UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2002, 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 No.: 001-13457
ORTHODONTIC CENTERS OF AMERICA, INC.
(Exact name of registrant as specified in its charter)
Delaware 72-1278948
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3850 N. CAUSEWAY BOULEVARD, SUITE 800
METAIRIE, LOUISIANA 70002
(504) 834-4392
(Address, including zip code, of principal executive offices and
Registrant's telephone number, including area code)
--------------------------------------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES X NO
---
At May 13, 2002 there were approximately 51,199,000 outstanding shares of the
Registrant's Common Stock, $.01 par value per share.
ORTHODONTIC CENTERS OF AMERICA, INC.
TABLE OF CONTENTS
Page
----
Part I. Financial Information
Item 1. Consolidated Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets -
March 31, 2002 and December 31, 2001.........................................................................3
Condensed Consolidated Statements of Income -
Three months ended March 31, 2002 and 2001 ..................................................................4
Condensed Consolidated Statements of Cash Flow -
Three months ended March 31, 2002 and 2001...................................................................5
Notes to Condensed Consolidated Financial Statements - March 31, 2002........................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations...................12
Item 3. Quantitative and Qualitative Disclosures about Market Risk..............................................22
Part II. Other Information
Item 1. Legal Proceedings.......................................................................................23
Item 6. Exhibits and Reports on Form 8-K........................................................................23
FORWARD-LOOKING STATEMENTS
Certain statements contained in this Report may not be based on
historical facts and are "forward looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. These forward-looking statements
may be identified by reference to a future period(s) or by the use of forward
looking terminology, such as "anticipate," "estimate," "believe," "expect,"
"foresee," "may," "would," "could" or "will." These forward-looking statements
include, without limitation, the statements regarding the Company's future
growth, deferred tax asset, liquidity, capital resources, allowances for
uncollectible amounts, implementation of our business systems for OrthAlliance
affiliated practices, outcomes of litigation with certain OrthAlliance
affiliated practices, advances to newly affiliated practices, repayment of
certain indebtedness, impairment of goodwill, allocation of proceeds from
certain litigating OrthAlliance affiliated practices and acquisition of service
agreements. We caution you not to place undue reliance on these forward-looking
statements, in that they involve certain risks and uncertainties that could
cause actual results to differ materially from anticipated results. These risks
and uncertainties include the inability to successfully integrate OrthAlliance,
various litigation pending against the Company, competition from other
orthodontists, pediatric dentists, dentists and management companies, the
availability of suitable new markets and suitable locations within such markets,
failure to consummate proposed developments or acquisitions, the ability of the
Company to effectively manage an increasing number of orthodontic centers,
changes in the general economy of the United States and the specific markets in
which the orthodontic centers are or are proposed to be located, risks relating
to the Company's foreign operations, unexpected operating results, changes in
the Company's operating or expansion strategy, the ability of the Company to
attract and retain qualified personnel, orthodontists and pediatric dentists,
the ability of the Company to effectively market its services and products,
existing and future regulations affecting the Company's business, the Company's
dependence on existing sources of funding, and other factors generally
understood to affect the financial results of orthodontic practice management
companies and other factors as may be identified from time to time in the
Company's Annual Report on Form 10-K for the year ended December 31, 2001 and
other filings with the Securities and Exchange Commission or in other public
announcements by the Company. We undertake no obligation to update these
forward-looking statements to reflect events or circumstances that occur after
the date of this Report.
2
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
Orthodontic Centers of America, Inc.
