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Table of Contents

 

 

 

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

 

x      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

 

For the fiscal year ended December 31, 2016

 

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 1-10670

 

HANGER, INC.

(Exact name of registrant as specified in its charter.)

 

Delaware
(State or other jurisdiction of
incorporation or organization)

 

84-0904275
(I.R.S. Employer
Identification No.)

 

 

 

10910 Domain Drive, Suite 300, Austin, TX
(Address of principal executive offices)

 

78758
(Zip Code)

 

Registrant’s phone number, including area code:  (512) 777-3800

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of class

 

Name of exchange on which registered

Common Stock, par value $0.01 per share

 

OTC Pink (operated by OTC Markets Group Inc.)

 

Securities registered pursuant to Section 12(g) of the Act:  None.

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x

 

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 ¨   No x

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ¨  No x

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) 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. ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ¨

 

Accelerated filer x

Non-accelerated filer ¨

 

Smaller reporting company ¨

 

 

Emerging growth company ¨

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter which was June 30, 2017, $425.8 million.

 

As of January 12, 2018 the registrant had 36,328,678 shares of its Common Stock issued and outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE:  None

 

 

 



Table of Contents

 

INDEX

 

Hanger, Inc.

 

 

 

Explanatory Note

ii

 

 

Part I

 

 

 

Item 1. Business

1

 

 

Item 1A. Risk Factors

12

 

 

Item 1B. Unresolved Staff Comments

24

 

 

Item 2. Properties

25

 

 

Item 3. Legal Proceedings

26

 

 

Item 4. Mine Safety Disclosures

28

 

 

Part II

 

 

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

29

 

 

Item 6. Selected Financial Data

31

 

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

33

 

 

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

96

 

 

Item 8. Financial Statements and Supplementary Data

97

 

 

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

98

 

 

Item 9A. Controls and Procedures

99

 

 

Item 9B. Other Information

109

 

 

Part III

 

 

 

Item 10. Directors, Executive Officers and Corporate Governance

110

 

 

Item 11. Executive Compensation

117

 

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

171

 

 

Item 13. Certain Relationships and Related Transactions, and Director Independence

174

 

 

Item 14. Principal Accountant Fees and Services

175

 

 

Part IV

 

 

 

Item 15. Exhibits and Financial Statement Schedules

177

 

 

Item 16. Form 10-K Summary

181

 

 

Signatures

182

 

 

Index to Financial Statements

F-1

 

 

Exhibits Index

E-1

 

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EXPLANATORY NOTE

 

We filed our Annual Report on Form 10-K for the year ended December 31, 2014 (the “2014 Form 10-K”) on May 12, 2017.  The 2014 Form 10-K contained our consolidated financial statements and related footnotes for the year ended December 31, 2014, as well as consolidated financial statements for the third and fourth quarters of 2014.  The 2014 Form 10-K also included a restatement of our previously issued consolidated financial statements and related footnotes for (i) the fiscal years ended December 31, 2013 and 2012; (ii) the first two quarters of fiscal year 2014 and (iii) each of the quarterly periods in fiscal year 2013 (the “Restatement”).  The 2014 Form 10-K also contained restated financial results for the fiscal years ended December 31, 2011 and 2010 (each unaudited), as summarized in Item 6. “Selected Financial Data” to the 2014 Form 10-K.  The Restatement resulted in a cumulative reduction to our previously reported income before taxes through June 30, 2014 of approximately $175.1 million due to prior misstatements.

 

The filing of this Annual Report on Form 10-K for the year ended December 31, 2016 has been delayed significantly as a result of the delay in our filing of the 2014 Form 10-K, the number of accounting periods encompassed within this filing, as well as the additional review, analysis and substantive procedures performed due to the material weaknesses in our internal control over financial reporting identified in connection with the completion and filing of the 2014 Form 10-K.  See Item 9A. “Controls and Procedures” in this Annual Report on Form 10-K for information regarding the identified material weaknesses.  Due to the delay in our 2017 quarterly filings and changes that have occurred in our business since December 31, 2016, certain of the information contained in this Annual Report on Form 10-K is presented in a manner that, where appropriate, reflects current or more recent information regarding our business.

 

We have not filed our Annual Report on Form 10-K for the year ended December 31, 2015 (the “2015 Form 10-K”) or Quarterly Reports on Form 10-Q for 2016 and 2015.  In lieu of filing a 2015 Form 10-K and Quarterly Reports for 2016 and 2015, we have included in this Annual Report on Form 10-K all material information required to be included in the 2015 Form 10-K and Quarterly Reports on Form 10-Q for 2016 and 2015.

 

We have made significant progress in our efforts to remediate material weaknesses that have prevented us from reporting our financial results on a timely basis.  To date, we have taken and continue to take the actions described in the section titled “Remediation Plans” included in Item 9A. “Controls and Procedures” in this Annual Report on Form 10-K to address previously identified material weaknesses.  Our remediation efforts are ongoing.  As we continue to evaluate and work to improve our internal control over financial reporting, we may implement additional measures or modify the currently identified remedial actions to remediate our material weaknesses.

 

Despite the substantial time and resources we have directed at our remediation efforts, we are unable to estimate at this time when these remediation efforts will be completed.  Until the remediation efforts, including any additional remediation efforts that our management identifies as necessary, are completed, the material weaknesses described in “Item 9A. Controls and Procedures” will continue to exist.

 

We intend to provide additional information regarding our remediation efforts with respect to the material weaknesses in future filings with the SEC.

 

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PART I

 

ITEM 1.  BUSINESS

 

Business Overview

 

General

 

Hanger, Inc. (“the Company,” “we,” “our,” or “us”) is a leading national provider of products and services that assist in enhancing or restoring the physical capabilities of patients with disabilities or injuries.  Built on the legacy of James Edward Hanger, the first amputee of the American Civil War, we and our predecessor companies have provided orthotic and prosthetic (“O&P”) services for over 150 years.  We provide O&P services, distribute O&P devices and components, manage O&P networks and provide therapeutic solutions to patients and businesses in acute, post-acute and clinic settings.  We operate through two segments - Patient Care and Products & Services.

 

Our Patient Care segment is primarily comprised of Hanger Clinic, which specializes in the design, fabrication and delivery of custom O&P devices through 706 patient care clinics and 115 satellite locations in 45 states and the District of Columbia, as of December 31, 2016.  We also provide payor network contracting services to other O&P providers through this segment.

 

Our Products & Services segment is comprised of our distribution and therapeutic solutions businesses.  As a leading provider of O&P products in the United States, we coordinate through our distribution business the procurement and distribution of a broad catalog of O&P parts, componentry and devices to independent O&P providers nationwide.  To facilitate speed and convenience, we deliver these products through our five distribution facilities that are located in Nevada, Georgia, Illinois, Pennsylvania and Texas.  The other business in our Products & Services segment is our therapeutic solutions business, which develops specialized rehabilitation technologies and provides evidence-based clinical programs for post-acute rehabilitation patients at approximately 4,000 skilled nursing and post-acute providers nationwide.

 

For the years ended December 31, 2016, 2015 and 2014, our net revenues were $1,042.1 million, $1,067.2 million and $1,012.1 million, respectively.  We recorded a loss from continuing operations of $107.4 million, $319.1 million and $3.0 million for the years ended December 31, 2016, 2015 and 2014, respectively.

 

The following table summarizes the percentage of net revenues derived from each of our two operating segments:

 

 

 

For the Years Ended December 31,

 

 

 

2016

 

2015

 

2014

 

Patient Care

 

80.6

%

82.0

%

82.7

%

Products & Services

 

19.4

%

18.0

%

17.3

%

 

See Note R - “Segment and Related Information” to our consolidated financial statements in this Annual Report on Form 10-K for additional information about our segments.

 

Industry Overview

 

We estimate that approximately $4.0 billion is spent in the United States each year for prescription-based O&P products and services through O&P clinics.  Orthotic devices, or “orthoses” are externally applied devices used to modify the structural and functional characteristics of the neuromuscular and skeletal system.  These devices typically are provided to patients suffering from musculoskeletal disorders, such as ailments of the back, extremities or joints; injuries from sports; or conditions such as cerebral palsy, scoliosis and stroke.  Prosthetic devices, or “prostheses” are artificial devices that replace a missing limb or portion of a limb.  These devices are normally provided to patients with amputated or congenitally absent limbs to replace the function and appearance of a limb so that patients can resume activities of daily living and work.  The most prevalent causes for amputations are from complications due to diabetes, trauma associated with accidents, or physical injury, tumor or infection.

 

The industry derives its primary revenue from the evaluation, fabrication and fitting of custom O&P devices to serve patients needing both new and replacement devices.  Additionally, O&P clinics typically provide patients with other non-custom orthotic products, diabetic shoes and inserts, and support patients through the repair and adjustment of their devices.

 

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We believe our Patient Care segment currently serves approximately 20% of the O&P clinic market.  We understand that the next largest provider of O&P services in the United States is the Veterans Administration (the “VA”), which operates 79 O&P clinics on behalf of its covered veteran patients.  In addition to serving veterans through their own facilities, in certain markets the VA is also a client of Hanger Clinic.  Approximately 9% of Hanger Clinic’s revenue is derived from services provided to veteran patients through contracts with the VA.

 

The balance of the O&P patient care market is highly fragmented and is typically characterized by regional and local independent O&P businesses.  We estimate that our top ten competitors have an average of approximately 25 clinics each, with the smallest having 16 and the largest having 36 clinics.  The remainder of the market is served by individual practitioners and smaller regional or market-based firms with approximately 10 or fewer clinics.  Based on this, we do not believe that any single competitor accounts for more than approximately 2% of the nation’s total estimated O&P clinic revenues.

 

We anticipate that the demand for O&P services will continue to grow as the nation’s population increases, and as a result of several trends, including the aging of the U.S. population, there will be an increase in the prevalence of disease associated disability and the demand for new and advanced devices.  We believe the typical replacement time for prosthetic devices is three to five years, while the typical replacement time for orthotic devices varies, depending on the device.

 

We estimate that approximately $1.7 billion is spent in the United States each year by providers of O&P patient care services for the O&P products, components, devices and supplies used in their businesses.  Our Products & Services segment distributes O&P products, components, devices and supplies to independent providers of O&P services and to our own patient care clinics.  We estimate that our distribution sales account for approximately 8% of the market for O&P products, components, devices and supplies (excluding sales to our Patient Care segment).

 

We estimate the market for rehabilitation technologies, integrated clinical programs and therapist training in skilled nursing facilities (“SNFs”) to be approximately $150 million annually.  We currently provide these products and services to approximately 30% of the estimated 15,000 SNFs located in the U.S.  We estimate the market for rehabilitation technologies, clinical programs and training within the broader post-acute rehabilitation markets to be approximately $400 million annually.  We do not currently provide a meaningful amount of products and services to this broader market.

 

Business Strategy

 

Our goal is to be the provider of choice for patients, referring physicians and customers seeking products and services that enhance human physical capabilities.  Our strategy is to pursue the creation of an integrated therapeutic solutions model that will have a strong focus in custom O&P and immediately adjacent markets to provide our patients and customers with a spectrum of services that address their individual needs.  To foster growth and gain further market share, we intend to focus on initiatives that will differentiate Hanger from our competitors.

 

Government led health care reform is driving significant changes to our business environment, with focus on lowering health care costs while improving patient outcomes and satisfaction.  As a result, our strategy is focused on enhancing the quality of care to elevate patient satisfaction, investing in processes and technologies to measure and report on patient outcomes and satisfaction, and further increasing our profile with referring health care providers and payors.  In addition, we are committed to reducing the cost of this care by undertaking several initiatives that include establishing device standards that provide the highest function, durability and comfort at the lowest cost, reconfiguring our supply chain and fabrication processes, streamlining internal administrative processes and reducing back-office functions performed within patient care clinic locations.

 

Business Description

 

Patient Care

 

Our Patient Care segment , which specializes in patient evaluation and the fabrication, fitting and delivery of O&P devices through our nationwide patient care clinic locations employs approximately 1,600 clinical prosthetists, orthotists and pedorthists, which we refer to as clinicians, substantially all of which are certified by either the American Board for Certification (“ABC”) or the Board of Certification of Orthotists and Prosthetists, which are the two boards that certify O&P clinicians.  To facilitate timely service to our patients, we also employ technicians, fitters and other ancillary providers to

 

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assist its clinicians in the performance of their duties.  Through this segment, we additionally provide network contracting services to independent providers of O&P through our “Linkia” business.

 

To complement and enhance our O&P business, we have provided certain non-custom orthotics directly to patients of hospital systems and other providers through our CARES patient care services unit (“CARES”) and Dosteon product group (“Dosteon”).  We completed the exit of our Dosteon businesses with the sale of the businesses in 2015.  The operating results and cash flows of Dosteon have been presented separately as discontinued operations in the consolidated financial statements.  We completed the exit of our CARES business through the closure of these operations during 2015.

 

Patients are typically referred to Hanger Clinic by an attending physician who determines a patient’s treatment and writes a prescription.  Our clinicians then consult with both the referring physician and the patient with a view toward assisting in the design of an orthotic or prosthetic device to meet the patient’s needs.  O&P devices are increasingly technologically advanced and custom designed to add functionality and comfort to patients’ lives, shorten the rehabilitation process and lower the cost of rehabilitation.  When providing custom orthoses, we design, fabricate, fit and maintain a wide range of custom-made braces and other devices (such as spinal, knee and other braces) that provide external support to patients suffering from musculoskeletal disorders, such as ailments of the back, extremities or joints and injuries from sports or other activities.  We also provide and fit non-custom, including “off the shelf” orthoses to patients with similar, though typically less severe, disorders, ailments and injuries.

 

Based on the prescription written by a referring physician, our clinicians examine and evaluate the patient and either design a custom device or, in the case of certain orthotic needs, utilize a non-custom device, including, in appropriate circumstances, an “off the shelf” device, to address the patient’s needs.  When fabricating a device, our clinicians ascertain the specific requirements, componentry and measurements necessary for the construction of the device.  Custom devices are constructed using componentry provided by a variety of third party manufacturers who specialize in O&P, coupled with sockets and other elements that are fabricated by our clinicians and technicians, to meet the individual patient’s physical and ambulatory needs.  Our clinicians and technicians typically utilize castings, electronic scans and other techniques to fabricate items that are specialized for the patient.  After fabricating the device, a fitting process is undertaken and adjustments are made to ensure the achievement of proper alignment, fit and patient comfort.  The fitting process often involves several stages to successfully achieve desired functional and cosmetic results.

 

Given the differing physical weight and size characteristics, location of injury or amputation, capability for physical activity and mobility, cosmetic and other needs of each individual patient, each fabricated prosthesis and orthosis is customized for each particular patient.  These custom devices are commonly fabricated at one of our regional or national fabrication facilities.

 

We have earned a reputation within the O&P industry for the development and use of innovative technology in our products, which has increased patient comfort and capability and can significantly enhance the rehabilitation process.  Frequently, our proprietary Insignia scanning system is used in the fabrication process.  The Insignia system scans the patient and produces an accurate computer generated image, resulting in a faster turnaround for the patient’s device and a more professional overall experience.

 

Our patient care clinics are typically managed by one of our clinicians, and also employ technical personnel who assist in the provision of services to patients and who fabricate various O&P devices, as well as office administrators who schedule patient visits, obtain approvals from payors and bill and collect for services rendered.  In recent years, we have established a centralized revenue cycle management organization that assists our clinics in pre-authorization, patient eligibility, denial management, collections, payor audit coordination and other accounts receivable processes.

 

The principal reimbursement sources for our services are:

 

·                  Commercial private payors and other non-governmental organizations, which consist of individuals, rehabilitation providers, commercial insurance companies, health management organizations (“HMOs”), preferred provider organizations (“PPOs”), hospitals, vocational rehabilitation centers, workers’ compensation programs, third party administrators and similar sources;

 

·                  Medicare, a federally funded health insurance program providing health insurance coverage for persons aged 65 or older and certain disabled persons, which provides reimbursement for O&P products and services based on

 

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prices set forth in published fee schedules with ten regional pricing areas for prosthetics and orthotics and by state for Durable Medical Equipment (“DME”);

 

·                  Medicaid, a health insurance program jointly funded by federal and state governments providing health insurance coverage for certain persons based upon financial need, regardless of age, which may supplement Medicare benefits for financially needy persons aged 65 or older; and

 

·                  U.S. Department of Veterans Affairs.

 

We typically enter into contracts with third party payors that allow us to perform O&P services for a referred patient and to be paid under the contract with the third party payor.  These contracts usually have a stated term of one to three years.  These contracts generally may be terminated without cause by either party on 60 to 90 days’ notice or on 30 days’ notice if we have not complied with certain licensing, certification, program standards, Medicare or Medicaid requirements or other regulatory requirements.  Reimbursement for services is typically based on a fee schedule negotiated with the third party payor that reflects various factors, including market conditions, geographic area and number of persons covered.  Many of our commercial contracts are indexed to the commensurate Medicare fee schedule that relates to the products or services being provided.

 

Government reimbursement, comprised of Medicare, Medicaid and the U.S. Department of Veterans Affairs, in the aggregate, accounted for approximately, 54.1%, 53.4% and 50.9% of our net revenue in 2016, 2015 and 2014, respectively.  These payors set maximum reimbursement levels for O&P services and products.  Medicare prices are adjusted each year based on the Consumer Price Index for All Urban Consumers (“CPI-U”) unless Congress acts to change or eliminate the adjustment.  The CPI-U is adjusted further by an efficiency factor (the “Productivity Adjustment” or the “Multi-Factor Productivity Adjustment”) in order to determine the final rate adjustment each year.  The Medicare price adjustments for 2016, 2015, 2014, 2013 and 2012 were (0.4%), 1.5%, 1.0%, 0.8% and 2.4%, respectively.  There can be no assurance that future adjustments will not reduce reimbursements for O&P services and products from these sources.

 

We, and the O&P industry in general, are subject to various Medicare compliance audits, including Recovery Audit Contractor (“RAC”) audits, Comprehensive Error Rate Testing (“CERT”) audits, Targeted Probe and Educate (“TPE”) audits and Zone Program Integrity Contractor (“ZPIC”) audits.  TPE audits are generally pre-payment audits, while RAC, CERT and ZPIC audits are generally post-payment audits.  The recently implemented TPE audits have replaced the previous Medicare Administrative Contractor (“MAC”) audits.  Adverse post-payment audit determinations generally require Hanger to reimburse Medicare for payments previously made, while adverse pre-payment audit determinations generally result in the denial of payment.  In either case, we can request a redetermination or appeal, if we believe the adverse determination is unwarranted, which can take an extensive period of time to resolve, currently up to six years or more.

 

Products & Services

 

Our Products & Services segment was established through the combination of our previously reported Distribution segment and Therapeutic Solutions segment.  Through our wholly-owned subsidiary, Southern Prosthetic Supply, Inc. (“SPS”), we distribute O&P components both to independent customers and to our own clinics in the Patient Care segment.  SPS purchases, warehouses and distributes over 400,000 SKUs from more than 300 different manufacturers.  By locating warehousing and distribution facilities in Nevada, Georgia, Illinois, Pennsylvania and Texas, we are able to deliver products to the vast majority of our distribution customers in the United States within two business days.  Through its SureFit subsidiary, SPS also manufactures and sells therapeutic footwear for diabetic patients in the podiatric market, and through its National Labs subsidiary it is a fabricator of O&P devices both for our patient care clinics and competitor clinics.

 

Our distribution business enables us to:

 

·                  centralize our purchasing and thus lower our material costs by negotiating purchasing discounts from manufacturers;

 

·                  better manage our patient care clinic inventory levels and improve inventory turns;

 

·                  improve inventory quality control;

 

·                  encourage our patient care clinics to use the most clinically appropriate products; and

 

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·                  coordinate new product development efforts with key vendors.

 

Through our wholly-owned subsidiaries, Accelerated Care Plus Corp. and Accelerated Care Plus Leasing, Inc. (together, “ACP”), our therapeutic solutions business is a leading provider of rehabilitation technologies and integrated clinical programs to rehabilitation providers.  Our unique value proposition is to provide our customers with a full-service “total solutions” approach encompassing proven medical technology, evidence based clinical programs, and ongoing therapist education and training.  Our services support increasingly advanced treatment options for a broader patient population and more medically complex conditions.  We serve approximately 4,000 skilled nursing and post-acute providers nationwide.

 

Competition

 

The O&P services industry is highly fragmented, consisting mainly of smaller regional and local firms.  We estimate that our top ten competitors have an average of approximately 25 clinics each, with the smallest having 16 clinics each and the largest having 36 clinics each.  The balance of the market is served by individual practitioners and smaller regional or market-based firms with approximately 10 or fewer clinics.  Based on this, we do not believe that any single competitor accounts for more than approximately 2% of the nation’s total estimated O&P clinic revenues.

