864,000 in 2003 to
$2.7 million in 2004, which was offset by $1.8 million of net cash used to
decrease accrued expenses and deferred premium revenue in 2004, compared to $0.2
million of net cash used to decrease those items in 2003. The $0.9 million
decrease in accrued expenses in 2004 was primarily due to a $1.3 million payment
to the seller of HN Dental and HN Vision in connection with the acquisition of
those entities in October 2003. The $0.9 million decrease in deferred premium
revenue in 2004 was primarily due to a change in the timing of monthly billings
to customers of HN Dental and HN Vision during the first quarter of 2004, which
was implemented in connection with the integration of HN Dental and HN Vision
into the Company's pre-existing operations.
Net cash used by investing activities was $0.1 million in 2004, compared to $0.1
million of net cash provided by investing activities in 2003. Net proceeds from
the sale or maturity of investments were $0.5 million in 2004, which was used to
finance $0.6 million of purchases of property and equipment. Net cash provided
by financing activities was $0.5 million in 2004, compared to $0.6 million of
net cash used by financing activities in 2003. Payments on debt and capital
lease obligations decreased from $0.6 million in 2003 to $0.1 million in 2004,
due to amendments to two of the outstanding convertible notes, which deferred
principal payments on the notes. See Note 4 to the accompanying condensed
consolidated financial statements for more information on the convertible notes.
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 2 to the accompanying condensed consolidated financial statements for a
discussion of recently adopted accounting principles and recently issued
accounting pronouncements.
IMPACT OF INFLATION
The Company's operations are potentially impacted by inflation, which can affect
premium rates, health care services expense, and selling, general and
administrative expense. The Company expects that its earnings will be positively
impacted by inflation in premium rates, because premium rates for dental and
vision 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 vision care
providers have been increasing due to inflation in recent years. The impact of
inflation on the Company's health care expenses is partially mitigated in the
short-term by the fact that approximately 30% of total health care services
expense consists of capitation (fixed) payments to providers. In addition, most
of the Company's selling, general and administrative expenses are impacted by
general inflation in the economy.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is subject to risk related to changes in short-term interest rates,
due to its investments in interest-bearing securities. As of March 31, 2004, the
Company's total cash and investments were approximately $32.6 million.
Therefore, a one percentage-point change in short-term interest rates would have
a $326,000 impact on the Company's annual investment income. The Company is not
subject to a material amount of risk related to changes in foreign currency
exchange rates.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The Company completed an evaluation as of March 31, 2004, under the supervision
and with the participation of the Company's management, including the Chief
Executive Officer and the Chief Financial Officer, of the effectiveness of the
design and operation of the Company's disclosure controls and procedures
pursuant to Exchange Act Rule 13a-14. Based on that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that the
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Company's disclosure controls and procedures are effective in alerting them, on
a timely basis, to material information related to the Company required to be
included in the Company's periodic filings with the Securities and Exchange
Commission.
CHANGES IN INTERNAL CONTROLS
No significant changes to the Company's internal controls were made during the
periods covered by this report.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is subject to various claims and legal actions arising in the
ordinary course of business. The Company believes all pending claims either are
covered by liability insurance maintained by the Company or by providers in the
Company's provider networks, or will not have a material adverse effect on the
Company's consolidated financial position or results of operations.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
31.1 Certification pursuant to 18 U.S.C. Section 1350
(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, and which
includes historical financial statements of HN Dental and HN Vision and pro
forma financial information for the Company related to the acquisition of HN
Dental and HN Vision. See Note 3 to the accompanying condensed consolidated
financial statements for more information on this acquisition.
The Company filed a Current Report on Form 8-K on April 15, 2004, to report the
issuance of a news release containing information on the Company's results of
operations for the quarter and year ended December 31, 2003.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized, in the City of Aliso
Viejo, State of California, on the 13th day of May 2004.
SAFEGUARD HEALTH ENTERPRISES, INC.
By: /s/ James E. Buncher
-----------------------
James E. Buncher
President and Chief Executive Officer
(Principal Executive Officer)
By: /s/ Dennis L. Gates
----------------------
Dennis L. Gates
Senior Vice President and Chief Financial Officer
(Principal Accounting Officer)
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