Condensed Consolidated Balance Sheets
March 31, December 31,
2002 2001(1)
-------------- ---------------
(Unaudited)
(in thousands, except share amounts)
ASSETS:
Current assets:
Cash and cash equivalents ................................................. $ 16,500 $ 14,172
Service fees receivable, net of allowance for uncollectible amounts ....... 66,869 58,610
Deferred income taxes ..................................................... 4,673 4,374
Advances to affiliated practices, net ..................................... 19,935 19,379
Supplies inventory ........................................................ 7,601 8,843
Prepaid expenses and other assets ......................................... 6,938 6,963
--------- ---------
Total current assets .................................................. 122,516 112,341
Property, equipment and improvements, net ...................................... 93,777 91,843
Advances to affiliated practices, less current portion, net .................... 13,615 12,357
Deferred income taxes .......................................................... 56,775 56,694
Intangible assets, net ......................................................... 229,146 229,276
Goodwill ....................................................................... 71,782 71,782
Other assets ................................................................... 6,084 6,173
--------- ---------
Total assets .......................................................... $ 593,695 $ 580,466
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
Accounts payable .......................................................... $ 7,622 $ 11,321
Accrued salaries and other accrued liabilities ............................ 15,848 18,142
Deferred revenue .......................................................... 1,929 1,929
Income taxes payable ...................................................... 13,487 1,363
Service fee prepayments ................................................... 13,311 13,976
Amounts payable to affiliated practices ................................... 8,284 9,627
Current portion of notes payable to affiliated practices .................. 2,355 4,036
--------- ---------
Total current liabilities ............................................. 62,836 60,394
Notes payable to affiliated practices, less current portion .................... 9,425 11,564
Long-term debt ................................................................. 112,785 119,000
Non-controlling interest in subsidiary ......................................... 32 56
Stockholders' equity:
Preferred stock, $.01 par value; 10,000,000 shares authorized;
no shares outstanding ................................................... -- --
Common stock, $.01 par value per share; 100,000,000 shares
authorized; 51,162,000 shares outstanding at March 31, 2002
and 50,914,000 shares outstanding at December 31, 2001 .................. 512 509
Additional paid-in capital ................................................ 210,243 208,949
Retained earnings ......................................................... 201,209 182,715
Accumulated other comprehensive loss ...................................... (2,615) (1,989)
Due from key employees for stock purchase program ......................... (488) (488)
Capital contribution receivable from stockholders ......................... (244) (244)
--------- ---------
Total stockholders' equity ............................................ 408,617 389,452
--------- ---------
Total liabilities and stockholders' equity ............................ $ 593,695 $ 580,466
========= =========
----------
(1) The consolidated balance sheet at December 31, 2001 has been derived from
the Company's audited consolidated financial statements at that date, but
does not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements.
See notes to condensed consolidated financial statements.
3
Orthodontic Centers of America, Inc.
Condensed Consolidated Statements of Income
Three months ended
March 31,
-------------------------------------
2002 2001
-------------- ---------------
(Unaudited)
(in thousands, except per share data)
Fee revenue ...................................... $ 111,323 $ 77,484
Direct expenses:
Employee costs .............................. 31,827 22,343
Orthodontic supplies ........................ 9,578 6,237
Rent ........................................ 10,075 6,809
Marketing and advertising ................... 8,950 6,241
--------- ---------
Total direct expenses ................... 60,430 41,630
General and administrative ....................... 14,404 8,262
Depreciation and amortization .................... 5,455 4,390
--------- ---------
Operating profit ................................. 31,034 23,202
Interest income (expense), net ................... (1,348) (1,099)
Non-controlling interest in subsidiary ........... 23 110
--------- ---------
Income before income taxes ....................... 29,709 22,213
Provision for income taxes ....................... 11,215 8,385
--------- ---------
Net income ....................................... $ 18,494 $ 13,828
========= =========
Net income per share
Basic ....................................... $ 0.36 $ 0.28
========= =========
Diluted ..................................... $ 0.36 $ 0.28
========= =========
Average shares outstanding:
Basic ....................................... 50,969 48,789
========= =========
Diluted ..................................... 51,787 49,948
========= =========
See notes to condensed consolidated financial statements.
4
Orthodontic Centers of America, Inc.