 

The business of providing O&P patient care services is highly competitive in the markets in which we operate.  In the prosthetic business, we compete with numerous small independent O&P providers for referrals from physicians, therapists, employers, HMOs, PPOs, hospitals, rehabilitation centers, out-patient clinics and insurance companies on both a local and regional basis.  In the orthotic business, we compete with other patient care service providers, including device manufacturers that have independent sales forces, on the basis of quality and timeliness of patient care, location of patient care clinics and pricing for services.

 

Although we serve a significant portion of the O&P patient care market, referral decisions made by surgeons, physicians and other medical providers are generally made on a local basis, based on their individual evaluation of the relative quality of care provided by us and our local market competitors.  Therefore, our national scale may not provide a competitive advantage in any particular market in which we operate.

 

We also compete with independent O&P providers for the retention and recruitment of qualified O&P clinicians.  In some markets, the demand for clinicians exceeds the supply of qualified personnel.

 

Our Products & Services segment competes with other distributors, manufacturers who sell their products directly and providers of equipment and services on a regional and national basis that have similar sales forces and products.  Some of our distributor competitors are also dedicated to the O&P industry, but many others are large medical product distributors who also distribute O&P products, particularly orthotic products.

 

Competitive Strengths

 

We believe that the combination of the following competitive strengths will help us to grow our businesses by increasing our net revenues, net income and market share:

 

·                  Leading market position both in the O&P market place and in the post-acute rehabilitation markets;

 

·                  National scale of operations, which better enables us to:

 

·                  establish our brand name and generate economies of scale;

 

·                  identify and implement best practices throughout our organization;

 

·                  collect, aggregate and publish our statistically significant clinical outcomes and patient satisfaction data and metrics;

 

·                  offer a single network solution to national and regional shared fabrication facilities;

 

·                  identify, test and deploy emerging technology; and

 

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·                  increase our influence on, and input into, regulatory trends;

 

·                  Distribution of, and purchasing power for, O&P components and finished O&P products, which enables us to:

 

·                  negotiate greater purchasing discounts from manufacturers and freight providers;

 

·                  reduce patient care clinic inventory levels and improve inventory turns through centralized purchasing control;

 

·                  access prefabricated and finished O&P products;

 

·                  promote the usage by our patient care clinics of clinically appropriate products that also enhance our profit margins; and

 

·                  expand the external client base of the distribution business in our Products & Services segment;

 

·                  Proven ability to rapidly incorporate technological advances in the fitting and fabrication of O&P devices;

 

·                  History of integrating small and medium sized O&P business acquisitions, including 139 O&P businesses between 1997 and 2015, representing over 365 patient care clinics;

 

·                  Highly trained clinicians, whom we provide with the highest level of continuing education and training through programs designed to inform them of the latest technological developments in the O&P industry;

 

·                  Experienced and committed management team; and

 

·                  Beneficial government relations efforts which enables us to educate legislators on the medical benefits and cost effectiveness of O&P services.

 

Suppliers

 

We purchase prefabricated O&P devices, components and materials from hundreds of suppliers across the country, which are utilized by our clinicians and technicians in the fabrication of O&P products.  These devices, components and materials are used in the products we offer in our patient care clinics throughout the United States.  Our Products & Services segment purchases, warehouses and distributes over 24,000 individual products from more than 300 different manufacturers.  As of December 31, 2016, only three of our third party suppliers individually accounted for more than 5% of our total annual purchases.  These three suppliers accounted for a combined total of 29% of annual purchases.

 

Sales and Marketing

 

In our Patient Care segment, primarily through their interaction with and provision of prosthetic or orthotic services to the patients of referring surgeons, physicians and other providers, our individual clinicians in local patient care clinics historically have conducted our sales and marketing efforts.  Due primarily to the fragmented nature of the O&P industry, the success of a particular patient care clinic has been largely a function of its local reputation for quality of care, responsiveness and length of service in the local communities.

 

To augment the efforts of the business segment personnel, we have developed a centralized sales and marketing department, whose efforts target the following:

 

·                  Marketing and Public Relations.  Our objective is to increase the visibility of the “Hanger” name by building relationships with major referral sources.  We also continue to explore creating alliances with certain vendors to market products and services on a nationwide basis.

 

·                  Business Development.  We have dedicated personnel in most of our operating regions who are responsible for arranging seminars, clinics and forums to educate and consult with patients and to increase the local

 

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community’s awareness of the “Hanger” name.  These business development managers also meet with local referral and contract sources to help our clinicians develop new relationships in their markets.

 

·                  Insurance Contracts.  Our specialty health care company, Linkia, works with national insurance companies to help manage their O&P networks.  Linkia is a network management organization dedicated solely to the O&P industry to improve the interface between payors and O&P providers by simplifying network management and administration, in-depth industry expertise and scalability to payors.

 

Marketing of our services is conducted on a national basis through a dedicated sales force, print and e-commerce catalogs and exhibits at industry and medical meetings and conventions.  We use directed marketing to segments of the health care industry, such as orthopedic surgeons, physical and occupational therapists, patient care managers and podiatrists, by providing specialized catalogs focused on their medical specialty.

 

In our Products & Services segment, we employ dedicated sales professionals that generally are responsible for a geographic region or specific product line.

 

Acquisition Strategy

 

Our strategy is to achieve long-term growth through disciplined diversification of our revenue streams, including geographic expansion or the broadening of our continuum of care through acquisitions.  One of the primary drivers in executing our acquisition strategy is expanding our ability to serve new patients in new geographic markets.

 

Once an acquisition is consummated, we integrate and generally centralize certain key functions including IT, marketing, sales, finance and administration to ensure that we can optimize cross-selling opportunities and realize cost efficiencies.

 

In some of our historical acquisitions, in addition to cash paid at closing, the purchase price has included unsecured subordinated promissory notes (“Seller Notes”) and contingent consideration terms (“earnouts”) associated with the achievement of certain designated collection targets for the acquired business.  Earnouts can be used to compromise between our valuation and seller’s expectations regarding purchase price, while providing protection from our overpayment if historical collections are not an accurate indicator of post-closing financial performance of the acquired business.

 

Our evaluation of the acquired business is based on various factors, including specialized know-how, reputation, geographic coverage, competitive position and service and product offerings, as well as our experience and judgment.  Our acquisition strategy is focused on acquiring the expertise of an assembled workforce to continue to build upon the core capabilities of our strategic business platforms and agency brands through the expansion of our service area or service capabilities to better serve our clients.

 

Acquisition Activity

 

We stopped making acquisitions subsequent to the first quarter of 2015, both due to the necessity of our utilizing available operating cash flow to fund accounting, legal and other professional fees in connection with our preparation and review of the financial statements, efforts to remediate material weaknesses, and related legal matters, as well as due to the effect of our non-compliance with certain of our debt covenants relating to our failure to meet financial statement reporting requirements.  Once we regain timely filing status, and provided no other events or factors emerge that would prevent our use of capital for the purposes of acquisitions, we currently intend to recommence acquisitions of O&P businesses similar to those that we have consummated in prior years.

 

In 2015, we acquired three O&P businesses with approximately $11.8 million in revenue, operating a total of 15 patient care clinics located in three states.  The aggregate purchase price for these businesses was approximately $15.3 million, including approximately $10.2 million in cash, approximately $4.7 million in Seller Notes, approximately $0.4 million working capital adjustments and no contingent consideration.  We allocated the purchase price for 2015 acquisitions to the individual net assets acquired and liabilities assumed.  The excess of purchase price over the aggregate fair values of the net assets acquired and liabilities assumed was recorded as goodwill.  We incurred minimal legal costs and other acquisition related expenses in connection with our 2015 acquisition activity.  Acquisition related expenses are included within “General and administrative expenses” in our consolidated statements of operations and comprehensive (loss) income in the period incurred.

 

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Government Regulation

 

The operations of our business are subject to a variety of federal, state and local governmental regulations.  We make every effort to comply with all applicable regulations through compliance programs, policies and procedures, manuals and personnel training.  Despite these efforts, we cannot guarantee that we will be in absolute compliance with all regulations at all times.  Failure to comply with applicable governmental regulations may result in significant penalties, including exclusion from the Medicare and Medicaid programs, which would have a material adverse effect on our business and financial results.

 

Fraud and Abuse.  Violations of fraud and abuse laws are punishable by criminal and/or civil sanctions, including, in some instances, False Claims Act liability (discussed below), imprisonment and exclusion from participation in federal health care programs, including Medicare, Medicaid, U.S. Department of Veterans Affairs health programs and the Department of Defense’s TRICARE program, formerly known as CHAMPUS.  These laws, which include but are not limited to federal and state anti-kickback laws, false claims laws, physician self-referral laws and federal criminal health care fraud laws, are discussed in further detail below.  We believe our billing practices, operations and compensation and financial arrangements with referral sources and others materially comply with applicable federal and state requirements.  However, we cannot assure that such requirements will always be interpreted by a governmental authority in a manner consistent with our interpretation and application.  The failure to comply, even if inadvertent, with any of these requirements could require us to alter our operations with and/or refund payments to the government.  Such refunds could be significant and could also lead to the imposition of significant penalties.  Even if we successfully defend against any action against us for violation of these laws or regulations, we would likely be forced to incur significant legal expenses and divert our management’s attention from the operation of our business.  Any of these actions, individually or in the aggregate, could have a material adverse effect on our business and financial results.

 

Anti-Kickback Laws.  Our operations are subject to federal and state anti-kickback laws.  The federal Anti-Kickback Statute (Section 1128B(b) of the Social Security Act) prohibits persons or entities from knowingly and willfully soliciting, offering, receiving or paying any remuneration in any form (including any kickback, bribe or rebate) in return for, or to induce, the referral of persons eligible for benefits under a federal health care program (including Medicare, Medicaid, the U.S. Department of Veterans Affairs health programs and TRICARE), or the ordering, purchasing, leasing, or arranging for, or the recommendation of purchasing, leasing or ordering of, items or services that may be paid for, in whole or in part, by a federal health care program.  Courts have held that the statute may be violated when even one purpose (as opposed to a primary or sole purpose) of the remuneration is to induce referrals or other business.

 

Recognizing that the Anti-Kickback Statute is broad and may technically prohibit beneficial commercial arrangements, the Office of Inspector General of the Department of Health and Human Services has developed regulations addressing certain business arrangements that will offer protection from scrutiny under the Anti-Kickback Statute.  These “Safe Harbors” describe activities which may be protected from prosecution under the Anti-Kickback Statute, provided that they meet all of the requirements of the applicable Safe Harbor regulation.  For example, the Safe Harbors cover activities such as offering discounts to health care providers and contracting with physicians or other individuals or entities that have the potential to refer business to us that would ultimately be billed to a federal health care program, so long as the discount is properly disclosed and appropriately reflected in any claims or charges.

 

Failure to qualify for Safe Harbor protection does not automatically mean that an arrangement is illegal.  Rather, the facts and circumstances of the arrangement must be analyzed to determine whether there is improper intent to pay or receive remuneration in return for referrals.  Conduct and business arrangements that do not fully satisfy one of the Safe Harbors may result in increased scrutiny by government enforcement authorities.  In addition, some states have anti-kickback laws that vary in scope and may apply regardless of whether a federal health care program is involved.

 

Our operations and business arrangements include, for example, discount programs or other financial arrangements with individuals and entities, such as lease arrangements with hospitals and certain participation agreements.  Therefore, our operations and business arrangements are required to comply with the anti-kickback laws.  Although our business arrangements and operations may not always satisfy all the criteria of a Safe Harbor, we believe that our operations are in material compliance with federal and state anti-kickback statutes.  Nonetheless, we cannot ensure that the government’s interpretation of a Safe Harbor provision will always be consistent with our own, and our arrangements may be subject to scrutiny under anti-kickback laws.  Noncompliance with such laws can result in a number of enforcement actions, including the imposition of civil monetary penalties and exclusion from federal health care programs.

 

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Medical Device Regulation.  We provide, distribute and lease products that are subject to regulation as medical devices by the U.S. Food and Drug Administration (“FDA”) under the Federal Food, Drug and Cosmetic Act (“FDCA”) and accompanying regulations.  In our Patient Care segment, with the exception of two products which have been cleared for marketing as prescription medical devices under section 510(k) of the FDCA, we believe that the products we provide, including O&P medical devices, accessories and components, are not Class III devices and thus are exempt from the FDA’s regulations for pre-market clearance or approval requirements and from most requirements relating to the quality system regulation (except for certain record keeping and complaint handling requirements).  In our Products & Services segment, ACP manufactures, leases and sells a number of rehabilitation devices that have been cleared or approved for marketing under section 510(k) of the FDCA, and are subject to the requirements of the quality system regulation.  All of our device businesses are required to adhere to regulations for medical devices regarding adverse event reporting, establishment registration and product listing, and we are subject to inspection by the FDA for compliance with all applicable requirements.  Labeling and promotional materials also are subject to scrutiny by the FDA and, in certain circumstances, by the Federal Trade Commission.  Our medical device operations are subject to inspection by the FDA for compliance with applicable FDA requirements, and the FDA has in the past raised compliance concerns in connection with these investigations.  We have addressed these concerns and believe we are in compliance with applicable FDA requirements, but we cannot assure that we will be found to be in compliance at all times.  Non-compliance could result in a variety of civil and/or criminal enforcement actions, including issuance of a Warning Letter, seizure, examination and inspection of our products and a civil injunction or criminal prosecution, which could have a material adverse effect on our business and results of operations.

 

Physician Self-Referral Laws.  We are also subject to federal and state physician self-referral laws.  With certain exceptions, the federal Medicare physician self-referral law (the “Stark Law”) (Section 1877 of the Social Security Act) prohibits a physician from referring Medicare beneficiaries to an entity for “designated health services” including DME and supplies, and prosthetic and orthotic devices and supplies, if the physician or the physician’s immediate family member has a financial relationship with the entity.  A financial relationship includes both ownership or investment interests and compensation arrangements.  An entity that furnishes designated health services pursuant to a prohibited referral may not present or cause to be presented a claim or bill for such designated health services.  Penalties for violating the Stark Law include denial of payment for the service, an obligation to refund any payments received, civil monetary penalties, potential False Claims Act litigation and the possibility of being excluded from the Medicare or Medicaid programs.

 

Despite the general prohibition on such physician financial relationships, the Stark Law does provide a number of exceptions from liability.  For example, with respect to ownership/investment interests, there is an exception under the Stark Law for referrals made to a publicly traded entity in which the physician or the physician’s immediate family member has an investment interest if the entity’s shares are generally available to the public at the time of the designated health service referral, and are traded on certain exchanges, including among others the New York Stock Exchange (“NYSE”) as well as over-the-counter quotation systems including the OTC Markets Group, Inc. (“OTC”) and/or the investment entity had shareholders’ equity exceeding $75.0 million for its most recent fiscal year or as an average during the three previous fiscal years.  We meet these tests and, therefore, believe that referrals from physicians who have ownership interests in our stock, or whose immediate family members have ownership interests in our stock, should not result in liability under the Stark Law.

 

With respect to compensation arrangements, there are exceptions under the Stark Law that permit physicians to maintain certain business arrangements, such as personal service contracts and equipment or space leases, with health care entities to which they refer patients for designated health services.  All of the elements of a Stark Law exception must be met in order for the exception to apply.  Further, unlike the Anti-Kickback Statute, under the Stark Law liability can result without specific intent to induce referrals.  We believe that our compensation arrangements with physicians comply with the Stark Law, either because the physician’s relationship fits fully within a Stark Law exception or because the physician does not generate prohibited referrals.  If, however, we receive a prohibited referral, our submission of a bill for services rendered pursuant to such a referral could subject us to sanctions under the Stark Law and applicable state self-referral laws, including false claims liability, potential exclusion and imposition of civil monetary penalties.  State self-referral laws may extend the prohibitions of the Stark Law to Medicaid beneficiaries, and there are some indications that the federal government may similarly expand the reach of the law.

 

False Claims Laws.  We are also subject to federal and state laws prohibiting individuals or entities from knowingly presenting, or causing to be presented, claims for payment to third party payors (including Medicare and Medicaid) that are false or fraudulent, are for items or services not provided as claimed, or otherwise contain misleading information.  Each of our patient care clinics is responsible for the preparation and submission of reimbursement claims to third party payors for items and services furnished to patients.  In addition, our personnel may, in some instances, provide advice on billing and

 

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reimbursement to purchasers of our products.  Also, prosecutors and so-called “qui tam” relators (whistleblowers) may claim that a regulatory violation or wrongfully-retained overpayment may be the basis of False Claims Act litigation.  Successful relators can receive a share of the recovery in a False Claims Act case ranging from 15% to 30%, depending on whether the government “intervenes” in the case.  Penalties in a False Claims Act case may include double or triple damages plus penalties ranging from $10,957 to $21,916 per claim.  These penalties are nearly double what they were in prior years.  While we endeavor to assure that our billing practices comply with applicable laws, if claims submitted to payors are deemed to be false, fraudulent or for items or services not provided as claimed, we may face liability for presenting or causing to be presented such claims.

 

 

Certification and Licensure.  Our clinicians and/or certain operating units may be subject to certification or licensure requirements under the laws of some states.  Most states do not require separate licensure for clinicians.  However, several states currently require clinicians to be certified by an organization such as the ABC.  The ABC conducts a certification program for clinicians and an accreditation program for patient care clinics.  The minimum requirements for new certified clinicians are a college degree, completion of an accredited master’s degree program, one to four years of residency at a patient care clinic under the supervision of a certified clinician and successful completion of certain examinations.  Minimum requirements for an accredited patient care clinic include the presence of a certified clinician and specific plant and equipment requirements.

 

While we endeavor to comply with all state licensure requirements, we cannot assure that we will be in compliance at all times with these requirements, or how they may be interpreted or re-interpreted by the various state and local agencies.  Failure to comply with state licensure requirements could result in suspension or termination of licensure, civil penalties, termination of our Medicare and Medicaid agreements, and repayment of amounts received from Medicare and Medicaid for services and supplies furnished by an unlicensed individual or entity.

 

HIPAA Violations.  The Health Insurance Portability and Accountability Act (“HIPAA”) provides criminal penalties for, among other offenses: health care fraud; theft or embezzlement with respect to a health care benefit program; false statements in connection with the delivery of or payment for health care benefits, items or services; and obstruction of criminal investigation of health care offenses.  Unlike other federal laws, these offenses are not limited to federal health care programs.

 

In addition, HIPAA authorizes the imposition of civil monetary penalties where a person offers or pays remuneration to any individual eligible for benefits under a federal health care program that such person knows or should know is likely to influence the individual to order or receive covered items or services from a particular provider, clinician or supplier.  Excluded from the definition of “remuneration” are incentives given to individuals to promote the delivery of preventive care (excluding cash or cash equivalents), incentives of nominal value and certain differentials in or waivers of coinsurance and deductible amounts.

 

These laws may apply to certain of our operations.  As noted above, we have established various types of discount programs and other financial arrangements with individuals and entities.  We also bill third party payors and other entities for items and services provided at our patient care clinics.  While we endeavor to ensure that our discount programs and other financial arrangements and billing practices comply with applicable laws, such programs, arrangements and billing practices could be subject to scrutiny and challenge under HIPAA.

 

Confidentiality and Privacy Laws.  The Administrative Simplification Provisions of HIPAA, and their implementing regulations, set forth privacy standards and implementation specifications concerning the use and disclosure of individually identifiable health information (referred to as “protected health information”) by health plans, health care clearinghouses and health care providers that transmit health information electronically in connection with certain standard transactions (“Covered Entities”).  HIPAA further requires Covered Entities to protect the confidentiality of protected health information by meeting certain security standards and implementation specifications.  In addition, under HIPAA, Covered Entities that electronically transmit certain administrative and financial transactions must utilize standardized formats and data elements (the “transactions/code sets standards”).  HIPAA imposes civil monetary penalties for non-compliance, and, with respect to knowing violations of the privacy standards, or violations of such standards committed under false pretenses or with the intent to sell, transfer or use protected health information for commercial advantage, criminal penalties.  Certain agents of Covered Entities (“business associates”) also have HIPAA responsibilities and liabilities.  We have business associates and are business associates to other Covered Entities.  We believe that we are subject to the Administrative Simplification Provisions of HIPAA and are taking steps to meet applicable standards and implementation specifications.  The new requirements have had a significant effect on the manner in which we handle health data and communicate with payors.

 

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In addition, state confidentiality and privacy laws may impose civil and/or criminal penalties for certain unauthorized or other uses or disclosures of protected health information.  We are also subject to these laws.  While we endeavor to assure that our operations comply with applicable laws governing the confidentiality and privacy of protected health information, we could face liability in the event of a use or disclosure of protected health information in violation of one or more of these laws.

 

Personnel and Training

 

None of our employees are subject to a collective bargaining agreement.  We believe that we have satisfactory relationships with our employees and strive to maintain these relationships by offering competitive benefit packages, training programs and opportunities for advancement.  We have approximately 4,800 employees of which approximately 1,500 are clinicians.

 

We provide a series of ongoing training programs to improve the professional knowledge of our clinicians.  For example, we have an annual education fair that is attended by our clinicians, leaders and other employees.  This annual meeting consists of lectures and seminars covering many clinical topics including the latest technology and process improvements, business courses and other courses that allow the clinicians to fulfill their ongoing continuing education requirements.

 

Insurance

 

We currently maintain insurance coverage for professional liability, product liability, general liability, directors’ and officers’ liability, workers’ compensation, executive protection, property damage and other lines of insurance.  Our general liability insurance coverage is $1.0 million per occurrence, with a $25.0 million umbrella insurance policy.  The coverage for professional liability, product liability and workers’ compensation is self-insured with both individual specific claim and aggregate stop-loss policies to protect us from either significant individual claims or dramatic changes in our loss experience.  Based on our experience and prevailing industry practices, we believe our coverage is adequate as to risks and amount.

 

Our Website

 

Our website is http://www.hanger.com.  We make available free of charge, on or through our website, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Section 16 filings (i.e. Forms 3, 4 and 5), proxy statements and other documents as required by applicable law and regulations as soon as reasonably practicable after electronically filing such reports with the SEC at http://www.sec.gov.  The public may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 100 F Street N.E., Washington, DC 20549.  The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330 (1-800-732-0330).  The SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC.  Our website also contains the charters of the Audit Committee, Corporate Governance and Nominating Committee, Compensation Committee and Quality and Technology Committee of our Board of Directors; our Code of Business Conduct and Ethics for Directors and Employees, which includes our principal executive, financial and accounting officers; as well as our Corporate Governance Guidelines.  Information contained on our website is not part of this report.

 

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ITEM 1A.  RISK FACTORS

 

Set forth below are certain risk factors that could adversely affect our business, results of operations and financial condition.  You should carefully read the following risk factors, together with the consolidated financial statements, related notes and other information contained in this Annual Report on Form 10-K.  This Annual Report on Form 10-K contains forward-looking statements that contain risks and uncertainties.  Please read the cautionary notice regarding forward-looking statements in Item 7. under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in connection with your consideration of the risk factors and other important factors that may affect future results described below.

 

The restatement of our previously issued consolidated financial statements was time-consuming and expensive and could expose us to additional risks that would adversely affect our financial position, results of operations and cash flows and, as a result, the value of our common stock.

 

As described in our 2014 Form 10-K, we restated our previously issued consolidated financial statements for the first two quarters in fiscal year 2014, for the fiscal years ended December 31, 2013 and 2012 and each of the quarters in fiscal year 2013.  We also restated our financial results for the fiscal years ended December 31, 2011 and 2010 (each unaudited), as summarized in Item 6. “Selected Financial Data” to our 2014 Form 10-K.  The Restatement was time-consuming and expensive and could expose us to a number of additional risks that would adversely affect our financial position, results of operations and cash flows as well as investor confidence and, as a result, the value of our common stock.

 

In particular, we incurred, and continue to incur, significant expense, including audit, legal, consulting and other professional fees, in connection with the Restatement and the ongoing remediation of material weaknesses in our internal control over financial reporting.  We have taken a number of steps that we have deemed appropriate and reasonable to strengthen our accounting function and reduce the risk of future restatements, including adding internal personnel and hiring outside consultants, as described in more detail in Item 9A. “Controls and Procedures” contained in this Annual Report on Form 10-K.  To the extent these steps are not successful, we may need to incur additional time and expense to address accounting issues that could arise in the future.  Our management’s attention has also been, and may further be, diverted from the operation of our business as a result of the time and attention required to address the ongoing remediation of material weaknesses in our internal controls.

 

We are also subject to claims, investigations and proceedings arising out of the misstatements contained in our previously issued financial statements.  For additional information regarding this litigation, see Item 3. “Legal Proceedings” in this Annual Report on Form 10-K.

 

We have identified material weaknesses in our internal control over financial reporting which could, if not remediated, adversely affect our ability to report our financial condition and results of operations in a timely and accurate manner, negatively impacting investor confidence and, as a result, the value of our common stock.

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934 (the “Exchange Act”), and is required to evaluate the effectiveness of these controls and procedures on a periodic basis and publicly disclose the results of these evaluations and related matters in accordance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002.  Management has identified numerous material weaknesses that existed as of December 31, 2015 and December 31, 2016, including material weaknesses relating to the ineffectiveness of the control environment.  See Item 9A. “Controls and Procedures” in this Annual Report on Form 10-K.  As a result of these material weaknesses, our management concluded that our internal controls and procedures were not effective as of December 31, 2015 and December 31, 2016.

 

A “material weakness” is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis.  We are actively engaged in developing and implementing remedial measures designed to address these material weaknesses.  Our remedial measures are not complete and are ongoing.  Although we are working to remedy the ineffectiveness of our internal control over financial reporting, there can be no assurance as to when the remedial measures will be fully developed, the timing and effectiveness of our implementation of such remedial measures or the aggregate cost of implementation.  Until our remedial measures are fully implemented, our management will continue to devote significant time and attention to these efforts.  If we do not complete our remediation in a timely fashion, or at all, or if our remedial measures are inadequate, there will continue to be an increased risk that we will be unable to timely file

 

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future periodic reports with the SEC and that our future consolidated financial statements could contain misstatements that will be undetected.  If we are unable to report our results in a timely and accurate manner, then we may not be able to comply with the applicable covenants in our credit agreements, and may be required to seek additional amendments or waivers under these credit agreements, which could adversely impact our liquidity and financial condition.  Further and continued determinations that there are material weaknesses in the effectiveness of our internal control over financial reporting could reduce our ability to obtain financing or could increase the cost of any financing we obtain and require additional expenditures of both money and our management’s time to comply with applicable requirements.

 

Any failure to implement or maintain required new or improved controls, or any difficulties we encounter in their implementation, could result in additional material weaknesses or material misstatements in our consolidated financial statements.  Any new misstatement could result in a further restatement of our consolidated financial statements, cause us to fail to meet timely our periodic reporting obligations with the SEC, cause us to violate debt covenants, reduce our ability to obtain financing or cause investors to lose confidence in our reported financial information, leading to a decline in the value of our common stock.  We cannot assure you that we will not discover additional weaknesses in our internal control over financial reporting.

 

Furthermore, as we grow our business, our disclosure controls and internal controls over financial reporting will become more complex, and we may require significantly more resources to ensure the effectiveness of these controls.  If we are unable to continue upgrading our internal controls, reporting systems and IT in a timely and effective fashion, then we may require additional management time and attention and other resources to be devoted to assist in compliance with the disclosure and financial reporting requirements and other rules that apply to public companies, which could adversely affect our business, financial position and results of operations.

 

The restatement of our previously issued financial results has resulted in private litigation and could result in private litigation judgments that could have a material adverse impact on our results of operations and financial condition.

 

We are subject to shareholder derivative litigation relating to certain of our previous public disclosures.  For additional discussion of this litigation, see Item 3. “Legal Proceedings” in this Annual Report on Form 10-K.  Our management has been and may be required in the future to devote significant time and attention to this litigation, and this and any additional matters that arise could have a material adverse impact on our results of operations and financial condition as well as on our reputation.  While we cannot estimate our potential exposure in these matters at this time, we have already incurred significant expense defending this litigation and expect to continue to need to incur significant expense in the defense.

 

The existence of the litigation may have an adverse effect on our reputation with referral sources and our patients themselves, which could have an adverse effect on our results of operations and financial condition.

 

Our failure to prepare and timely file our periodic reports with the SEC limits our access to the public markets to raise debt or equity capital, impacts our ability to obtain alternative financing and could have negative consequences under the terms of our existing credit agreements.

 

We have not made timely periodic reporting filings with the SEC since the filing of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2014.  We did not file our Annual Reports on Form 10-K for 2014, 2015 or 2016, or our Quarterly Reports on Form 10-Q for 2015, 2016 or 2017, within the time frame required by the SEC.  As a result of our late SEC filings, we are limited in our ability to access the public markets to raise debt or equity capital, which could prevent us from pursuing transactions or implementing business strategies that we believe would be beneficial to our business.

 

As disclosed in the 2014 Form 10-K, we entered into amendments to the Credit Agreement, dated as of June 17, 2013, among us, the lenders from time to time party thereto and Bank of America, N.A. (the “Credit Agreement”), that waived certain actual or potential defaults and amended various covenants and other provisions.  We entered into the Sixth Amendment and Waiver, effective as of June 22, 2017, with respect to our Credit Agreement (the “Sixth Amendment and Waiver”), which waives defaults and events of default under the Credit Agreement and also modifies certain of the terms and covenants contained in the Credit Agreement, including increasing the applicable interest rates, with some of the modifications terminating at such time as we meet various conditions.  The Sixth Amendment also extended the deadline by which we must deliver to the Agent under the Credit Agreement our audited financial statements and related audit report for the fiscal year ended December 31, 2016, from August 15, 2017 to February 15, 2018.  On August 1, 2016, we entered a Term B Credit Agreement that provides for a $280 million senior unsecured term loan facility under which all outstanding principal is due at

 

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maturity on August 1, 2019 (the “Term B Credit Agreement,” and together with the Credit Agreement the “Credit Agreements”) and all borrowings bear interest at a fixed rate per annum equal to 11.50% payable quarterly in arrears.

 

We entered into the Term B Amendment, effective as of June 23, 2017, with respect to our Term B Credit Agreement (the “Term B Amendment”) which extended the deadline by which we must deliver to Wilmington Trust, National Association, as the Term B agent our audited financial statements, the related audit report and a consolidated budget for the fiscal year ended December 31, 2016, from August 15, 2017 to February 15, 2018.  The Amendment also extends the deadline by which the Compliance Date must occur from August 15, 2017 until February 15, 2018.

 

If we fail to comply with the terms of our Credit Agreement as amended by the Fifth Amendment and Waiver and the Sixth Amendment and Waiver or the terms of our Term B Credit Agreement, as amended by the Term B Amendment, which include financial ratio covenants and the obligation to provide audited financial statements for the year ended December 31, 2017 by March 31, 2018, or if we are unsuccessful at further amending or waiving the Credit Agreement when the existing amendments and waivers expire (if such further amendment and waivers become necessary), then we may be subject to numerous penalties, including but not limited to the acceleration of all of our debt outstanding pursuant to the Credit Agreements.  In the event that the debt was to be accelerated, then we may need to seek alternative financing to satisfy our financial obligations.  This alternative financing may not be available to us on terms that are favorable to us, or at all.

 

In addition, the Credit Agreement expires on June 17, 2018.  At the time the Credit Agreement expires, we will need to seek a new credit agreement with current or new lenders to satisfy our ongoing liquidity needs and financial obligations.  This new credit agreement may not be available to us at favorable terms or at all.

 

See Note N - “Long-Term Debt” to our consolidated financial statements for additional information regarding the Credit Agreements and our long-term debt.

 

We have substantial indebtedness, and our failure to comply with the covenants and payment requirements of that indebtedness may subject us to increased interest expenses, lender consent and amendment costs or adverse financial consequences.

 

As of September 30, 2017, we had approximately $487.6 million in indebtedness.  This current level of indebtedness is comprised of approximately $191.7 million of borrowings under our Credit Agreement, approximately $270.7 million of borrowings under our Term B Credit Agreement and approximately $25.2 million of indebtedness related to other financing obligations and seller notes.  Under these Credit Agreements, we are required to comply with certain financial covenants and other provisions.  In addition to other requirements, these provisions include requirements that we timely prepare our financial statements and timely receive audits on our annual financial statements, meet certain financial ratio requirements and timely pay interest and principal when due.  Due to our material weaknesses and other factors, we did not file our 2014 annual financial statements until May 12, 2017.  Additionally, we have failed in our compliance with certain of our financial covenants.  These failures on our part have resulted in defaults under our debt agreements.  To remedy these defaults, we have had to provide lenders with consent and amendment fees, have experienced increasing constraints on our ability to borrow under our debt agreements, have been required to pay higher interest costs and have been required to adhere to increased restrictions on the use of the funds we borrow.  To the extent that we fail to meet our financial statement requirements in future periods, our operating trends do not enable us to meet our financial covenant requirements, we are unable to pay interest or principal when due or we are unable to meet other covenants and requirements contained within our Credit Agreements, we may default under one or both of our Credit Agreements.  A default under one or both of these agreements could result in further increases in consent or amendment fees to lenders, further increases in interest costs, the imposition of additional constraints on borrowing by our lenders or potentially more serious liquidity constraints and adverse financial consequences, including reductions in the value of our common stock or the necessity of seeking protection from creditors under bankruptcy laws.  See the “Liquidity and Capital Resources” section in this Management’s Discussion and Analysis for further discussion.

 

Additionally, our current Credit Agreements include variable interest rates.  In the event that interest rates rise, we will be required to pay greater interest expenses, which will have an adverse effect on our income from operations and financial condition.

 

To remedy issues we may encounter with meeting our debt obligations, or for other purposes, we may find it necessary to seek further refinancing of our indebtedness, and may do so with debt instruments that are more costly than our existing instruments (and which will rank senior to our equity securities), or we may issue additional equity securities which may

 

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dilute the ownership interests or value of our existing shareholders.  These actions may decrease the value of our equity securities.

 

Health care reform has initiated significant changes to the United States health care system and we expect to see further changes in the health care system in the future.

 

Various health care reform provisions became law upon enactment of the Patient Protection and Affordable Care Act, Pub. L. No. 111-148, on March 23, 2010 (the “Affordable Care Act”).  The reforms contained in the Affordable Care Act have impacted our business.  Continued political, economic and regulatory influences are subjecting the health care industry in the United States to fundamental change.  Further changes relating to the health care industry and in health care spending may adversely affect our revenue.  We anticipate that Congress will continue to review and assess alternative health care delivery and payment systems and may in the future propose and adopt legislation effecting additional fundamental changes in the health care system.  Although efforts at replacing the Affordable Care Act and overhauling the health care system have currently stalled in Congress, health care reform remains a priority for the Trump Administration and for many members of Congress.  We cannot assure you as to the ultimate content, timing or effect of changes, nor is it possible at this time to estimate the impact of potential legislation on our business.  However, although the specific reforms to the current health care system cannot be accurately predicted at this time, such changes could have a considerable impact on how health care is reimbursed, particularly on the coverage for certain types of services and on the reimbursement levels provided by government sources.

 

Changes in government reimbursement levels could adversely affect our Patient Care segment’s net revenue, cash flows and profitability.

 

We derived approximately 54.1%, 53.4% and 50.9% of our net revenue for the years ended December 31, 2016, 2015 and 2014, respectively, of our net revenue from reimbursements for O&P services and products from programs administered by Medicare, Medicaid and the U.S. Department of Veterans Affairs.  Each of these programs set reimbursement levels for the O&P services and products provided under their program.  If these agencies reduce reimbursement levels for O&P services and products in the future, our net revenues could substantially decline.  In addition, the percentage of our net revenues derived from these sources may increase as the portion of the U.S. population over age 65 continues to grow, making us more vulnerable to reimbursement reductions by these organizations.  Reduced government reimbursement levels could result in reduced private payor reimbursement levels because fee schedules of certain third party payors are indexed to Medicare reimbursement levels.  Furthermore, the health care industry is experiencing a trend towards cost containment as government and other third party payors seek to impose lower reimbursement rates and negotiate reduced contract rates with service providers.  This trend could adversely affect our net revenues.  For example, a number of states have reduced their Medicaid reimbursement rates for O&P services and products, or have reduced Medicaid eligibility, and others are in the process of reviewing Medicaid reimbursement policies generally, including for prosthetic and orthotic devices.

 

Medicare provides for reimbursement for O&P products and services based on prices set forth in fee schedules for ten regional service areas.  Medicare prices are adjusted each year based on the CPI-U unless Congress acts to change or eliminate the adjustment.  The Medicare price (decreases)/increases for 2016, 2015, and 2014 were (0.4%), 1.5%, and 1.0%, respectively.  The Affordable Care Act (“ACA”) changed the Medicare inflation factors applicable to O&P (and other) suppliers.  The annual updates for years subsequent to 2011 are based on the percentage increase in the CPI-U for the 12-months ended in June of the previous year.  Section 3401(m) of the ACA required that for 2011 and each subsequent year, the fee schedule update factor based on the CPI-U for the 12-months ended in June of the previous year is to be adjusted by the annual change in economy-wide private nonfarm business multifactor productivity (the “MFP Adjustment”).  The MFP Adjustment may result in the percentage increase being less than zero for a year and may result in payment rates for a year being less than such payment rates for the preceding year.  Although the decrease in the Medicare O&P fee schedule for 2016 is not unprecedented, it is the first time that there has been a decrease since 2011, when the Productivity Adjustment was first introduced following the ACA.  The Centers for Medicare & Medicaid Services (“CMS”) has not yet issued a final rule implementing these adjustments for years beyond 2011, but has indicated in a proposed rule that it will do so as part of the annual program instructions to the O&P fee schedule updates.  See 75 Fed. Reg. 40040, 40122-25 (July 13, 2010).  If the U.S. Congress were to legislate additional modifications to the Medicare fee schedules, our net revenues from Medicare and other payors could be adversely and materially affected.

 

Alternative models of reimbursement for durable medical equipment, prosthetics, orthotics and supplies (“DMEPOS”) may also affect our business.  The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 requires that Medicare replace the current fee schedule payment methodology for certain DMEPOS items and services with “single

 

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payment amounts” determined through a competitive bidding process, and CMS has issued regulations finalizing the methodology for adjusting fee schedule amounts for such items.  See 79 Fed, Reg. 66120, 66123 (November 6, 2014).  The types of DMEPOS subject to competitive bidding under the statute include: oxygen and oxygen equipment; continuous positive airway pressure devices, single and bi-level; standard manual and power wheelchairs, scooters and walkers; Group 2 complex rehabilitative power wheelchairs; hospital beds, commode chairs, patient lifts and seat lifts; support surfaces or pressure reducing mattresses and overlays; enteral nutrients, supplies and equipment; negative pressure wound therapy pumps; infusion pumps; transcutaneous electrical nerve stimulation devices; standard nebulizers; and certain mail-order diabetic testing supplies.  Under the DMEPOS Competitive Bidding Program, suppliers compete to submit bids for selected products, and the Medicare suppliers offering the best price, in addition to meeting applicable quality and financial standards, are awarded contracts to supply the designated products and services to Medicare beneficiaries in specified competitive bidding areas.  Although our product offerings currently subject to competitive bidding do not comprise a significant portion of our business, it is possible that the DMEPOS Competitive Bidding Program may expand to include other types of products we offer, or that other payors will adopt similar models for reimbursement, which may negatively affect our net revenue.

 

The Budget Control Act of 2011 required, among other things, mandatory across-the-board reductions in Federal spending, or “sequestration”.  While delayed by the American Taxpayer Relief Act of 2012, President Obama issued a sequestration order on March 1, 2013.  For services provided on or after April 1, 2013, Medicare fee-for-service claim payments, including those for DMEPOS as well as claims under the DMEPOS Competitive Bidding Program, are reduced by 2 percent.  On November 2, 2015, President Obama signed the Bipartisan Budget Act of 2015 into law, which provided for two years of increases to discretionary spending to be offset by an additional year of Medicare sequestration, through 2025.  This is a claims payment adjustment with limited impact on us; no permanent reductions in the Medicare DMEPOS fee schedule have been made as a result of sequestration, therefore additional reimbursements from Medicaid, the VA and commercial payors who use the Medicare fee schedule as a basis for reimbursement have not been impacted.

 

CMS may also develop policies to limit Medicare coverage of specific products and services.  Medical administrative contractors may issue local coverage determinations (“LCD”) that limit coverage for a particular item or service in their jurisdiction only.  This can lead to state-by-state variation in Medicare coverage for some items and services.  Any LCD that negatively impacts orthotic or prosthetic reimbursement would negatively affect our revenue.

 

Finally, patients may continue to move to Medicare Advantage plans from traditional Medicare plans, which will change the nature of the reimbursement received by us from the traditional Medicare program and negatively affect our net revenue.

 

If the average rates that commercial payors pay us decline significantly, then it would have a material adverse effect on our net revenues, earnings and cash flows.

 

We derived approximately 39.2%, 39.6% and 41.4% of our net revenue for the years ended December 31, 2016, 2015 and 2014, respectively, from reimbursements for O&P services and products for patients who have commercial payors as their primary payor.  We continue to experience downward pressure on some of our commercial payment rates as a result of general conditions in the market, recent and future consolidations among commercial payors, increased focus on O&P services and products and other factors.  There is no guarantee that commercial payment rates will not be materially lower in the future, particularly given the fluctuations in government reimbursement rates.