Condensed Consolidated Statements of Cash Flows
Three months ended
March 31,
------------------------
2002 2001
-------- --------
(Unaudited)
(in thousands)
Operating activities:
Net income .................................................................. $ 18,494 $ 13,828
Adjustments to reconcile net income to net
cash provided by operating activities:
Provision for bad debt expense ............................................ 171 132
Depreciation and amortization ............................................. 5,455 4,390
Deferred income taxes ..................................................... (380) 601
Non-controlling interest in subsidiary .................................... (23) (110)
Changes in operating assets and liabilities:
Service fee receivables and prepayments ................................. (9,095) (4,262)
Supplies inventory ...................................................... 1,242 755
Prepaid expenses and other .............................................. 114 (41)
Amounts payable to affiliated practices ................................. (1,343) 1,057
Accounts payable and other current liabilities .......................... 6,129 1,130
-------- --------
Net cash provided by operating activities ...................................... 20,764 17,480
Investing activities:
Purchases of property, equipment and improvements ........................... (4,747) (2,250)
Intangible assets acquired .................................................. (2,510) (5,751)
Advances to affiliated practices, net ....................................... (1,814) (1,698)
-------- --------
Net cash used in investing activities .......................................... (9,071) (9,699)
Financing activities:
Repayment of notes payable to affiliated practices .......................... (3,822) --
Repayment of long-term debt ................................................. (5,000) (899)
Proceeds from long-term debt ................................................ -- 128
Issuance of common stock .................................................... 1,297 555
-------- --------
Net cash used in financing activities .......................................... (7,525) (216)
Effect of exchange rate changes on cash and cash equivalents ................... (1,840) --
Change in cash and cash equivalents ............................................ 2,328 7,565
Cash and cash equivalents at beginning of period ............................... 14,172 4,689
-------- --------
Cash and cash equivalents at end of period ..................................... $ 16,500 $ 12,254
======== ========
Supplemental cash flow information:
Cash paid during period for:
Interest ................................................................ $ 1,205 $ 917
======== ========
Income taxes ............................................................ $ 53 $ 1,962
======== ========
Supplemental disclosures of non-cash investing and financing activities:
Notes payable and common stock issued
to obtain Service Agreements ............................................. $ -- $ 313
======== ========
See notes to condensed consolidated financial statements.
5
Orthodontic Centers of America, Inc.
Notes to Condensed Consolidated Financial Statements (Unaudited)
March 31, 2002
1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
Orthodontic Centers of America, Inc. (the "Company") provides integrated
business services to orthodontic and pediatric dental practices throughout the
United States and in Japan, Mexico, Puerto Rico and Spain.
The Company provides business operations, financial, marketing and
administrative services to orthodontic practices and pediatric dental practices.
These services are provided under service, management service and consulting
agreements (hereinafter referred to as "Service Agreements") with orthodontists
or pediatric dentists and/or their wholly-owned professional entities (hereafter
referred to as "Affiliated Practices"). Because the Company does not control the
Affiliated Practices, it does not consolidate their financial results.
The Company's consolidated financial statements include service fees earned
under the Service Agreements and the expenses of providing the Company's
services, which generally includes all expenses of the Affiliated Practices
except for the practitioners' compensation and certain expenses directly related
to the Affiliated Practices, such as professional insurance coverage.
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments considered
necessary for a fair presentation have been included. Operating results for the
three month period ended March 31, 2002 are not necessarily indicative of the
results that may be expected for the year ending December 31, 2002. For further
information, refer to the consolidated financial statements and footnotes
thereto included in the Company's Annual Report on Form 10-K for the year ended
December 31, 2001.
2. REVENUE RECOGNITION
Fee revenue consists of service fees earned by the Company under the Service
Agreements. Effective January 1, 2000, the Company changed its method of revenue
recognition for service fees earned under its Service Agreements. Fee revenue is
generally recognized as service fees are contractually due under the Company's
Service Agreements, except that recognition of a portion of the service fees is
deferred because patient contract revenue is calculated on a straight-line basis
over the term of the patient contracts (which, for orthodontic patients, average
about 26 months), and are reduced by amounts retained or to be retained by
Affiliated Entities.