 

We are continuously in the process of negotiating new agreements and renegotiating agreements that are up for renewal with commercial payors, who tend to be aggressive in their negotiations with us.  Sometimes many significant agreements are up for renewal or being renegotiated at the same time.  In the event that our continual negotiations result in overall commercial rate reductions in excess of overall commercial rate increases, the cumulative effect could have a material adverse effect on our financial results.  Consolidations in the commercial payor market have significantly increased the negotiating leverage of commercial payors.  Our negotiations with payors are also influenced by competitive pressures, and we may experience decreased contracted rates with commercial payors or experience decreases in patient volume as our negotiations with commercial payors continue.  If the average rates that commercial payors pay us decline significantly, or if we see a decline in commercial patients, it would have a material adverse effect on our revenues, earnings and cash flows.

 

Changes in government reimbursement levels could adversely affect our Products & Services segment’s net revenues, cash flows and profitability.

 

In addition to the risks to our Patient Care segment businesses discussed previously, changes in government reimbursement levels could also adversely affect the net revenues, cash flows and profitability of the businesses in our Products & Services

 

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segment.  In particular, a significant majority of our therapeutic services sales involve devices and related services provided to SNFs and similar businesses.  Reductions in government reimbursement levels to SNFs have caused, and could continue to cause, such SNFs to reduce or cancel their use of our therapeutic service devices and modalities, negatively impacting net revenues, cash flows and profitability.  For example, in July 2011 CMS announced an across the board reduction of approximately 11% in SNF reimbursement levels, which negatively impacted the demand for our devices and treatment modalities.  Although CMS has announced increases in SNF reimbursement levels in the years since (the agency announced an increase of 1.3% for FY 2014, 2.0% for FY 2015, 1.4% for FY 2016, 2.4% for FY 2017, and 1.0% for FY 2018), we cannot predict whether any other changes to reimbursement levels will be implemented, or if implemented what form any changes might take.  Further, the Department of Health & Human Services Office of Inspector General (“OIG”) has indicated concerns with the Medicare payment system for SNFs and has suggested that the payment system needs to be reevaluated.  OIG’s specific concerns relate to issues such as Medicare payments that exceed SNFs’ costs, how Medicare pays for therapy based primarily on the volume of services rather than beneficiary characteristics, and the high error rate for SNF billing.  Concerns such as these may result in further changes to SNF reimbursement levels and processes, even if they do not directly relate to O&P services.

 

We depend on reimbursements by third party payors, as well as payments by individuals, which could lead to delays and uncertainties in the reimbursement process.

 

We receive a substantial portion of our payments for health care services on a fee for service basis from third party payors, including Medicare and Medicaid, private insurers and managed care organizations.  We estimate that we have received approximately 93.3%, 93.0% and 92.3% of our net revenues from such third party payors during 2016, 2015 and 2014, respectively.  We estimate that such amounts included approximately 30.5%, 30.3% and 29.4% from Medicare in 2016, 2015 and 2014, respectively, 14.8%, and 14.2% and 12.8% from Medicaid programs in 2016, 2015 and 2014, respectively.  In addition, we estimate net revenues from the U.S. Department of Veterans Affairs (“VA”) were 8.8%, 8.9% and 8.7% in 2016, 2015 and 2014, respectively.

 

The reimbursement process is complex and can involve lengthy delays.  Third party payors continue their efforts to control expenditures for health care, including proposals to revise reimbursement policies.  While we recognize revenue when health care services are provided, there can be delays before we receive payment.  In addition, third party payors may disallow, in whole or in part, requests for reimbursement based on determinations that certain amounts are not reimbursable under plan coverage, that services provided were not medically necessary or that additional supporting documentation is necessary.  Retroactive adjustments may change amounts realized from third party payors.  Third party payors may require pre-authorizations for certain services and/or devices, which may result in a delay in our ability to provide services or to provide services at all.  Additionally, we may see an increase in bundled payment models, which can result in delays before we receive payment or no payment at all for certain services.

 

Changes in government reimbursement levels and policies such as those described above may also contribute to uncertainties surrounding the reimbursement process.  We are subject to governmental audits of our reimbursement claims under Medicare, Medicaid, the VA and other governmental programs and may be required to repay these agencies if found that we were incorrectly reimbursed.  Delays and uncertainties in the reimbursement process may adversely affect accounts receivable, increase the overall costs of collection and cause us to incur additional borrowing costs.

 

We also may not be paid with respect to co-payments and deductibles that are the patient’s financial responsibility.  Many of the plans offered on the state health insurance exchanges have high deductibles and require coinsurance that patients cannot afford to pay.  Amounts not covered by third party payors are the obligations of individual patients from whom we may not receive whole or partial payment.  We also may not receive whole or partial payments from uninsured and underinsured individuals.  In such an event, our earnings and cash flow would be adversely affected, potentially affecting our ability to maintain our restrictive debt covenant ratios and meet our financial obligations.

 

Additionally, employer based plans and other individual plans are increasingly relying on “high deductible” plan designs.  As their participation in health plans with these high deductible designs increases, our patients will face greater financial burdens and participatory costs that may affect their decisions regarding the timing of their replacement of their devices.  Due to cost considerations, they may seek to repair or refurbish their existing devices and delay the purchase of new replacement devices, which will adversely affect our revenues and our profitability.

 

The risks associated with third party payors, co-payments and deductibles and the inability to monitor and manage accounts receivable successfully could still have a material adverse effect on our business, financial condition and results of

 

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operations.  Furthermore, our collection policies or our provisions for allowances for Medicare, Medicaid and contractual discounts and doubtful accounts receivable may not be adequate.

 

Due to constraints in the growth of our rates of reimbursement, we may face cost pressures that adversely affect our profitability.

 

Due to increased pressures on governmental and commercial payors to seek ways of reducing the costs of care, those payors have and may continue to seek ways to reduce growth in the rate of our reimbursement for the services we provide.  This constraint in the rate of growth in reimbursement may adversely affect our profitability as we experience increases in the wages, materials and other costs necessary to the conduct of our business.  These cost increases may adversely affect our profitability and our profit margins.

 

Given the complexities and demands related to reimbursement, we may fail to adequately provide the staffing and systems necessary to ensure we effectively manage our reimbursement processes.

 

The nature of our business requires that we are effective in the assessment of patient eligibility, the process of pre-authorization, the recordation and collection of provider documentation, the timely and complete submission of claims for reimbursement, the application of cash receipts to patient accounts, the timely response to payor denials and the conduct of collection activities.  If we fail to provide adequate or qualified staffing, we could incur reductions in the amount of reimbursement we receive for the O&P services that we provide.

 

We face periodic reviews, audits and investigations under our contracts with federal and state government agencies, and these audits could have adverse findings that may negatively impact our business.

 

We contract with various federal and state governmental agencies to provide O&P services.  Pursuant to these contracts, we are subject to various governmental reviews, audits and investigations to verify our compliance with the contracts and applicable laws and regulations.  Any adverse review, audit or investigation could result in:

 

·                  refunding of amounts we have been paid pursuant to our government contracts;

 

·                  imposition of fines, penalties and other sanctions on us;

 

·                  loss of our right to participate in various federal programs;

 

·                  damage to our reputation in various markets; or

 

·                  material and/or adverse effects on our business, financial condition and results of operations.

 

In recent years we have seen a significant increase in Medicare audits, including RAC audits, CERT audits and MAC prepayment audits.  In addition, ZPICs are responsible for the identification of suspected fraud through medical record review.  Medicare has also recently implemented the new TPE prepayment audit.  We believe that Medicare audits, inquiries and investigations will continue to occur from time to time in the ordinary course of our business.  Medicare audits could have a material and adverse effect on our business financial condition and results of operations, particularly if we are unsuccessful at final adjudication.

 

Consolidation of manufacturers within the O&P industry may adversely affect our business by increasing prices we pay for certain devices and components.

 

We depend on a limited number of manufacturers who supply us with certain key devices and components used in the prostheses we provide to our patients, particularly with respect to high technology components.  These manufacturers are subject to a consolidation trend within the O&P industry.  To the extent this trend continues, consolidation amongst certain manufacturers could result in a sole or limited source for certain high technology devices and components used in the devices we provide to patients.  Any such consolidation could require us to pay increased prices for such devices and components, which could significantly reduce our gross margin and profitability and have a material adverse effect on our business.

 

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We are subject to numerous federal, state and local governmental regulations, noncompliance with which could result in significant penalties that could have a material adverse effect on our business.

 

A failure by us to comply with the numerous federal, state and/or local health care and other governmental regulations to which we are subject, including the regulations discussed under “Government Regulation” in Item 1.  “Business” above, could result in significant penalties and adverse consequences, including exclusion from the Medicare and Medicaid programs, which could have a material adverse effect on our business.

 

Within our Products & Services segment, we provide certain equipment and consultative services to SNFs, who, due to reimbursement pressures, may choose to discontinue our services or seek alternative arrangements for the provision of this equipment.

 

Approximately $57.4 million of our net revenue in 2016 related to recurring revenues derived from providing therapeutic equipment and related consultative services to SNFs.  SNFs have been experiencing reimbursement pressures which could adversely impact our business with them.  To reduce costs, these facilities could choose to forgo our services, or seek alternative arrangements for the provision of the equipment we provide them, thereby reducing our revenue, earnings and could adversely impact the carrying value of our goodwill and other intangible assets.

 

Completing the implementation of NextGen, our comprehensive clinic management system, could interfere with our patient care clinic operations and adversely affect our business, financial condition and results of operations.

 

We depend on our IT infrastructure to achieve our business objectives.  Beginning in late 2013, we commenced the roll-out of a new patient management and electronic health record system in our patient care clinics.  In the third quarter of 2014, we halted the roll-out due to the negative impact the roll-out had on revenue cycle management.  We have revised, updated and reduced the amount of customizations made to the system, which we now refer to as NextGen.  We have also substantially improved our revenue cycle management function, and are currently in the process of completing the roll-out of NextGen, and anticipate the roll-out to continue through the first half of 2019.  Any disruptions, delays or complications in the implementation process, or any deficiencies in the design, operation or expected performance of the NextGen system, could result in higher than expected implementation costs, the diversion of management’s and other employees’ attention from the day-to-day operations of our patient care clinics, including scheduling patient visits, and other disruptions to our patient care business.  Any of these consequences could have an adverse impact on our revenue or costs, billing and related accounts receivable collections, all of which impacts cash flow and could materially and adversely affect our business, financial condition and results of operations.

 

To address our business needs and weaknesses in financial controls, we will likely be required to upgrade certain of our operational and financial systems in future years.  If we fail in the selection or implementation of such systems, or fail to maintain our existing systems, our business and financial results could be adversely affected.

 

We are highly dependent on our ability to procure materials and componentry, manage our inventories, support our patient encounters and to otherwise support the administrative requirements associated with our human resource, financial and other needs.  We may not have sufficient financial capacity to implement such systems, or may fail in our selection and implementation of such systems.  The failure to implement systems in a timely manner may adversely affect our ability to establish an effective control environment.  If we are delayed in the implementation of systems, and existing systems are not adequately maintained, we could experience adverse interruptions in our ability to operate, or experience excessive costs associated with the remediation of consequential systems issues.  Additionally, our failure to correctly select and implement systems could cause operational disruptions, delays, duplicative operating costs or other financial burdens which could adversely affect our business and financial condition.

 

Our products and services face the risk of technological obsolescence, which, if realized, could have a material adverse effect on our business.

 

The medical device industry is characterized by rapid and significant technological change.  There can be no assurance that third parties will not succeed in developing and marketing technologies, products or services that are more effective than ours or that would render our products and services obsolete or noncompetitive.  Additionally, new surgical procedures and medications could be developed for diabetes, trauma associated with accidents or physical injury, tumors, infection or musculoskeletal disorders of the back, extremities or joints that would replace or reduce the importance of our prosthetic and orthotic products and services.  Accordingly, our success will depend upon our ability to respond to future medical and technological changes that may impact the demand for our prosthetic and orthotic products and services.

 

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Our failure to economically procure necessary components and to conduct timely and effective inventories of the materials and components we use in our business could result in an adverse effect on our business, financial condition and results of operations.

 

Our business involves the use of materials and componentry we acquire from third party manufacturers.  If manufacturers critical to our business substantially increase the cost of the components they sell to us, then our inability to acquire the necessary materials and components on a cost effective basis may adversely affect revenues and earnings.  Additionally, to successfully perform our business, it is necessary that we conduct timely and thorough inventories of our raw materials and Work in Process (“WIP”).  The conduct of these inventories are costly and time consuming.  If we encounter issues in their conduct, given that our clinicians oversee the inventory processes which occur in our clinic locations, remedial procedures can disrupt our ability to see and treat patients, and thereby adversely affect our revenues and profitability.

 

Our common stock was delisted from the NYSE and moved to the OTC, affecting the trading of our common stock and reputation.

 

Our common stock was delisted from the NYSE in February 2016 as a result of our failure to file our Annual Report on Form 10-K for the year ended December 31, 2014 within the extended compliance period required by the NYSE.  After the delisting, our common stock began trading on the OTC.  There can be no assurance whether or when our common stock will be relisted for trading on the NYSE or another national securities exchange.  Our shareholders may continue to face material adverse consequences as a result of our trading on the OTC rather than a national securities exchange, including, but not limited to, a decrease in the price of our common stock, increased volatility, decreased trading activity or liquidity, a lack of analyst research and a further decline in institutional holders whose charters do not allow them to hold securities in unlisted companies.  In addition, the delisting from the NYSE may have had and may continue to have a negative impact on our reputation and, as a consequence, our business and the price of our common stock.

 

If we are unable to retain our senior management and key employees, then our business and results of operations and financial position could be harmed.

 

Our ability to maintain our competitive position is largely dependent on the services of our senior management, clinicians and other key employees.  Although we have employment agreements with our senior management, these agreements do not prevent those individuals from ceasing their employment with us at any time.  Additionally, adverse publicity and increased demands associated with the Restatement and associated litigation and regulatory investigations could increase our key employee retention risks.  If we are unable to retain existing senior management, clinicians and other key employees, or to attract other such qualified employees on terms satisfactory to us, then our business could be adversely affected.

 

Our non-compete agreements and other restrictive covenants involving clinicians may not be enforceable.

 

We have contracts with clinicians in many states.  Some of these contracts include provisions preventing these clinicians from competing with us both during and after the term of our relationship with them.  The law governing non-compete agreements and other forms of restrictive covenants varies from state to state.  Some states are reluctant to strictly enforce non-compete agreements and restrictive covenants applicable to health care providers.  There can be no assurance that our non-compete agreements related to affiliated clinicians will not be successfully challenged as unenforceable in certain states.  In such event, we would be unable to prevent former affiliated clinicians from competing with us, potentially resulting in the loss of some of our patients, reducing our revenues and earnings.

 

Cyber-attacks, system security risks, data breaches and other technology failures could adversely affect our ability to conduct business, our results of operations and our financial position.

 

A technology failure could occur and potentially disrupt our business, damage our reputation and adversely affect our profitability.  Our information technology (“IT”) systems are subject to the risk of computer viruses or other malicious codes, unauthorized access or cyber-attacks.  The administrative and technical controls and other preventive actions that we take to reduce the risk of cyber incidents and protect our IT systems may be insufficient to prevent physical and electronic break-ins, cyber-attacks or other security breaches to our computer systems.  In addition, disruptions or breaches could occur as a result of natural disasters, man-made disasters, epidemic/pandemic, industrial accident, blackout, criminal activity, technological changes or events, terrorism or other unanticipated events beyond our control.  While we have insurance intended to provide coverage from certain losses related to such incidents and a variety of preventative security measures such as risk management, information protection, disaster recovery and business continuity plans, we cannot predict the method or

 

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outcome of every possible cyber incident or ensure that we have protected ourselves against every possible cyber threat in light of the varied and increasingly complex breaches faced by companies on a regular basis.  Unanticipated problems with our systems or recovery plans could have a material adverse impact on our ability to conduct business, our results of operations and our financial position.

 

A cybersecurity incident could cause a violation of HIPAA and other privacy laws and regulations or result in a loss of confidential data.

 

A cyber-attack that bypasses our IT security systems causing an IT security breach, loss of protected health information or other data subject to privacy laws, loss of proprietary business information, or a material disruption of our IT business systems, could have a material adverse impact on our business, financial condition or results of operations.  In addition, our future results of operations, as well as our reputation, could be adversely impacted by theft, destruction, loss, or misappropriation of protected health information, other confidential data or proprietary business information.

 

Insurance coverage for some of our losses may be inadequate and may be subject to the credit risk of commercial insurance companies.

 

Some of our insurance coverage is through various third-party insurers.  To the extent we hold policies to cover certain groups of claims or rely on insurance coverage obtained by third parties to cover such claims, but either we or such third parties did not obtain sufficient insurance limits, did not buy an extended reporting period policy, where applicable, or the issuing insurance company is unable or unwilling to pay such claims, we may be responsible for those losses.  Furthermore, for our losses that are insured or reinsured through commercial insurance companies, we are subject to the “credit risk” of those insurance companies.  While we believe our commercial insurance company providers currently are creditworthy, there can be no assurance that such insurance companies will remain so in the future.

 

We have made and may continue to make acquisitions, which could divert the attention of management and which may not be integrated successfully into our existing business.  We may not find suitable acquisitions in the future, which could adversely affect our ability to penetrate new markets and achieve our growth objectives.

 

In past years we have pursued, and may continue to pursue, acquisitions to increase our market penetration, enter new geographic markets and expand the scope of services we provide.  We cannot assure that we will identify suitable acquisition candidates, acquisitions will be completed on acceptable terms or at all, our due diligence process will uncover all potential liabilities or issues affecting our integration process, we will not incur breakup, termination or similar fees and expenses, or we will be able to integrate successfully the operations of any acquired business.  Furthermore, acquisitions in new geographic markets and services may require us to comply with new and unfamiliar legal and regulatory requirements, which could impose substantial obligations on us and our management, cause us to expend additional time and resources and increase our exposure to penalties or fines for noncompliance with such requirements.  The acquisitions could be of significant size and involve operations in multiple jurisdictions.  The acquisition and integration of another business could divert management attention from other business activities.  This diversion, together with other difficulties we may incur in integrating an acquired business, could have a material adverse effect on our business, financial condition and results of operations.  In addition, we may incur debt to finance acquisitions.  Such borrowings may not be available on terms as favorable to us as our current borrowing terms and may increase our leverage.

 

In order to remain competitive, we are required to make capital expenditures relating to our leaseholds and our equipment.

 

A substantial portion of our capital expenditure requirements relate to maintaining and upgrading the appearance and function of our patient care clinic and satellite locations.  If we do not maintain our facilities, their relative appearance to that of our competitors could adversely affect our ability to attract and retain patients.  In addition, changing competitive conditions or the emergence of any significant advances in O&P technology could require us to invest significant capital in additional equipment or capacity in order to remain competitive.  If we are unable to fund any such investment or otherwise fail to invest in such items, our business, financial condition or results of operations could be materially and adversely affected.

 

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We may not be able to adequately protect our intellectual property and other proprietary rights that are material to our business or to defend successfully against intellectual property infringement claims by third parties.

 

Our ability to compete effectively depends in part upon our intellectual property rights, including but not limited to our trademarks and copyrights, and our proprietary technology.  Our use of contractual provisions, confidentiality procedures and agreements, and trademark, copyright, unfair competition, trade secret and other laws to protect our intellectual property rights and proprietary technology may not be adequate.  Litigation may be necessary to enforce our intellectual property rights and protect our proprietary technology, or to defend against claims by third parties that the conduct of our businesses or our use of intellectual property infringes upon such third-party’s intellectual property rights.  Any intellectual property litigation or claims brought against us, whether or not meritorious, could result in substantial costs and diversion of our resources, and there can be no assurances that favorable final outcomes will be obtained in all cases.  The terms of any settlement or judgment may require us to pay substantial amounts to the other party or cease exercising our rights in such intellectual property, including ceasing the use of certain trademarks used by us to distinguish our services from those of others or ceasing the exercise of our rights in copyrightable works.  In addition, we may have to seek a license to continue practices found to be in violation of a third-party’s rights, which may not be available on reasonable terms, or at all.  Our business, financial condition or results of operations could be adversely affected as a result.

 

The market price of our common stock may fluctuate significantly.

 

The market price of our common stock may fluctuate significantly.  Among the factors that could affect our stock price are:

 

·                  industry or general market conditions;

 

·                  domestic and international economic factors unrelated to our performance;

 

·                  changes in our referral sources’ or customers’ preferences;

 

·                  new regulatory pronouncements and changes in regulatory guidelines;

 

·                  lawsuits, enforcement actions and other claims by third parties or governmental authorities;

 

·                  actual or anticipated fluctuations in our quarterly operating results;

 

·                  changes in securities analysts’ estimates of our financial performance or lack of research and reports by industry analysts;

 

·                  action by institutional shareholders or other large shareholders, including future sales of our common stock;

 

·                  speculation in the press or investment community;

 

·                  investor perception of us and our industry;

 

·                  changes in market valuations or earnings of similar companies;

 

·                  announcements by us or our competitors of significant contracts, acquisitions or strategic partnerships;

 

·                  any future sales of our common stock or other securities;

 

·                  additions or departures of key personnel; and

 

·                  ability to get current and file future filings timely.