Amounts retained or to be retained by an Affiliated Practice equal the
Affiliated Practice's proportionate share of the portion of that straight-line
allocation of patient contract revenue that is collected during the relevant
period, and the patient receivables that represent the uncollected portion of
that straight-line allocation of patient contract revenue. Amounts retained or
to be retained are reduced by any operating losses, depreciation, interest on
outstanding loans, bad debt or other expenses that the Company has incurred but
for which it has not been reimbursed by the Affiliated Practice; however, these
unreimbursed expenses reduce amounts retained by an Affiliated Practice only up
to the amounts that would otherwise be retained by the Affiliated Practice. Any
remaining unreimbursed expenses would reduce amounts retained or to be retained
by the Affiliated Practice in subsequent periods. For the Company's general form
of Service Agreements (under which service fees are generally determined, at
least in part, based upon a percentage of practice operating profit), the
amounts retained or to be retained by an Affiliated
6
Orthodontic Centers of America, Inc.
Notes to Condensed Consolidated Financial Statements (Unaudited)(continued)
Practice are estimated using the percentage of practice operating profits that
may be retained by the Affiliated Practice under the Service Agreement. For
Service Agreements of OrthAlliance, Inc. ("OrthAlliance"), which was acquired by
the Company in November 2001, under which service fees are generally determined,
at least in part, based upon a percentage of practice revenue and reimbursement
of practice related expenses, amounts retained or to be retained by an
Affiliated Practice are estimated using the percentage of practice revenue that
may be retained by the Affiliated Practice under the terms of the Service
Agreement, minus the estimated amount of practice related expenses for which
OrthAlliance may be reimbursed under the Service Agreement.
Many of OrthAlliance's Affiliated Practices require that their patients pay a
down payment of approximately 25% of the total treatment fee at the commencement
of treatment. This results in the Company receiving cash in advance of incurring
certain practice related expenses and recognizing certain service fees as fee
revenue, which are deferred and recorded as service fee prepayments. Service fee
prepayments represent cash received in excess of service fees that have been
recognized as fee revenue, less an estimate of the portion of that cash that the
applicable Affiliated Practice is to retain and practice related expenses that
have not yet been incurred.
Most of the Affiliated Practices pledge their billed and unbilled patient fees
receivable to the Company as collateral for the Company's service fees. The
Company is generally responsible for billing and collection of the patient fees
receivable, which are conducted in the name of the applicable Affiliated
Practice. Collections from patient fees receivable are generally deposited into
depository bank accounts that the Company establishes and maintains.
The Company generally collects its service fees receivable from funds that are
collected from patient fees receivable and deposited into depository bank
accounts. This results in deferral of collection of a portion of the Company's
service fees receivable until the related patient fees receivable that have been
pledged to the Company are collected and the funds are deposited into a
depository bank account. This deferral is generally for a period that averages
less than 90 days, as patient fees receivable are generally collected within
that period of time. The Company does not generally charge Affiliated Practices
any interest on these deferred balances of service fees receivable. For
newly-developed centers (which typically generate operating losses during their
first 12 months of operations), the Company generally defers payment of a
portion of its service fees relating to unreimbursed expenses over a five-year
period that generally commences in the second year of the center's operations,
and charges the Affiliated Practices interest on those deferred amounts at
market rates. Under the Company's revenue recognition policy, those unreimbursed
expenses are not recognized as revenue or recorded as service fees receivable
until such revenue is collateralized by patient fees receivable pledged by
Affiliated Practices. Pledged patient fees receivable which prove to be
uncollectible have the effect of reducing the amount of service fees receivable
collected by the Company.
In some cases, the Company assists Affiliated Practices in obtaining financing
for their share of operating expenses by providing a guaranty of loans from a
third-party lender. Information about amounts guaranteed by the Company is
provided in "ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL RESOURCES."
7
Orthodontic Centers of America, Inc.