 

The stock markets have experienced extreme volatility in recent years that has been unrelated to the operating performance of particular companies.  These broad market fluctuations may adversely affect the market price of our common stock.  In the past, following periods of volatility in the market price of a company’s securities, class action litigation has often been instituted against such company.  Any litigation of this type brought against us could result in substantial costs and a diversion of management’s attention and resources, which would harm our business, results of operations and financial condition.

 

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If securities or industry analysts do not publish research or publish misleading or unfavorable research about our business, our stock price and trading volume could decline.

 

The trading market for our common stock will depend in part on the research and reports that securities or industry analysts publish about us or our business, especially after our stock is no longer traded on the OTC and is once again traded on a national securities exchange.  If one or more analysts downgrade our stock or publishes misleading or unfavorable research about our business, our stock price would likely decline.  If one or more of these analysts ceases coverage of us or fails to publish reports on us regularly, demand for our stock could decrease, which could cause our stock price or trading volume to decline.

 

We do not intend to pay dividends on our common stock and, consequently, your ability to achieve a return on your investment will depend on appreciation in the price of our common stock.

 

We do not intend to declare and pay dividends on our common stock for the foreseeable future.  We currently intend to invest our future earnings, if any, to fund our growth, to develop our business, and to potentially fund future share repurchases.  Therefore, you are not likely to receive any dividends on your common stock for the foreseeable future, and the success of an investment in shares of our common stock will depend upon any future appreciation in their value.  There is no guarantee that shares of our common stock will appreciate in value or even maintain the price at which shareholders have purchased their shares.

 

Disruptions in our disaster recovery systems, management continuity planning or information systems could limit our ability to operate our business effectively, or adversely affect our financial condition and results of operations.

 

Our IT systems facilitate our ability to conduct our business.  While we have disaster recovery systems and business continuity plans in place, any disruptions in our disaster recovery systems or the failure of these systems to operate as expected could, depending on the magnitude of the problem, adversely affect our operating results by limiting our capacity to effectively monitor and control our operations.  Despite our implementation of a variety of security measures, our technology systems could be subject to physical or electronic break-ins and similar disruptions from unauthorized tampering.  In addition, in the event that a significant number of our management personnel were unavailable in the event of a disaster, our ability to effectively conduct business could be adversely affected.

 

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ITEM 1B.  UNRESOLVED STAFF COMMENTS

 

None.

 

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ITEM 2.  PROPERTIES

 

As of December 31, 2016, we operated 821 patient care locations, comprised of 706 patient care clinics and 115 satellite locations, in 45 states and the District of Columbia.  We own twelve buildings, including ten buildings that house a patient care clinic and two buildings that are currently unoccupied.  Our patient care clinics occupied under leases have terms expiring between 2017 and 2027.  Our patient care clinics average approximately 3,000 square feet in size.  In total, including locations relating to our non-patient care businesses, administrative and fabrication locations, as well as storage and other non-occupied space, we currently have 951 locations, of which, 939 are under lease.

 

We believe our leased and owned facilities are adequate for carrying out our current and anticipated future O&P operations.  We believe we will be able to renew such leases as they expire or find comparable or alternative space on commercially suitable terms.  See Note M - “Leases” to our consolidated financial statements in this Annual Report on Form 10-K for additional information regarding our facilities leases.

 

The following table sets forth the number of our patient care clinics located in each state as of December 31, 2016:

 

State

 

Patient
Care
Locations

 

 

 

Alabama

 

12

Arizona

 

40

Arkansas

 

6

California

 

73

Colorado

 

27

Connecticut

 

14

District of Columbia

 

2

Florida

 

53

Georgia

 

42

Idaho

 

1

Illinois

 

22

Indiana

 

11

Iowa

 

18

Kansas

 

18

Kentucky

 

8

Louisiana

 

14

Maine

 

9

Maryland

 

13

Massachusetts

 

7

Michigan

 

14

Minnesota

 

22

Mississippi

 

12

Missouri

 

27

Montana

 

3

Nebraska

 

13

Nevada

 

5

New Hampshire

 

2

New Jersey

 

7

New Mexico

 

13

New York

 

30

North Carolina

 

23

North Dakota

 

5

Ohio

 

41

Oklahoma

 

11

Oregon

 

10

Pennsylvania

 

41

South Carolina

 

16

South Dakota

 

2

Tennessee

 

22

Texas

 

46

Utah

 

8

Virginia

 

14

Washington

 

21

West Virginia

 

6

Wisconsin

 

12

Wyoming

 

5

 

Other leased real estate holdings include our distribution facilities in Texas, Nevada, Georgia, Illinois and Pennsylvania, our corporate headquarters in Austin, Texas, the headquarters for our therapeutic solutions in Reno, Nevada, which is co-located with our Nevada distribution facility and the headquarters for our distribution business in Alpharetta, Georgia, which is co-located with our Georgia distribution facility.  We additionally operate eighteen leased fabrication facilities that assist our patient care locations in the fabrication of devices.  Seven of these locations are co-located with a patient care clinic location.  The fabrication facilities are located in the states of Alabama, Arizona, California, Colorado, Connecticut, Florida, Georgia, Kansas, Maryland, Minnesota, New York, Ohio, Pennsylvania, Tennessee and Texas.  Substantially all of our owned properties are pledged to collateralize bank indebtedness.  See Note N - “Long-Term Debt” to our consolidated financial statements in this Annual Report on Form 10-K for additional information regarding our outstanding debt and related collateral.

 

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ITEM 3.  LEGAL PROCEEDINGS

 

Securities and Derivative Litigation

 

In November 2014, a securities class action complaint, City of Pontiac General Employees’ Retirement System v. Hanger, et al., C.A. No. 1:14-cv-01026-SS, was filed against us in the United States District Court for the Western District of Texas.  The complaint named us and certain of our current and former officers for allegedly making materially false and misleading statements regarding, inter alia, our financial statements, RAC audit success rate, the implementation of new financial systems, same-store sales growth, and the adequacy of our internal processes and controls.  The complaint alleged violations of Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated thereunder.  The complaint sought unspecified damages, costs, attorneys’ fees, and equitable relief.

 

On April 1, 2016, the court granted our motion to dismiss the lawsuit for failure to state a claim upon which relief can be granted, and permitted plaintiffs to file an amended complaint.  On July 1, 2016, plaintiffs filed an amended complaint.  On September 15, 2016, we and certain of the individual defendants filed motions to dismiss the lawsuit.  On January 26, 2017, the court granted the defendants’ motions and dismissed with prejudice all claims against all defendants for failure to state a claim.  On February 24, 2017, plaintiffs filed a notice of appeal to the United States Court of Appeals for the Fifth Circuit.  Appellate briefing was completed on August 18, 2017 and the appeal remains pending.  The Court of Appeals has scheduled oral argument for the appeal the week of March 5, 2018.

 

In February and August of 2015, two separate shareholder derivative suits were filed in Texas state court against us related to the announced restatement of certain of our financial statements.  The cases were subsequently consolidated into Judy v. Asar, et. al., Cause No. D-1-GN-15-000625On October 25, 2016, plaintiffs in that action filed an amended complaint, and the case is currently pending before the 345th Judicial District Court of Travis County, Texas.

 

The amended complaint in the consolidated derivative action names us and certain of our current and former officers and directors as defendants.  It alleges claims for breach of fiduciary duty based, inter alia, on the defendants’ alleged failure to exercise good faith to ensure that we had in place adequate accounting and financial controls and that disclosures regarding our business, financial performance and internal controls were truthful and accurate.  The complaint seeks unspecified damages, costs, attorneys’ fees, and equitable relief.

 

As disclosed in our Current Report on Form 8-K filed with the SEC on June 6, 2016, the Board of Directors appointed a Special Litigation Committee of the Board (the “Special Committee”).  The Board delegated to the Special Committee the authority to (1) determine whether it is in our best interests to pursue any of the allegations made in the derivative cases filed in Texas state court (which cases were consolidated into the Judy case discussed above), (2) determine whether it is in our best interests to pursue any remedies against any of our current or former employees, officers or directors as a result of the conduct discovered in the Audit Committee investigation concluded on June 6, 2016 (the “Investigation”), and (3) otherwise resolve claims or matters relating to the findings of the Investigation.  The Special Committee retained independent legal counsel to assist and advise it in carrying out its duties and reviewed and considered the evidence and various factors relating to our best interests.  In accordance with its findings and conclusions, the Special Committee determined that it is not in our best interest to pursue any of the claims in the Judy derivative case.  Also in accordance with its findings and conclusions, the Special Committee determined that it is not in our best interests to pursue legal remedies against any of our current or former employees, officers, or directors.

 

On April 14, 2017, we filed a motion to dismiss the consolidated derivative action based on the resolution by the Special Committee that it is not in our best interest to pursue the derivative claims.  Counsel for the derivative plaintiffs opposed that motion and moved to compel discovery.  In a hearing held on June 12, 2017, the Travis County court denied plaintiffs’ motion to compel, and held that the motion to dismiss would be considered only after appropriate discovery was concluded.

 

The plaintiffs have since subpoenaed counsel for the Special Committee, seeking a copy of the full report prepared by the Special Committee and its independent counsel.  Counsel for the Special Committee, as well as our counsel, take the position that the full report is not discoverable under Texas law.  Plaintiffs’ counsel has indicated it will file a motion to compel the Special Committee’s counsel to produce the report, but it has not yet done so.  Upon resolution of the discovery dispute and completion of discovery, we intend to file a motion to dismiss the consolidated derivative action.

 

Management intends to vigorously defend against the shareholder derivative action and the appeal in the securities class action.  At this time, we cannot predict how the Courts will rule on the merits of the claims and/or the scope of the potential

 

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loss in the event of an adverse outcome.  Should we ultimately be found liable, the resulting damages could have a material adverse effect on our consolidated financial position, liquidity or results of our operations.

 

Other Matters

 

In May 2015, one of our clinics received a civil investigative demand for records relating to a sample of claims submitted to Medicare and Medicaid for reimbursement, and we provided records in response to the subpoena.  In May 2017, we were informed by an Assistant United States Attorney that it was investigating whether we properly provided and claimed reimbursement for prosthesis skins and covers from July 2013 (after an industry announcement) to the present.  We have reviewed the claims, and have cooperated with the government’s investigation.  We anticipate this matter will be resolved in 2018 and that any resolution will not have a material impact on any future periods.

 

From time to time we are subject to legal proceedings and claims which arise in the ordinary course of our business, including additional payments under business purchase agreements.  In the opinion of management, the amount of ultimate liability, if any, with respect to these actions will not have a materially adverse effect on our consolidated financial position, liquidity or results of our operations.

 

We are in a highly regulated industry and receive regulatory agency inquiries from time to time in the ordinary course of our business, including inquiries relating to our billing activities.  No assurance can be given that any discrepancies identified during a regulatory review will not have a material adverse effect on our consolidated financial statements.

 

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ITEM 4.  MINE SAFETY DISCLOSURES

 

Not applicable.

 

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PART II

 

ITEM 5.                    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

The following information in this Item 5 of this Annual Report on Form 10-K is not deemed to be “soliciting material” or to be “filed” with the SEC or subject to Regulation 14A or 14C under the Exchange Act or to the liabilities of Section 18 of the Exchange Act, and will not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Exchange Act, except to the extent we specifically incorporate it by reference into such a filing.

 

Market Information

 

Our common stock was listed and traded on the NYSE from December 15, 1998 to February 26, 2016 under the symbol “HGR.”  On February 29, 2016, our common stock began trading on the OTC under the symbol “HNGR” after the NYSE notified us on February 26, 2016 of immediate suspension of trading of and the initiation of delisting procedures against our common stock for failing to file our 2014 Annual Report Form 10-K for the year ended December 31, 2014 within the extended compliance period granted by the NYSE.  The following table sets forth the high and low closing sale prices for our common stock for the periods indicated as reported on the NYSE (through February 26, 2016) and the OTC (beginning on February 29, 2016):

 

Year ended December 31, 2016

 

High

 

Low

 

First Quarter

 

$

15.67

 

$

2.49

 

Second Quarter

 

7.97

 

6.25

 

Third Quarter

 

11.00

 

7.43

 

Fourth Quarter

 

11.50

 

7.75

 

 

Year ended December 31, 2015

 

High

 

Low

 

First Quarter

 

$

26.52

 

$

20.49

 

Second Quarter

 

25.07

 

22.13

 

Third Quarter

 

23.59

 

13.54

 

Fourth Quarter

 

17.53

 

13.55

 

 

Year ended December 31, 2014

 

High

 

Low

 

First Quarter

 

$

40.47

 

$

32.25

 

Second Quarter

 

35.12

 

29.01

 

Third Quarter

 

32.31

 

20.52

 

Fourth Quarter

 

24.19

 

19.58

 

 

Holders

 

At January 12, 2018, there were approximately 171 holders of record of our 36,328,678 shares of outstanding common stock.

 

Dividend Policy

 

We have never paid cash dividends on our common stock and intend to continue this policy for the foreseeable future.  We plan to retain earnings for use in our business.  The terms of our credit agreements and certain other agreements limit the payment of dividends on our common stock and such agreements are expected to continue to limit the payment of dividends in the future.

 

Any future determination to pay cash dividends will be at the discretion of our Board of Directors and will be dependent on our results of operations, financial condition, contractual and legal restrictions and any other factors deemed to be relevant.

 

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Sales of Unregistered Securities

 

During the period January 1, 2015 through December 31, 2017, we did not sell any securities that were unregistered under the Securities Act of 1933.

 

Issuer Purchases of Equity Securities

 

During the years ended December 31, 2015 and 2016, and through December 31, 2017, we have not made any purchases of our common stock.

 

STOCK PERFORMANCE CHART

 

The annual changes in the cumulative total shareholder return on our common stock for the five-year period shown in the graph below are based on the assumption that $100 had been invested in our common stock, the Standard & Poor’s 500 Stock Index, the Standard & Poor’s Small Cap 600 Stock Index, the Russell 2000 Stock Index, the Standard & Poor’s 500 Health Care Services Index and the Standard & Poor’s 500 Health Care Facilities Index on December 31, 2011, and that all quarterly dividends were reinvested at the average of the closing stock prices at the beginning and end of the quarter.  The total cumulative dollar returns shown on the graph represent returns that such investments would have had on December 31, 2016.

 

 

 

 

As of December 31,

 

 

 

2011

 

2012

 

2013

 

2014

 

2015

 

2016

 

Hanger, Inc.

 

$

100.00

 

$

146.39

 

$

210.49

 

$

117.17

 

$

88.01

 

$

61.53

 

S&P 500 Index - Total Returns

 

$

100.00

 

$

116.00

 

$

153.57

 

$

174.60

 

$

177.01

 

$

198.18

 

S&P Small Cap 600 Index

 

$

100.00

 

$

116.33

 

$

164.38

 

$

173.84

 

$

170.41

 

$

215.67

 

Russell 2000 Index

 

$

100.00

 

$

116.35

 

$

161.52

 

$

169.42

 

$

161.95

 

$

196.45

 

S&P 500 Health Care Services Index

 

$

100.00

 

$

120.37

 

$

145.31

 

$

175.54

 

$

181.27

 

$

162.03

 

S&P 500 Health Care Facilities Index

 

$

100.00

 

$

158.24

 

$

205.26

 

$

281.04

 

$

249.76

 

$

254.13

 

 

Our stock price in 2016 was negatively impacted by our common stock’s suspension on February 26, 2016 and subsequent delisting from trading on the NYSE and the commencement of trading on February 29, 2016 on the OTC.

 

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ITEM 6.  SELECTED FINANCIAL DATA

 

The following tables set forth certain selected consolidated financial data for each of the years in the five-year period ended December 31, 2016, and is derived from the consolidated financial statements of Hanger, Inc. and its subsidiaries. The Consolidated Financial Statements for each of the years in the three-year period ended December 31, 2016 are included in this Annual Report on Form 10-K.  The selected consolidated balance sheet data as of December 31, 2014, 2013 and 2012 and the consolidated statements of operations data for the years ended December 31, 2013 and 2012 are derived from our consolidated financial statements, which are not included in this Annual Report on Form 10-K.  The selected consolidated financial data set forth below is qualified in its entirety by, and should be read in conjunction with, the consolidated financial statements and notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K.

 

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Consolidated Statements of Operations and

 

Year Ended December 31,

 

Comprehensive (Loss) Income:

 

2016

 

2015

 

2014

 

2013

 

2012

 

 

 

(in thousands, except per share amounts)

 

Net revenue

 

$

1,042,054

 

$

1,067,172

 

$

1,012,100

 

$

975,769

 

$

923,521

 

Material costs

 

332,071

 

336,283

 

324,284

 

302,003

 

285,873

 

Personnel costs

 

363,537

 

367,094

 

353,586

 

325,780

 

299,004

 

Other operating costs

 

139,024

 

140,839

 

136,885

 

115,767

 

110,881

 

General and administrative expenses

 

107,224

 

111,761

 

86,115

 

78,658

 

81,182

 

Professional accounting and legal fees

 

41,233

 

28,647

 

44,798

 

5,821

 

4,907

 

Depreciation and amortization

 

44,887

 

46,343

 

38,929

 

34,185

 

32,589

 

Impairment of intangible assets

 

86,164

 

385,807

 

223

 

 

 

(Loss) income from operations

 

(72,086

)

(349,602

)

27,280

 

113,555

 

109,085

 

Interest expense, net

 

45,199

 

29,892

 

28,277

 

30,576

 

34,620

 

Loss on extinguishment of debt

 

6,031

 

7,237

 

 

6,645

 

 

(Loss) income from continuing operations before income taxes

 

(123,316

)

(386,731

)

(997

)

76,334

 

74,465

 

(Benefit) provision for income taxes

 

(15,910

)

(67,614

)

2,023

 

30,455

 

26,206

 

(Loss) income from continuing operations

 

(107,406

)

(319,117

)

(3,020

)

45,879

 

48,259

 

Income (loss) from discontinued operations, net of income taxes

 

935

 

(7,974

)

(15,946

)

(5,368

)

(235

)

Net (loss) income

 

$

(106,471

)

$

(327,091

)

$

(18,966

)

$

40,511

 

$

48,024

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive (loss) income, net

 

(27

)

474

 

(868

)

899

 

(734

)

Comprehensive (loss) income

 

$

(106,498

)

$

(326,617

)

$

(19,834

)

$

41,410

 

$

47,290

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic Per Common Share Data:

 

 

 

 

 

 

 

 

 

 

 

(Loss) income from continuing operations

 

$

(2.99

)

$

(8.96

)

$

(0.09

)

$

1.32

 

$

1.41

 

Income (loss) from discontinued operations, net of income taxes

 

0.03

 

(0.22

)

(0.45

)

(0.16

)

(0.01

)

Basic (loss) income per share

 

$

(2.96

)

$

(9.18

)

$

(0.54

)

$

1.16

 

$

1.40

 

Shares used to compute basic per common share amounts

 

35,933

 

35,635

 

35,309

 

34,826

 

34,274

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted Per Common Share Data:

 

 

 

 

 

 

 

 

 

 

 

(Loss) income from continuing operations

 

$

(2.99

)

$

(8.96

)

$

(0.09

)

$

1.30

 

$

1.39

 

Income (loss) from discontinued operations, net of income taxes

 

0.03

 

(0.22

)

(0.45

)

(0.15

)

(0.01

)

Diluted (loss) income per share

 

$

(2.96

)

$

(9.18

)

$

(0.54

)

$

1.15

 

$

1.38

 

Shares used to compute diluted per common share amounts

 

35,933

 

35,635

 

35,309

 

35,209

 

34,737

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

Consolidated Balance Sheet Data:

 

2016

 

2015

 

2014

 

2013

 

2012

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

7,157

 

$

58,753

 

$

11,699

 

$

1,613

 

$

13,130

 

Working capital

 

$

55,014

 

$

139,824

 

$

75,197

 

$

112,910

 

$

130,636

 

Total assets

 

$

755,104

 

$

973,084

 

$

1,235,733

 

$

1,141,163

 

$

1,120,766

 

Total debt

 

$

472,650

 

$

566,433

 

$

522,336

 

$

479,050

 

$

523,000

 

Shareholders’ equity

 

$

65,414

 

$

165,246

 

$

483,536

 

$

491,313

 

$

437,055

 

 

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ITEM 7.                    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward Looking Statements

 

This Annual Report on Form 10-K including this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (or “Management’s Discussion and Analysis”) contains statements that are forward-looking statements within the meaning of the federal securities laws.  Forward-looking statements include information concerning our liquidity and our possible or assumed future results of operations, including descriptions of our business strategies.  These statements often include words such as “believe,” “expect,” “project,” “potential,” “anticipate,” “intend,” “plan,” “estimate,” “seek,” “will,” “may,” “would,” “should,” “could,” “forecasts” or similar words.  These statements are based on certain assumptions that we have made in light of our experience in the industry as well as our perceptions of historical trends, current conditions, expected future developments and other factors we believe are appropriate in these circumstances.  We believe these judgments are reasonable, but you should understand that these statements are not guarantees of performance or results, and our actual results could differ materially from those expressed in the forward-looking statements due to a variety of important factors, both positive and negative, that may be revised or supplemented in subsequent reports.

 

These statements involve risks, estimates, assumptions and uncertainties that could cause actual results to differ materially from those expressed in these statements as described in this Annual Report on Form 10-K, and any claims, investigations or proceedings arising as a result, as well as our ability to remediate the material weaknesses in our internal control over financial reporting described in Item 9A. “Controls and Procedures” contained in this Annual Report on Form 10-K, changes in the demand for our O&P products and services, uncertainties relating to the results of operations or recently acquired O&P patient care clinics, our ability to enter into and derive benefits from managed-care contracts, our ability to successfully attract and retain qualified O&P clinicians, federal laws governing the health care industry, uncertainties inherent in investigations and legal proceedings, governmental policies affecting O&P operations and other risks and uncertainties generally affecting the health care industry.

 

Readers are cautioned that all forward-looking statements involve known and unknown risks and uncertainties including, without limitation, those described in Item 1A. “Risk Factors” contained in this Annual Report on Form 10-K, some of which are beyond our control.  Although we believe that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate.  Therefore, there can be no assurance that the forward-looking statements included in this report will prove to be accurate.  Actual results could differ materially and adversely from those contemplated by any forward-looking statement.  In light of the significant risks and uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved.  We undertake no obligation to publicly release any revisions to any forward-looking statements in this discussion to reflect events and circumstances occurring after the date hereof or to reflect unanticipated events.  Forward-looking statements and our liquidity, financial condition and results of operations may be affected by the risks set forth in Item 1A. “Risk Factors” or by other unknown risks and uncertainties.

 

Restatement of Prior Financial Information

 

In our Annual Report on Form 10-K for the year ended December 31, 2014 (the “2014 Form 10-K”), which we filed on May 12, 2017, we restated our prior financial filings.  In that filing, we restated:

 

(a)         our Consolidated Balance Sheet as of December 31, 2013 and the related Statements of Operations and Comprehensive (Loss) Income, Consolidated Statements of Changes in Shareholders’ Equity and Consolidated Statements of Cash Flows for the fiscal years ended December 31, 2013 and December 31, 2012;

 

(b)         our “Selected Financial Data” in Item 6. for fiscal years 2013, 2012, 2011 (unaudited) and 2010 (unaudited); and

 

(c)          our “Quarterly Financial Information (Unaudited)” for the first two quarters in the fiscal year ended December 31, 2014 and each of the quarters in the fiscal year ended December 31, 2013.

 

Accordingly, investors should not rely upon any consolidated financial statements for these periods and any earnings releases or other communications relating to these periods that occurred prior to our filing the 2014 Form 10-K.  For information regarding the nature and effects of our restatement of prior financial reports, in addition to information which we have provided you in this Annual Report on Form 10-K, we encourage you to also refer to our 2014 Form 10-K.

 

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Table of Contents

 

Effect of Delay in Financial Filings

 

Due to our detection of the material weaknesses and the necessity of our correction of previously issued financial information, we have been undergoing extensive delays in the filing of our periodic reports with the SEC.  Our 2014 Form 10-K included consolidated financial statements for the years ended December 31, 2014, December 31, 2013 and December 31, 2012, financial information pertaining to quarterly periods in 2014 and 2013, as well as selected financial data for the years ended December 31, 2011 and December 31, 2010 (both unaudited).  We also presented the effects of our restatement of the previously filed financial statements.

 

Upon the completion of that filing, we commenced the preparation and review of the financial statements provided in this Annual Report on Form 10-K.  The delay in our completion of this filing relates primarily to the effects of our delay in the completion of the 2014 Form 10-K, the number of accounting periods encompassed within this filing and, importantly, due to the necessity of our performance of additional review, analysis and substantive procedures related to the material weaknesses, to ensure that our consolidated financial statements for the periods encompassed by this report are complete and accurate in all material respects.

 

With the completion and filing of this Annual Report on Form 10-K, we are now focused on the preparation, review and filing of our financial information for interim periods in 2017, and in preparing and commencing our work relating to our annual financial statements for the year ended December 31, 2017.

 

Our efforts to remediate our material weaknesses, restate our historical financial statements, prepare this Annual Report and other factors have come at a cost in excess of the amount we estimate we would otherwise have incurred.  The estimated professional fees associated with these efforts are as follows:

 

( in millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance to be Paid

 

Year

 

Expensed

 

Paid

 

in Future Periods

 

 

 

 

 

 

 

 

 

2014

 

$

37.9

 

$

(1.8

)

$

36.1

 

2015

 

23.5

 

(26.0

)

33.6

 

2016

 

37.2

 

(47.9

)

22.9

 

2017

 

30.3

 

(38.0

)

15.2

 

 

In 2018, we currently estimate that we will incur an additional $11.8 million of such excess fees.  Of the $11.8 million in excess fees estimated to be incurred in 2018, we estimate that we will pay approximately $10.3 million, such that total payments for excess fees in 2018 will total $25.5 million, which includes $15.2 million related to prior periods.  See the “Liquidity and Capital Resources” section in this Management’s Discussion and Analysis for further discussion.

 

Unless otherwise stated, this Management’s Discussion and Analysis has been written to provide you with pertinent information regarding our performance during the periods encompassed by this report.  Accordingly, we have not provided information regarding our performance during subsequent periods.  Nevertheless, for certain information and events, which relate primarily to our indebtedness, capital structure and liquidity, we have provided disclosure regarding subsequent periods or have included further information in Note U - “Subsequent Events” to our consolidated financial statements.  Additionally, we have referenced certain trends and events occurring subsequent to December 31, 2016 as forward-looking items within this Management’s Discussion and Analysis.

 

Non-GAAP Measures

 

In this Management’s Discussion and Analysis, we refer to certain financial measures and statistics (or “metrics”) that are not prescribed under generally accepted accounting principles (“GAAP”) as applied in the United States.  We utilize these non-GAAP measures in order to evaluate the underlying factors that affect our business performance and trends.  These non-GAAP measures should not be considered in isolation and should not be considered superior to, or a substitute for, financial measures calculated in accordance with GAAP.  We have defined and provided a reconciliation of these non-GAAP measures

 

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to their most comparable GAAP measures.  The non-GAAP measures used in this Management’s Discussion and Analysis are as follows:

 

Adjusted Gross Revenue and Disallowed Revenue - “Adjusted gross revenue” reflects our gross billings after their adjustment to reflect estimated discounts established in our contracts with payors of health care claims.  As discussed in “Reimbursement Trends” below, pursuant to our contracts with payors, a portion of our adjusted gross billings may be disallowed based on factors including physician documentation, patient eligibility, plan design, prior authorization, timeliness of filings or appeal, coding selection, failure by certain patients to pay their portion of claims, computational errors associated with sequestration and other factors.  We refer to these and other amounts as being “disallowed revenue.”  Our net revenue reflects adjusted gross revenue after reduction for the estimated aggregate amount of disallowed revenue for the applicable period.  To facilitate analysis of the comparability of our results, we provide these non-GAAP measures due to the significant changes that we have experienced in recent years in disallowed revenue which are further discussed below.  In addition, we provide measures of material costs, personnel costs, other operating costs, general and administrative expenses, professional accounting and legal fees, depreciation and amortization and operating expenses as a percentage of adjusted gross revenue because we believe these percentages provide an investor with another meaningful measure to compare our results with prior periods.  These measures are non-GAAP and unaudited.

 

Overview

 

We are a leading national provider of products and services that assist in enhancing or restoring the physical capabilities of patients with disabilities or injuries.  Built on the legacy of James Edward Hanger, the first amputee of the American Civil War, Hanger and its predecessor companies have provided O&P services for over 150 years.  We provide O&P services, distribute O&P devices and components, manage O&P networks and provide therapeutic solutions to patients and businesses in acute, post-acute and clinic settings.  We operate through two segments - Patient Care and Products & Services.  For further descriptions of our segments, see the Business Description section of Item 1.  “Business” in this Annual Report on Form 10-K.

 

Our Patient Care segment is primarily comprised of Hanger Clinic which specializes in the design, fabrication and delivery of custom O&P devices.  As of December 31, 2016, we provided these services through 706 patient care clinics and 115 satellite locations in 45 states and the District of Columbia.  We also provide payor network contracting services to other O&P providers through this segment.

 

Our Products & Services segment is comprised of our distribution and our therapeutic solutions businesses.  As a leading supplier of O&P products in the United States, we coordinate through our distribution business the procurement and distribution of a broad catalog of O&P parts, componentry and devices to independent O&P providers nationwide.  To facilitate speed and convenience, we deliver these products through our five distribution facilities that are located in Nevada, Georgia, Illinois, Pennsylvania and Texas.  The other business in our Products & Services segment is our therapeutic solutions business, which develops specialized rehabilitation technologies and provides evidence-based clinical programs for post-acute rehabilitation to patients at approximately 4,000 skilled nursing and post-acute providers nationwide.

 

In each of 2015 and 2016, we incurred a material impairment of our goodwill.  These non-cash charges were the most significant contributing factor to our reported loss from operations and net loss in each period.  We performed a step one intangible valuation as of October 1, 2016, December 31, 2015 and September 30, 2015.  We discuss the causes and manner of our determination of these impairment charges in Note H - “Goodwill and Other Intangible Assets” to our consolidated financial statements in this Annual Report on Form 10-K.

 

See Note R - “Segment and Related Information” to our consolidated financial statements in this Annual Report on Form 10-K for disclosure of financial information by operating segment for 2016, 2015 and 2014.

 

Reimbursement Trends

 

In our Patient Care segment, we are reimbursed primarily through employer-based plans offered by commercial insurance carriers, Medicare, Medicaid and the VA.  The following is a summary of our payor mix, expressed as an approximate percentage of net revenues for the periods indicated:

 

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For the Years Ended December 31,

 

 

 

2016

 

2015

 

2014

 

 

 

 

 

 

 

 

 

Medicare

 

30.5

%

30.3

%

29.4

%

Medicaid

 

14.8

%

14.2

%

12.8

%

Commercial Insurance/Managed Care (excluding Medicare and Medicaid Managed Care)

 

39.2

%

39.6

%

41.4

%

Veterans Administration

 

8.8

%

8.9

%

8.7

%

Private Pay

 

6.7

%

7.0

%

7.7

%

Patient Care

 

100.0

%

100.0

%

100.0

%

 

Patient Care constitutes 80.6%, 82.0% and 82.7% of our net revenue for 2016, 2015 and 2014, respectively.  Our remaining revenue is produced in our Products & Services segment which derives its revenue from commercial transactions with independent O&P providers, healthcare facilities and other customers.  In contrast to revenues from our Patient Care segment, payment for these products and services are not directly subject to third party reimbursement from health care payors.

 

The amount of our reimbursement varies based on the nature of the O&P device we fabricate for our patients.  Given the particular physical weight and size characteristics, location of injury or amputation, capability for physical activity and mobility, cosmetic and other needs of each individual patient, each fabricated prostheses and orthoses is customized for each particular patient.  The nature of this customization and the manner by which our claims submissions are reviewed by payors makes our reimbursement process administratively difficult.

 

To receive reimbursement for our work, we must ensure that our clinical, administrative and billing personnel receive and verify certain medical and health plan information, record detailed documentation regarding the services we provide and accurately and timely perform a number of claims submission and related administrative tasks.  Traditionally, we have performed these tasks in a manual fashion and on a decentralized basis.  In recent years, due to increases in payor pre-authorization processes, documentation requirements, pre-payment reviews and pre- and post-payment audits, our ability to successfully undertake these tasks using our traditional approach has become increasingly challenging.  We believe these changes in industry trends have been brought about in part by increased nationwide efforts to reduce health care costs.

 

A measure of our effectiveness in securing reimbursement for our services can be found in the degree to which payors ultimately disallow payment of our claims.  Payors can deny claims due to their determination that a physician who referred a patient to us did not sufficiently document that a device was medically necessary or clearly establish the ambulatory (or “activity”) level of a patient.  Claims can also be denied based on our failure to ensure that a patient was currently eligible under a payor’s health plan, that the plan provides full O&P benefits, that we received prior authorization, that we filed or appealed the payor’s determination timely, on the basis of our coding, failure by certain classes of patients to pay their portion of a claim and for various other reasons.  If any portion of, or administrative factor within, our claim is found by the payor to be lacking, then the entirety of the claim amount may be denied reimbursement.  Due to the increasing demands of these processes, the level and capability of our staffing, as well as our material weaknesses and other considerations, our consolidated disallowed revenue and bad debt expense, and their relationship to consolidated adjusted gross revenue increased over historical levels to a peak level in 2014.  In 2016 and 2015, due to initiatives discussed below, we achieved decreases in our disallowed revenue.  Disallowed revenue and bad debt expense over the past five years has been as follows (dollars in millions, unaudited):

 

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For the Years Ended December 31,

 

(dollars in millions)

 

2016

 

2015

 

2014

 

2013

 

2012

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenue

 

$

1,042.1

 

$

1,067.2

 

$

1,012.1

 

$

975.8

 

$

923.5

 

Disallowed revenue

 

49.3

 

60.6

 

82.3

 

65.6

 

46.3

 

Adjusted gross revenue

 

$

1,091.4

 

$

1,127.8

 

$

1,094.4

 

$

1,041.4

 

$

969.8

 

 

 

 

 

 

 

 

 

 

 

 

 

Disallowed revenue

 

$

49.3

 

$

60.6

 

$

82.3

 

$

65.6

 

$

46.3

 

Bad debt expense

 

13.8

 

12.9

 

11.6

 

5.1

 

4.4

 

Disallowed revenue & bad debt expense

 

$

63.1

 

$

73.5

 

$

93.9

 

$

70.7

 

$

50.7

 

 

 

 

 

 

 

 

 

 

 

 

 

Disallowed revenue %

 

4.5

%

5.4

%

7.5

%

6.3

%

4.8

%

Bad debt expense %

 

1.3

%

1.1

%

1.1

%

0.5

%

0.4

%

Disallowed revenue & bad debt expense %

 

5.8

%

6.5

%

8.6

%

6.8

%

5.2

%

 

Adjusted gross revenue in the above chart reflects our gross billings after reduction for estimated contractual discounts.  As can be seen by the chart, the percentage of our gross billings that have been disallowed increased to 7.5% in 2014 from 4.8% in 2012.  Due to industry trends and our specific administrative factors, our collection experience degraded and disallowed revenue increased during those periods.  Industry trends included an increased level of payor audits and more stringent requests by payors that referring physician documentation be provided in connection with claims.  During that period of time, we utilized a decentralized billing and collections approach, where invoicing and collections were undertaken at individual patient care locations.  Our typical locations have an average of two office administrators who are required to handle patient administration, purchasing, and clinician support tasks.  Due to increasing payor documentation demands and budgetary limitations on staffing, administrative staff were increasingly unable to successfully address the growing levels of payor denials.  In 2014, our accounts receivable trends were further complicated due to issues encountered with our implementation of a new patient management and electronic health record system.  Due to system customizations that were subsequently determined to not be adequately tested, staffing deficiencies in cash application functions and other related procedural issues, billing and collections were further adversely affected due to this system implementation during that year as can be seen by the increase in the disallowed revenue rate and bad debt expense in that year.  Throughout this period, our processes were also impeded due to the subsequently identified underlying material control weakness in the administration of our contracts.  As contracts were negotiated or amended with payors, our procedures did not provide adequate assurance of timely documented reconciliation of updated terms and conditions with those loaded into our remote billing systems.

 

Commencing in late 2014 and continuing through 2015 and 2016, we took a number of actions to halt and reverse these disallowed revenue and bad debt trends.  These initiatives included: (i) the retention of consultants and constitution of a central revenue cycle management function; (ii) the halting of the roll-out of our new patient management and electronic health record system to address the identified issues; and (iii) the establishment of new clinic-level procedures and training regarding the collection of supporting documentation and the importance of diligence in our claims submission processes.  The percentage of our gross billings that have been disallowed decreased to 4.5% in 2016 from 7.5% in 2014.  These initiatives are each discussed more fully in sections provided for each of them below.  In addition to the declines in disallowed revenue experienced in 2015 and 2016, through these initiatives, we currently believe we will experience a further decrease in disallowed revenue in 2017.

 

In 2016, we experienced a $2.7 million increase in bad debt expense in our Products & Services segment as compared with 2015 resulting from the bankruptcy of one large customer of our distribution business and financial difficulties encountered by another.

 

These adverse trends also resulted in increases to our consolidated accounts receivable allowances during the period of 2012 through 2014.  In a manner similar to the improvements achieved in disallowance trends, the initiatives undertaken in establishing a revenue cycle management function, addressing weaknesses in our new patient management and electronic health record system and in improving our procedures and standards for clinic-level documentation have had a favorable effect on our accounts receivable balances in 2015 and 2016.  Our accounts receivable balances for 2012 through 2016 were as follows (dollars in millions, unaudited):

 

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As of December 31,

 

(dollars in millions)

 

2016

 

2015

 

2014

 

2013

 

2012

 

 

 

 

 

 

 

 

 

 

 

 

 

Accounts receivable, before allowance

 

$

221.2

 

$

270.9

 

$

271.3

 

$

213.5

 

$

185.3

 

Allowance for disallowed revenue

 

(61.1

)

(81.3

)

(87.2

)

(52.3

)

(31.5

)

Accounts receivable, gross

 

160.1

 

189.6

 

184.1

 

161.2

 

153.8

 

Allowance for doubtful accounts

 

(15.5

)

(15.0

)

(9.9

)

(6.5

)

(4.9

)

Accounts receivable, net

 

$

144.6

 

$

174.6

 

$

174.2

 

$

154.7

 

$

148.9

 

 

 

 

 

 

 

 

 

 

 

 

 

Allowance for disallowed revenue %

 

27.6

%

30.0

%

32.1

%

24.5

%

17.0

%

Allowance for doubtful accounts %

 

7.0

%

5.5

%

3.6

%

3.0

%

2.6

%

Total allowance %

 

34.6

%

35.5

%

35.7

%

27.5

%

19.6

%

 

Revenue Cycle Management

 

Prior to 2014, we performed our eligibility, patient pre-authorization, patient documentation, claims coding, claims submission, collection, cash application and claims audit support activities (our “revenue cycle management” functions) primarily on a decentralized location by location basis.  Due to the increases experienced in disallowed revenue, as well as to address certain procedural requirements of our new patient management and electronic health record system and to otherwise improve the effectiveness of our revenue cycle management functions, during 2014 we commenced the process of establishing a centralized revenue cycle management organization with the strategy to gradually transition these functions from our decentralized clinic locations to a centralized organization.  We continued and expanded this initiative in 2015 and 2016.

 

As discussed in the “Reimbursement Trends” section above, we experienced decreases in our disallowed revenue in 2015 and 2016, as compared with 2014.  In addition to other training and claims documentation initiatives, we believe that decreases we have experienced in disallowed revenue (as well as our overall accounts receivables balances) are due in part to our revenue cycle management initiative.

 

New System Implementation

 

In 2014, in our Patient Care segment, we commenced the implementation of a new patient management and electronic health record system at our patient care clinics.  A key purpose of the system was to automate clinician documentation, claims coding and other increasingly complex clinic administrative requirements.  In connection with the system implementation, we customized certain templates and software code within a system developed by NextGen.  In 2014, as the system was installed at increasing numbers of clinics, we encountered difficulties in clinic workload, were unable to timely apply cash we received from payors to patient accounts and experienced a marked increase in our accounts receivable balance.  Due to these issues, we halted the implementation at the end of the third quarter of 2014, after the system had been installed at approximately one-third of our sites.

 

We believe the implementation issues we encountered related primarily to inadequate testing of the system, a failure to successfully establish and effectively staff a central cash applications function, insufficient training and other difficulties associated with our customizations of the software code.

 

We subsequently resolved the issues we encountered with the system and our implementation process, and recommenced implementation in 2016.  We currently estimate approximately two-thirds of our clinic locations will be utilizing this system by the end of 2017, and we will convert the remaining one-third of our locations to this system by mid-2019.

 

Clinic-Level Claims Documentation

 

In addition to our revenue cycle management initiatives and resolution of the aforementioned issues associated with our implementation of our new electronic health record and patient management system, in 2016 we commenced more intensive training and increased our internal clinic-level emphasis on the importance of adherence to procedural and documentation

 

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Table of Contents

 

standards.  The absence of sufficient documentation establishing medical necessity and a patient’s degree of ability for future activity is a key factor utilized by payors when denying our claims for reimbursement.  Irrespective of a patient’s need and the existence of a referral from the treating physician, we have found it increasingly necessary to retrieve other supporting documentation and notes from referring physicians themselves to further justify and document their medical determinations relating to the patients they refer to us.  Given that these referring physicians do not work for us, the retrieval of this additional information to suit payors can be difficult and time-consuming.

 

In 2016, we believe our efforts to increase our discipline through this clinic-level claims documentation initiative assisted us in further reducing the level of our disallowed sales.  However, we also believe these efforts had a one-time indirect effect of reducing our overall revenue growth rate during that year.  In addition to other factors affecting our same clinic sales trends in 2016, as clinicians and their office administrators increased their attention on achieving higher documentation standards, we believe we were able to see and treat fewer patients, thereby contributing to our reduced same clinic patient care revenue.

 

We are continuing to apply this documentation discipline in 2017.  With the initial start up impact behind us, we do not believe it will be a significant factor in our year over year revenue growth trends for 2017.

 

Increasing Patient Responsibility for the Cost of Devices

 

The majority of our devices are provided as replacement devices to patients with devices that are broken or have become worn with age.  Prosthetic devices are typically replaced every three to five years.  In recent years, an increasing number of employers have been shifting the cost burdens in their health plans to employees through use of “high deductible” or “consumer-driven” health plans.  These plan designs typically require the patient to bear a greater portion of the cost of their care in exchange for a lower monthly premium.  We believe the increased use of these plans has and will continue to have the effect of causing patients to delay the replacement of their devices and could accordingly adversely impact our revenue.

 

Products & Services Segment Trends

 

Within our Products & Services segment, we provide therapeutic equipment and services to patients at SNFs and other healthcare provider locations.  In late 2016, a number of our clients, including several of our larger SNF clients elected to discontinue their use of our therapeutic services.  We believe these discontinuances relate primarily to their overall efforts to reduce the costs they bear for therapy-related services within their facilities.  As a part of those terminations of service, in a number of cases, we elected to sell terminating clients the equipment which we had utilized for their locations which resulted in our recognition of $6.7 million in equipment sales in this segment during 2016 as compared with $2.9 million in 2015 and $2.4 million in 2014.  In 2017, we anticipate that we will experience a decrease of approximately $11.0 million in services and supplies revenue associated with customer discontinuances of their therapy services and that our equipment sales will decrease to levels similar to those experienced in 2015 and 2014, resulting in approximately a $15.0 million decrease in revenue from therapeutic services in 2017 as compared with 2016.  We also currently believe that our revenues from these therapeutic services will continue to decline in 2018.  Within this portion of our business, we have responded to these trends through increases in our marketing programs which convey the value we believe our services have to patients at SNFs and have begun to increase our focus on sales of our therapeutic services to other adjacent health services provider markets.

 

Discontinuance of the Dosteon and CARES Businesses

 

On November 5, 2014, the Audit Committee of our Board of Directors approved a plan to sell or otherwise dispose of Dosteon and CARES, both part of our Patient Care segment.  This action was taken as a result of our strategic evaluation of these businesses.  As of December 31, 2014, Dosteon qualified as assets held for sale and discontinued operations.  As such the assets, operating results and cash flows of the Dosteon disposal group have been presented separately as discontinued operations within our consolidated financial statements.  The CARES business did not qualify as assets held for sale and was ultimately wound down in 2015.  Accordingly, the CARES business has been classified as a continuing operation in our consolidated financial statements for all financial periods through 2015, the year of its cessation of operations.  The information provided herein is for continuing operations, unless otherwise indicated.  See Note S - “Discontinued Operations” to our consolidated financial statements in this Annual Report on Form 10-K for additional discussion of our discontinued operations.

 

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Acquisitions

 

Since the first quarter of 2015, we have made no acquisitions.  We halted our acquisitions at that time both due to the necessity of our utilizing available operating cash flow to fund accounting, legal and other professional fees in connection with our preparation and review of the financial statements, efforts to remediate Material Weaknesses, and related legal matters, as well as due to the effect of our non-compliance with certain of our debt covenants relating to our failure to meet financial statement reporting requirements.  Once we regain timely filing status, and provided no other events or factors emerge that would prevent our use of capital for the purposes of acquisitions, we currently intend to recommence acquisitions of O&P businesses similar to those that we have consummated in prior years.

 

In the first quarter of 2015, we acquired three O&P businesses with approximately $11.8 million in revenue, operating a total of 15 patient care clinics located in three states.  The aggregate purchase price for these businesses was $15.3 million, including $10.2 million in net cash, $4.7 million of Seller Notes and $0.4 million of working capital adjustments and other.

 

In 2014, we acquired twelve O&P businesses and one distribution business with approximately $55.7 million in revenue, operating a total of 37 patient care clinics and one distribution center located in eleven states.  The aggregate purchase price for these businesses was $52.7 million, including $38.1 million in net cash, $14.0 million of Seller Notes and $0.6 million of working capital adjustments and other.

 

WalkAide System Coverage Decision

 

Our WalkAide system is a device manufactured and sold through our Products & Services segment that is designed to use functional electrical stimulation, or “FES”, to improve ambulation in people experiencing a condition known as “foot drop.”  Foot drop is a gait abnormality in which patients have difficulty lifting the front part of their foot as they walk due to weakness, irritation or damage to the common fibular nerve in the lower leg.

 

In 2006, CMS issued a National Coverage Determination (“NCD”) that provided limited Medicare coverage for the WalkAide system in specific cases where the foot drop condition was caused by partial spinal injury.  In an effort to seek expanded Medicare coverage, in 2012 and 2013 we conducted randomized clinical trials involving a use of the WalkAide system for patients with foot drop caused by stroke.  Based on the outcomes of those studies, in late 2013 we requested that CMS reopen the 2006 NCD to include coverage under Medicare for foot drop caused by stroke.  However, in the fourth quarter of 2014, after reviewing the results of the clinical trial, CMS determined that they would not reopen the NCD to expand coverage.

 

The WalkAide system remains a steady, but not significant, part of our overall business.

 

Seasonality

 

We believe our business is affected by the degree to which patients have otherwise met the deductibles for which they are responsible in their medical plans during the course of the year.  The first quarter is normally our lowest relative net revenue quarter, followed by the second and third quarters, which are somewhat higher and consistent with one another, and, due to the general fulfillment by patients of their health plan co-payments and deductible requirements towards the year’s end, our fourth quarter is normally our highest revenue producing quarter.

 

Our results are also affected, to a lesser extent, by our holding of an education fair in the first quarter of each year.  This one week event is conducted to assist our clinicians in maintaining their training and certification requirements and to facilitate a national meeting with our clinical leaders.  We also invite manufacturers of the componentry for the devices we fabricate to these annual events so they can demonstrate their products and otherwise assist in our training process.  During the first quarters of 2016, 2015 and 2014, we spent approximately $2.1 million, $2.0 million and $2.1 million, respectively, on travel and other costs associated with this one week event.  In addition to the costs we incur associated with this annual event, we also lose the productivity of a significant portion of our clinicians during the one week period in which this event occurs, which contributes to the lower seasonal revenue level we experience during the first quarter of each year.

 

Business Environment and Outlook

 

We have a positive view of the long-term need for prosthetic and orthotic devices and services within the markets that we serve.  To address the debilitating effects of injuries and medical conditions such as diabetes, vascular disease, cancer and

 

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congenital disorders, we believe patients will have a continuing need for the O&P services that we provide.  As the population grows and ages, we also believe there will be a gradual underlying increase in market demand.

 

To ensure we maintain and grow our share of this market, we believe that it will be necessary for us to find effective means to automate and better organize our business processes, improve our reimbursement capabilities and lower our cost structure in the longer term.  Our size may afford us the ability to achieve economies of scale through purchasing and process automation initiatives that would be difficult for our smaller competitors.  However, our size can work against us if we do not succeed in effectively serving our referring physicians and in competing with our individual competitors in each of the markets that we serve.

 

Additionally, we will need to overcome the adverse effects which the material weaknesses, Restatement and Investigation have had on our reputation.

 

Critical Accounting Policies

 

Our analysis and discussion of our financial condition and results of operations is based upon the consolidated financial statements that have been prepared in accordance with GAAP.  The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.  GAAP provides the framework from which to make these estimates, assumptions and disclosures.  We have chosen accounting policies within GAAP that management believes are appropriate to fairly present, in all material respects, our operating results and financial position.  Our significant accounting policies are stated in Note B - “Significant Accounting Policies” to the consolidated financial statements included in this Annual Report on Form 10-K.  We believe the following accounting policies are critical to understanding our results of operations and the more significant judgments and estimates used in the preparation of our consolidated financial statements.

 

Revenue Recognition

 

Patient Care Segment

 

Revenues in our Patient Care segment are primarily derived from the sale of O&P devices and are recognized when the patient has received the device or service.  At or subsequent to delivery, we issue an invoice to a third party payor, which primarily consists of commercial insurance companies, Medicare, Medicaid, the VA and private or patient pay (“Private Pay”).  We recognize revenue for the amounts we expect to receive from payors based on expected contractual reimbursement rates, which are net of estimated contractual discounts.  Government reimbursement, comprised of Medicare, Medicaid and the U.S. Department of Veterans Affairs, in the aggregate, accounted for approximately, 54.1%, 53.4% and 50.9% of our net revenue in 2016, 2015 and 2014, respectively.

 

These revenue amounts are further revised as claims are adjudicated, which may result in disallowances, or decreases to revenue.  We believe that adjustments related to write-offs of receivables should predominantly be recorded as a reduction of revenues, which we refer to as disallowed revenue.  This is due to the majority of our revenues being collected from commercial insurance companies, Medicare, Medicaid and the VA, most of which are under contractual reimbursement rates.  As such, adjustments do not relate to an inability to pay, but to contractual allowances, lack of timely claims submission, insufficient medical documentation or other administrative errors.  Amounts recorded to bad debt expense, which are presented within “Other operating costs,” generally relate to commercial payor bankruptcies and private pay balances for which there was an assessment of collectability and collection attempts were made.  At the end of each period, we establish allowances for estimated disallowances relating to that period based on prior adjudication experience and record such amounts as an adjustment to revenue.  In a similar fashion, we estimate and record allowances for doubtful accounts on unpaid receivables at each period end.  We also record a liability, with a corresponding adjustment to revenue, for refunds expected to be paid to our patients or third party payors.

 

Medicare and Medicaid regulations and the various agreements we have with other third party payors, including commercial healthcare providers under which these contractual adjustments and disallowed revenue are calculated, are complex and are subject to interpretation and adjustment and may include multiple reimbursement mechanisms for different types of services.  Therefore, the particular O&P devices and related services authorized and provided, and the related reimbursement, are subject to interpretation and adjustment that could result in payments that differ from our estimates.  Additionally, updated regulations and reimbursement schedules, and contract renegotiations occur frequently, necessitating regular review and

 

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assessment of the estimation process by management.  As a result, there is a reasonable possibility that recorded estimates will change materially in the short-term and any related adjustments will be recorded as changes in estimates when they become known.

 

For more information on our use of estimates to calculate allowances for disallowed revenue and doubtful accounts, refer to the “Accounts Receivable, Net” section below.

 

We often invoice patients or payors after a device is delivered.  To account for this delay, we record an estimated revenue accrual for devices delivered but not yet invoiced at period end.  This estimate is based on a historical look-back analysis of lag times between delivery and invoicing that occur over a period end.

 

Products & Services Segment

 

Revenues in our Products & Services segment are derived from the distribution of O&P components and the leasing and sale of rehabilitation equipment and ancillary consumable supplies combined with equipment maintenance, education, and training.  Distribution revenues are recorded upon the delivery of products, net of estimated returns.

 

Equipment leasing and related services revenue are recognized over the applicable term as the customer has the right to use the equipment and as the services are provided.  Equipment sales revenue is recognized upon delivery, with any related services revenue deferred and recognized as the services are performed.  Sales of consumables are recognized upon delivery.

 

Accounts Receivable, Net

 

Patient Care Segment

 

We establish allowances for accounts receivable to reduce the carrying value of such receivables to their estimated net realizable value.  The Patient Care segment’s accounts receivables are recorded net of unapplied cash, estimated allowance for disallowed revenue and estimated allowance for doubtful accounts, as described in the Revenue Recognition accounting policy above.

 

Both the allowance for disallowed revenue and the allowance for doubtful accounts estimates consider historical collection experience by each of the Medicare and non-Medicare (commercial insurance, Medicaid, Veteran’s Administration and Private Pay) primary payor class groupings.  For each payor class grouping, liquidation analysis of historical period end receivable balances are performed to ascertain collections experience by aging category.  We believe the use of historical collection experience applied to current period end receivable balances is reasonable.  In the absence of an evident adverse trend, we use historical experience rates calculated using an average of four quarters of data with at least twelve months of adjudication.  We believe the time periods analyzed provide sufficient time for most balances to adjudicate in the normal course of operations.  We will modify the time periods analyzed when significant trends indicate that adjustments should be made.  In addition, estimates are adjusted when appropriate for information available up through the issuance of the consolidated financial statements.

 

Products & Services Segment

 

Products & Services segment’s allowance for doubtful accounts is estimated based on the analysis of the segment’s historical write-offs experience, accounts receivable aging and economic status of its customers.  Accounts receivable that are deemed uncollectible are written-off to the allowance for doubtful accounts.  Accounts receivable are also recorded net of an allowance for estimated sales returns.

 

Inventories

 

Inventories are valued at the lower of estimated cost or net realizable value, with cost determined on a first-in, first-out (“FIFO”) basis.  Provisions have also been made to reduce the carrying value of inventories for excess, obsolete, or otherwise impaired inventory on hand at period-end.

 

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Patient Care Segment

 

Substantially all of our Patient Care segment inventories are recorded through a periodic approach whereby inventory quantities are adjusted on the basis of a quarterly physical count.  Segment inventories relate primarily to raw materials and WIP at Hanger Clinics.  Inventories at Hanger Clinics totaled $29.1 million and $30.1 million at December 31, 2016 and 2015, respectively, with WIP inventory representing $9.0 million and $8.9 million of the total inventory, respectively.

 

Raw materials consists of purchased parts, components, and supplies which are used in the assembly of O&P devices for delivery to patients.  In some cases, purchased parts and components are also sold directly to patients.  Raw materials are valued based on recent vendor invoices, reduced by estimated vendor rebates.  Such rebates are recognized as a reduction of cost of materials in the consolidated statements of operations and comprehensive (loss) income when the related devices or components are delivered to the patient.  Approximately 69% and 52% of materials at December 31, 2016 and 2015, respectively were purchased from our Products & Services segment.  Raw material inventory was $20.1 million and $21.2 million at December 31, 2016 and 2015 respectively.

 

WIP consists of devices which are in the process of assembly at our clinics or fabrication centers.  WIP quantities were determined by the physical count of patient orders at the end of every quarter of 2016 and 2015 while the related stage of completion of each order was established by clinic personnel.  We do not have an inventory costing system and as a result, the identified WIP quantities were valued on the basis of estimated raw materials, labor, and overhead costs.  To estimate such costs, we develop bills of materials for certain categories of devices that we assemble and deliver to patients.  Within each bill of material, we estimate (i) the typical types of component parts necessary to assemble each device; (ii) the points in the assembly process when such component parts are added; (iii) the estimated cost of such parts based on historical purchasing data; (iv) the estimated labor costs incurred at each stage of assembly; and (v) the estimated overhead costs applicable to the device.

 

Products & Services Segment

 

Product & Service segment inventories consist primarily of finished goods at its distribution centers as well as raw materials at fabrication facilities, and totaled $39.1 million and $38.4 million as of December 31, 2016 and 2015, respectively.  Finished goods include products that are available for sale to third party customers as well as to our Patient Care segment as described above.  Such inventories were determined on the basis of perpetual records and a physical count at year end.  Inventories in connection with therapeutic services are valued at a weighted average cost.

 

Business Combinations

 

We record tangible and intangible assets acquired and liabilities assumed in business combinations under the acquisition method of accounting.  For consideration of the net assets acquired, we typically pay cash and issue a Seller Note.  We may also include contingent consideration with payment terms associated with the achievement of designated collection targets of the acquired business.  Amounts paid for each acquisition are allocated to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition inclusive of identifiable intangible assets.  The estimated fair value of identifiable assets and liabilities are based on detailed valuations performed internally or by external valuation specialists that use information and assumptions provided by management.  We allocate any excess purchase price over the fair value of the net tangible and identifiable assets acquired and liabilities assumed to goodwill.  Significant management judgments and assumptions are required in determining the fair value of acquired assets and liabilities, particularly acquired intangible assets, including estimated useful lives.  The valuation of purchased intangible assets is based upon estimates of the future performance and discounted cash flows from the acquired business.  Each asset acquired or liability assumed is measured at estimated fair value from the perspective of a market participant.  Subsequent changes in estimated fair value of contingent consideration are recognized as “General and administrative expenses” within the consolidated statements of operations and comprehensive (loss) income.

 

Goodwill and Other Intangible Assets, Net

 

Goodwill represents the excess of the purchase price over the estimated fair value of net identifiable assets acquired and liabilities assumed from purchased businesses. We assess goodwill for impairment annually during the fourth quarter, and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. We have the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. If it is determined that a two-step goodwill impairment test is necessary or more efficient than a qualitative approach, we will measure the fair value of the reporting units using a

 

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combination of income and market approaches. Any impairment would be recognized by a charge to income from operations and a reduction in the carrying value of the goodwill.

 

If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired, and the second step of the impairment test is not required. The second step, if required, compares the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. The fair value of a reporting unit is allocated to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. If the carrying amount of the reporting unit’s goodwill exceeds its implied fair value, an impairment charge is recognized in an amount equal to that excess.

 

We apply judgment in determining the fair value of our reporting units and the implied fair value of goodwill which is dependent on significant assumptions and estimates regarding expected future cash flows, terminal value, changes in working capital requirements, and discount rates.

 

The fair value of acquired customer intangibles is estimated using an excess earnings model. Key assumptions utilized in the valuation model include pro-forma projected cash flows adjusted for market-participant assumptions, forecasted customer retention curve, and discount rate. Customer intangibles are amortized, using the straight-line method over an estimated useful life of four to ten years. The fair value of non-compete agreements are estimated using a discounted cash flow model. The related intangible assets are amortized, using the straight-line method, over their term which ranges from two to five years. Other definite-lived intangible assets are recorded at cost and are amortized, using the straight-line method, over their estimated useful lives of up to seventeen years.  The fair value associated with trade names is estimated using the relief-from-royalty method with the primary assumptions being the royalty rate and expected revenues associated with the trade names.  These assets, some of which have indefinite lives, are primarily included in the Products & Services segment. Indefinite lived trade name intangible assets are assessed for impairment in the fourth quarter of each year, or more frequently if events or changes in circumstances indicate that the asset might be impaired.  Trade name intangible assets with definite lives are amortized over their estimated useful lives of one to ten years.

 

For the years ended December 31, 2016 and 2015, we recorded impairments of our goodwill totaling $86.0 million and $382.9 million, respectively. See Note H - “Goodwill and Other Intangible Assets” to our consolidated financial statements in this Annual Report on Form 10-K for additional information regarding these charges.

 

In conjunction with our Goodwill impairment testing at December 31, 2015, we reevaluated the estimated useful life of our customer list intangibles. In the fourth quarter of 2015, the estimated useful life of our customer list intangibles was reduced from 10 years to four years in our Patient Care segment and from 14 years to 10 years in our Products & Services segment. This change in the estimated useful lives increased amortization for the years ended December 31, 2015 and 2016 by approximately $6.0 million and $7.0 million, respectively.

 

As described, we apply judgment in the selection of key assumptions used in both steps of the goodwill impairment test and as part of our evaluation of intangible assets tested annually and at interim testing dates as necessary. If these assumptions differ from actual, we could incur additional impairment charges and those charges could be material.

 

Income Taxes

 

We recognize deferred tax assets and liabilities for net operating loss and other credit carry forwards and the expected tax consequences of temporary differences between the tax basis of assets and liabilities and their reported amounts using enacted tax rates in effect for the year the differences are expected to reverse. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The evaluation of deferred tax assets requires judgment in assessing the likely future tax consequences of events that have been recognized in our financial statements or tax returns, and future profitability by tax jurisdiction.

 

We provide a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We have experienced losses in the past three years due to impairments of our intangible assets, increased professional fees in relation to our restatement and related remediation procedures for identified material weaknesses, and increased interest and bank fees. These losses have necessitated that we evaluate the sufficiency of our valuation allowance. We are able to carry back our tax losses generated in 2016 and 2015 to prior years and recoup all the losses without increasing our net operating loss carryforwards for federal tax purposes. Even though these credit carry forwards did not increase, we have $94.2 million of net deferred tax assets as of December 31, 2016. We expect to generate income before taxes in future periods at a level that

 

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would allow for the full realization of the majority of our net deferred tax assets. We continue to maintain a valuation allowance of approximately $6.9 million as of December 31, 2016, against net deferred tax assets, primarily related to various state jurisdictions where we do not currently believe that the full realization of our deferred tax assets is more likely than not.

 

We evaluate our deferred tax assets quarterly to determine whether adjustments to the valuation allowance are appropriate in light of changes in facts or circumstances, such as changes in expected future pre-tax earnings, tax law, interactions with taxing authorities and developments in case law. In making this evaluation, we rely on our history of pre-tax earnings. Our material assumptions are our forecasts of future pre-tax earnings and the nature and timing of future deductions and income represented by the deferred tax assets and liabilities, all of which involve the exercise of significant judgment.

 

Although we believe our estimates are reasonable, the ultimate determination of the appropriate amount of valuation allowance involves significant judgment. If expected future taxable income is not achieved a larger valuation allowance against our deferred tax assets could be required and could be significant.

 

We believe that our tax positions are consistent with applicable tax law, but certain positions may be challenged by taxing authorities.  In the ordinary course of business, there are transactions and calculations where the ultimate tax outcome is uncertain.  In addition, we are subject to periodic audits and examinations by the Internal Revenue Service and other state and local taxing authorities.  In these cases, we record the financial statement effects of a tax position when it is more-likely-than-not, based on the technical merits, that the position will be sustained upon examination.  We record the largest amount of tax benefit that is greater than fifty percent likely of being realized upon settlement with a taxing authority that has full knowledge of all relevant information.  If not paid, the liability for uncertain tax positions is generally recorded as a reduction of income tax expense at the earlier of the period when the position is effectively settled or when the statute of limitations has expired.  Although we believe our estimates are reasonable, actual results could differ from these estimates.

 

Recent Accounting Pronouncements

 

Refer to the “Recent Accounting Pronouncements” section in Note B - “Significant Accounting Policies” in this Annual Report on Form 10-K for disclosure of  recent accounting pronouncements that are either expected to have more than a minimal impact on our consolidated financial position and results of operation, or that we are still assessing to determine their impact.

 

Results of Operations - Year Ended December 31, 2016 Compared to Year Ended December 31, 2015

 

From 2015 through 2016, our annual consolidated results of operations were as follows:

 

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For the Years Ended
December 31,

 

Percent
Change

 

(dollars in millions)

 

2016

 

2015

 

2016 v 2015

 

 

 

 

 

 

 

 

 

Net revenue

 

$

1,042.1

 

$

1,067.2

 

(2.4

)%

Material costs

 

332.1

 

336.3

 

(1.2

)%

Personnel costs

 

363.5

 

367.1

 

(1.0

)%

Other operating costs

 

139.1

 

140.9

 

(1.3

)%

General and administrative expenses

 

107.2

 

111.8

 

(4.1

)%

Professional accounting and legal fees

 

41.2

 

28.6

 

44.1

%

Depreciation and amortization

 

44.9

 

46.3

 

(3.0

)%

Impairment of intangible assets

 

86.2

 

385.8

 

(77.7

)%

Loss from operations

 

(72.1

)

(349.6

)

(79.4

)%

 

 

 

 

 

 

 

 

Interest expense, net

 

45.2

 

29.9

 

51.2

%

Extinguishment of debt

 

6.0

 

7.2

 

(16.7

)%

Loss from continuing operations before income taxes

 

(123.3

)

(386.7

)

(68.1

)%

Benefit for income taxes

 

(15.9

)

(67.6

)

(76.5

)%

Loss from continuing operations

 

(107.4

)

(319.1

)

(66.3

)%

Income (loss) from discontinued operations, net of income taxes

 

0.9

 

(8.0

)

(111.3

)%

Net loss

 

$

(106.5

)

$

(327.1

)

(67.4

)%

 

Material costs, personnel costs and other operating costs reflect expenses we incur in connection with our delivery of care through our clinic locations and other patient care operations, or distribution of products and services, and exclude expenses incurred in connection with general and administrative activities.  General and administrative expenses reflect expenses we incur in the general management and administration of our businesses that are not directly attendant to the operation of our clinics or provision of products and services.

 

Due to the substantial amount and increase in the expenses we incur for professional accounting and legal services, we separately disclose these expenses within operating expenses.  We have incurred increases in these expenses primarily in connection with the Restatement, the Investigation and in connection with our accounting and remedial activities associated with the material weaknesses.  We currently anticipate that these expenses will remain significant in comparison to a normal level of expenditure at least through 2018.

 

When the financial statement carrying amount of a long-lived asset or asset group exceeds its fair value and is not recoverable, an asset impairment is recognized.  The significant decline in the trading value of our stock impaired assets in the Patient Care, Distribution and Therapeutic reporting units.  Impairment losses are separately disclosed within (Loss) income from operations in this Annual Report on Form 10-K.

 

During the years 2015 through 2016, our operating expenses as a percentage of net revenue were as follows:

 

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For the Years Ended December 31,

 

 

 

2016

 

2015

 

 

 

 

 

 

 

Material costs

 

31.9

%

31.5

%

Personnel costs

 

34.9

%

34.4

%

Other operating costs

 

13.2

%

13.2

%

General and administrative expenses

 

10.3

%

10.5

%

Professional accounting and legal fees

 

4.0

%

2.7

%

Depreciation and amortization

 

4.3

%

4.3

%

Impairment of intangible assets

 

8.3

%

36.2

%

Operating expenses

 

106.9

%

132.8

%

 

Due to the significance of disallowed revenue as discussed above in Reimbursement Trends, the rate of disallowed revenue experienced during the periods encompassed by this Annual Report on Form 10-K and to assist in evaluating the comparability of expense trends, the following table provides our adjusted gross revenue, disallowed revenue and net revenue for each year as well as our expenses as a percentage of adjusted gross revenue:

 

 

 

For the Years Ended December 31,

 

(dollars in millions)

 

2016

 

2015

 

 

 

 

 

 

 

Net revenue

 

$

1,042.1

 

$

1,067.2

 

Disallowed revenue

 

49.3

 

60.6

 

Adjusted gross revenue

 

$

1,091.4

 

$

1,127.8

 

 

 

 

 

 

 

Material costs

 

30.4

%

29.8

%

Personnel costs

 

33.3

%

32.6

%

Other operating costs

 

12.8

%

12.5

%

General and administrative expenses

 

9.8

%

9.9

%

Professional accounting and legal fees

 

3.8

%

2.5

%

Depreciation and amortization

 

4.1

%

4.1

%

Impairment of intangible assets

 

7.9

%

34.2

%

Operating expenses

 

102.1

%

125.6

%

 

During the previous two years, the number of patient care clinics and satellite clinics we operated have been as follows:

 

 

 

As of December 31,

 

 

 

2016

 

2015

 

 

 

 

 

 

 

Patient Care Clinics

 

706

 

721

 

Satellite Clinics

 

115

 

116

 

Total Clinics

 

821

 

837

 

 

Patient care clinics reflect locations that are licensed as a primary location to provide O&P services and which are fully-staffed and open throughout a typical operating week.  To facilitate patient convenience, we also operate satellite clinics.  These are remote locations associated with a primary care clinic, utilized to see patients and are open for operation on less than a full-time basis during a typical operating week.

 

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Net revenue.  Net revenue for the year ended December 31, 2016 was $1,042.1 million, a decrease of $25.1 million, or 2.4%, from $1,067.2 million for the year ended December 31, 2015.  Net revenue by operating segment, after elimination of intersegment activity, was as follows:

 

 

 

For the Years Ended December 31,

 

 

 

Percent

 

(dollars in millions)

 

2016

 

2015

 

Change

 

Change

 

 

 

 

 

 

 

 

 

 

 

Patient Care

 

$

840.1

 

$

875.0

 

$

(34.9

)

(4.0

)%

Products & Services

 

202.0

 

192.2

 

9.8

 

5.1

%

Net revenue

 

$

1,042.1

 

$

1,067.2

 

$

(25.1

)

(2.4

)%

 

Patient Care net revenue decreased $34.9 million or 4.0% to $840.1 million for the year ended December 31, 2016 from $875.0 million for the year ended December 31, 2015.  Patient care clinic net revenue declined $27.9 million primarily due to increased time spent processing submissions of claims coupled with the consolidation and closure of lower performing clinics.  CARES net revenue declined $6.4 million in 2016 as the business unit was closed in 2015, and network contract management revenue declined $0.6 million for the year ended December 31, 2016 compared with the year ended December 31, 2015.  Products & Services net revenue increased $9.8 million or 5.1% for year ended December 31, 2016 to $202.0 million from $192.2 million for year ended December 31, 2015.  Net revenue from our distribution products increased $6.3 million from higher prosthetic sales, and therapeutic services net revenue increased $3.5 million primarily from sale of equipment to customers who discontinued our services as described in “Products & Services Segment Trends” section above.

 

Material costs.  Material costs for the year ended December 31, 2016 were $332.1 million, a decrease of $4.2 million, or 1.2%, from $336.3 million for the year ended December 31, 2015.  Material costs by operating segment, after elimination of intersegment activity, were as follows:

 

 

 

For the Years Ended December 31,

 

 

 

Percent

 

(dollars in millions)

 

2016

 

2015

 

Change

 

Change

 

 

 

 

 

 

 

 

 

 

 

Patient Care

 

$

256.0

 

$

262.3

 

$

(6.3

)

(2.4

)%

Products & Services

 

76.1

 

74.0

 

2.1

 

2.8

%

Material costs

 

$

332.1

 

$

336.3

 

$

(4.2

)

(1.2

)%

 

 

 

 

 

 

 

 

 

 

Percent of net revenue

 

31.9

%

31.5

%

 

 

 

 

Percent of adjusted gross revenue

 

30.4

%

29.8

%

 

 

 

 

 

Material costs increased to 31.9% of net revenue in 2016 compared to 31.5% in 2015, and increased to 30.4% of adjusted gross revenue in 2016 compared to 29.8% in 2015.  With the shutdown of the CARES business in 2015, material costs were lower by $3.6 million in 2016.  In addition, Hanger Clinic’s material costs decreased $2.7 million for the year ended December 31, 2016 from lower revenue.  Material costs in Products & Services increased $2.1 million from higher net revenue for distribution products for the year ended December 31, 2016 compared to the year ended December 31, 2015.  Material costs were also impacted by product mix and vendor rebates.

 

Personnel costs.  Personnel costs for the year ended December 31, 2016 decreased $3.6 million to $363.5 million from $367.1 million for the year ended December 31, 2015.  Personnel costs by operating segment were as follows:

 

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For the Years Ended December 31,

 

 

 

Percent

 

(dollars in millions)

 

2016

 

2015

 

Change

 

Change

 

 

 

 

 

 

 

 

 

 

 

Patient Care

 

$

315.9

 

$

317.9

 

$

(2.0

)

(0.6

)%

Products & Services

 

47.6

 

49.2

 

(1.6

)

(3.3

)%

Personnel costs

 

$

363.5

 

$

367.1

 

$

(3.6

)

(1.0

)%

 

 

 

 

 

 

 

 

 

 

Percent of net revenue

 

34.9

%

34.4

%

 

 

 

 

Percent of adjusted gross revenue

 

33.3

%

32.6

%

 

 

 

 

 

Although we experienced an overall decline in personnel costs of $3.6 million in 2016 as compared to 2015, due to the decline in net revenue, personnel costs increased to 34.9% of net revenue in 2016 compared to 34.4% in 2015, and increased to 33.3% of adjusted gross revenue in 2016 compared to 32.6% in 2015.  For the year ended December 31, 2016, personnel costs for our Patient Care segment decreased $2.0 million, or 0.6%, as compared to the year ended December 31, 2015.  The shutdown of the CARES business decreased personnel costs $3.4 million.  To address the increased time demand on processing revenue reimbursements, additional billing and collection personnel were added.  Excluding CARES, this increase in personnel, coupled with an annual merit increase for employees added $10.5 million in higher salary, benefits and payroll taxes costs.  Within patient care personnel costs, bonus and commissions were $8.9 million lower for 2016 compared to 2015 driven by lower segment revenue.  Excluding CARES, temporary labor and other costs were $0.2 million lower in 2016 compared to the prior year.  Personnel costs in the Products & Services segment declined $1.6 million, or 3.3%, primarily from lower bonuses and commissions of $3.6 million, partially offset by $2.0 million of increases in salary, benefit and other employee compensation for 2016 compared to 2015.

 

Other operating costs.  Other operating costs were $139.1 million in 2016, a $1.8 million, or 1.3%, decrease compared to the $140.9 million incurred in 2015.  The shutdown of the CARES business decreased other operating costs by $4.4 million.  Rent, utilities, occupancy, office and other operating costs increased $1.5 million in 2016 as compared to 2015.  Bad debt expense increased $1.1 million primarily from the bankruptcy of one large customer in our distribution area.

 

General and administrative expenses.  For the year ended December 31, 2016, general and administrative expenses decreased $4.6 million, or 4.1% to $107.2 million from $111.8 million for the year ended December 31, 2015.  Decreases in bonus and other personnel costs lowered personnel compensation by $3.3 million in 2016 compared to 2015, partially offset by $3.0 million of additional salary, benefits and payroll taxes that included an annual merit increase coupled with additional personnel hired in the accounting and finance function to help mitigate the material weakness and support the Restatement effort.  Facility, other related office personnel costs and casual labor were lower by $4.3 million for 2016 compared to 2015.

 

Professional accounting and legal fees.  Professional accounting and legal fees increased 44.1% to $41.2 million for the year ended December 31, 2016 from $28.6 million for the year ended December 31, 2015 from the restatement of prior financial periods and costs related to our financial accounting remediation process.  Accounting related fees increased $10.7 million, legal fees increased $2.6 million and other related expenses decreased $0.7 million for the comparative twelve months.

 

Depreciation and amortization.  Depreciation and amortization for the year ended December 31, 2016 decreased to $44.9 million from $46.3 million for the year ended December 31, 2015.  The $1.4 million, or 3.0%, decrease included a $1.0 million decline in depreciation from therapeutic program equipment sold to customers as discussed above in “Products & Services Segment Trends” and assets becoming fully depreciated.  In addition, the decline in depreciation and amortization expenses in 2016 compared to the 2015 included $0.5 million lower leasehold improvements and building depreciation from the closing and consolidation of low performing clinics, a decline of $0.4 million in amortization from the complete amortization in 2015 of non-compete agreements in therapeutic services, and $0.3 million lower software depreciation.  Declines in depreciation and amortization were partially offset by a $0.8 million increase in customer list intangible amortization primarily from the change in estimated useful lives during the fourth quarter of 2015.

 

Impairment of intangible assets.  As more fully explained in Note H - “Goodwill and Intangible Assets” to our consolidated financial statements in this Annual Report on Form 10-K, we recorded an impairment of intangible assets of $86.2 million for the year ended December 31, 2016 and $385.8 million for the year ended December 31, 2015.  In 2016, we recorded a total goodwill impairment charge of $86.0 million, of which $64.9 million related to our Therapeutic reporting unit and $21.1

 

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million related to our Distribution reporting unit.  In 2015, we recorded a goodwill impairment charge of $382.9 million related to our Patient Care reporting unit. Other intangible asset impairments of $0.2 million in 2016 and $2.9 million in 2015 related to our Therapeutic reporting unit’s indefinite life tradename.

 

Loss from operations.  Loss from operations was $72.1 million for the year ended December 31, 2016 compared with a loss from operations of $349.6 million for the year ended December 31, 2015, a decrease of $277.5 million or 79.4%.  The decrease in the loss from continuing operations was the result of lower impairment of intangible assets partially offset by higher professional accounting and legal fees.

 

Interest expense, net.  Interest expense for the year ended December 31, 2016 increased to $45.2 million from $29.9 million for the year ended December 31, 2015.  The $15.3 million increase included $10.8 million of additional interest cost associated with early extinguishment of the senior notes and $4.8 million of higher interest expense associated with debt refinancing in the third quarter of 2016 as more fully disclosed in Note N - “Long-term Debt” in this Annual Report on Form 10-K.  This is offset by $0.3 million lower interest mainly associated with a reduction in outstanding borrowings.

 

Extinguishment of debt.  We recorded charges of $6.0 million in 2016 in conjunction with covenant violations, amendments and waivers related to two debt agreements.  Charges for extinguishment of debt for the year ended December 31, 2016 were $1.2 million lower than the year ended December 31, 2015 from the write-off of previously unamortized debt issuance costs.  In 2015, seven agreements were entered into that included debt waivers and amendments resulting in charges of $7.2 million.  See Note N - “Long-Term Debt” in this Annual Report on Form 10-K for more details.

 

Benefit for income taxes.  An income tax benefit of $15.9 million was recognized for the year ended December 31, 2016, compared to a benefit of $67.6 million for the year ended December 31, 2015. This reduction in tax benefit was primarily due to lower losses from continuing operations before income taxes. Our effective tax rate from continuing operations was 12.9% and 17.5% for 2016 and 2015, respectively. The effective tax rates differ from the statutory rate due primarily to non-deductible goodwill impairments and other non-deductible expenses.

 

Income (loss) from discontinued operations, net of income taxes.  Net income from the discontinued operations of Dosteon for the year ended December 31, 2016 was $0.9 million compared to a net loss of $8.0 million for the year ended December 31, 2015.  Components of the Dosteon business were either sold or ceased operations by the end of the second quarter of 2015.  Net income recognized in 2016 relates to contingent consideration resulting from the disposal.

 

Net loss.  Our net loss for year ended December 31, 2016 was $106.5 million as compared to a net loss of $327.1 million for year ended December 31, 2015.  Changes in net loss from period to period were driven by a lower impairment charge in 2016 as compared to 2015, offset by lower tax benefits and higher expenses in 2016 primarily including professional fees and interest expense.

 

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Results of Operations - Quarterly Periods December 31, 2016 Compared to Quarterly Periods December 31, 2015

 

Quarterly results of operations for 2016 and the comparative quarters in 2015 were as follows:

 

 

 

For the Quarters Ended,

 

 

 

Unaudited

 

 

 

2016

 

2015

 

(dollars in millions)

 

Dec 31

 

Sep 30

 

Jun 30

 

Mar 31

 

Dec 31

 

Sep 30

 

Jun 30

 

Mar 31

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenue

 

$

281.0

 

$

260.1

 

$

264.5

 

$

236.5

 

$

285.7

 

$

275.2

 

$

272.8

 

$

233.5

 

Material costs

 

87.0

 

85.4

 

83.0

 

76.7

 

88.1

 

85.5

 

85.9

 

76.8

 

Personnel costs

 

96.9

 

89.1

 

88.4

 

89.1

 

95.6

 

95.2

 

89.9

 

86.4

 

Other operating costs

 

36.1

 

34.3

 

31.9

 

36.8

 

34.0

 

32.9

 

37.6

 

36.4

 

General and administrative expenses

 

23.7

 

25.7

 

30.2

 

27.6

 

27.1

 

29.7

 

29.1

 

25.9

 

Professional accounting and legal fees

 

9.8

 

9.0

 

10.7

 

11.7

 

9.6

 

9.3

 

4.9

 

4.8

 

Depreciation and amortization

 

10.2

 

11.3

 

11.7

 

11.7

 

16.0

 

10.2

 

9.9

 

10.2

 

Impairment of intangible assets

 

86.2

 

 

 

 

385.0

 

0.8

 

 

 

Operating expenses

 

349.9

 

254.8

 

255.9

 

253.6

 

655.4

 

263.6

 

257.3

 

240.5

 

(Loss) income from operations

 

(68.9

)

5.3

 

8.6

 

(17.1

)

(369.7

)

11.6

 

15.5

 

(7.0

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense, net

 

13.7

 

12.8

 

9.8

 

8.9

 

8.0

 

7.4

 

7.3

 

7.2

 

Extinguishment of debt

 

 

6.0

 

 

 

7.2

 

 

 

 

(Loss) income from continuing operations before income taxes

 

(82.6

)

(13.5

)

(1.2

)

(26.0

)

(384.9

)

4.2

 

8.2

 

(14.2

)

(Benefit) provision for income taxes

 

(1.5

)

(5.6

)

(0.3

)

(8.5

)

(69.8

)

1.1

 

0.3

 

0.8

 

(Loss) income from continuing operations

 

(81.1

)

(7.9

)

(0.9

)

(17.5

)

(315.1

)

3.1

 

7.9

 

(15.0

)

(Loss) income from discontinued operations, net of income taxes

 

(0.1

)

0.4

 

0.6

 

 

(0.7

)

 

(6.3

)

(1.0

)

Net (loss) income

 

$