Notes to Condensed Consolidated Financial Statements (Unaudited)(continued)
3. INTANGIBLE ASSETS
The Company generally affiliates with an existing orthodontic or pediatric
dental practice by acquiring substantially all of the non-professional assets of
the practice, either directly or indirectly through a stock purchase, and
entering into a Service Agreement with the orthodontist or pediatric dentist
and/or his or her professional corporation or other entity. The terms of the
Service Agreements range from 20 to 40 years, with most ranging from 20 to 25
years. The acquired assets generally consist of equipment, furniture, fixtures
and leasehold interests. The Company records these acquired tangible assets at
their fair value as of the date of acquisition, and depreciates or amortizes the
acquired assets using the straight-line method over their useful lives. The
remainder of the purchase price is allocated to an intangible asset, which
represents the costs of obtaining the Service Agreement. In the event the
Service Agreement is terminated, the related Affiliated Practice is generally
required to purchase all of the related assets, including the unamortized
portion of intangible assets, at the current book value.
Service Agreements are amortized over the shorter of their term or 25 years.
Amortization expense was $2.6 million and $2.1 million for the three months
ended March 31, 2002 and 2001, respectively. Accumulated amortization was $34.9
million and $22.8 million as of March 31, 2002 and 2001, respectively.
Intangible assets and the related accumulated amortization are written off when
fully amortized.
4. EARNINGS PER SHARE
Basic and diluted earnings per share are based on the weighted average number of
shares of common stock and common equivalent shares (stock options) outstanding
during the period.
5. ACCOUNTING CHANGE
On January 1, 2002, the Company adopted Statement of Financial Accounting
Standards (SFAS) No. 141, "Business Combinations," SFAS No. 142, "Goodwill and
Other Intangible Assets," and SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets," except for provisions in SFAS No. 141 and SFAS
No. 142 related to the business combination with OrthAlliance, which were
adopted on November 9, 2001. SFAS No. 141 requires that the purchase method of
accounting be used for all business combinations initiated after June 30, 2001,
and prohibits the use of the pooling-of-interests method for such transactions.
SFAS No. 142 requires that goodwill and intangible assets with indefinite lives,
including such assets recorded in past business combinations, no longer be
amortized, but instead be tested for impairment by measuring the reporting unit
at fair value with the initial impairment test performed within six months from
the beginning of the year in which the standard is adopted. SFAS No. 142 also
requires that the impairment test be performed at least annually thereafter,
with interim testing required if circumstances warrant. Intangible assets with
finite lives will continue to be amortized over their useful lives and reviewed
for impairment. The Company applied provisions of SFAS No. 141 and SFAS No. 142
in recording its business combination with OrthAlliance in November 2001, and
did not amortize goodwill arising from the combination in accordance with SFAS
No. 142. The Company has not completed its initial evaluation of goodwill
impairment that is required with the adoption of SFAS No. 142. However, based on
a preliminary evaluation, the Company does not believe that its existing
goodwill balance is currently impaired under the new standard. However, no
assurances can be given regarding future impairment. The Company anticipates
completing the initial evaluation by June 30, 2002, which is within the six
month transition period allowed by the new standard upon adoption.
SFAS No. 144 addresses the financial accounting and reporting for the impairment
or disposal of long-lived assets. SFAS No. 144 supersedes SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of," and provisions of APB Opinion No. 30,
8
"Reporting the Results of Operations - Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions," for the disposal of a segment of a business. The
adoption of SFAS No. 144 did not impact our financial position or results of
operations.
9
6. BUSINESS COMBINATION WITH ORTHALLIANCE
On November 9, 2001, a newly-formed subsidiary of the Company merged with and
into OrthAlliance. As a result of the merger, OrthAlliance became a wholly-owned
subsidiary of the Company. OrthAlliance provides management and consulting
services to orthodontic and pediatric dental practices throughout the United
States.
The acquisition was accounted for using the purchase method of accounting. The
results of operations of OrthAlliance subsequent to November 9, 2001 have been
included in the Company's consolidated statements of income. The results of
OrthAlliance do not include results of operations relating to Service Agreements
with certain affiliated practices that are parties to litigation pending against
OrthAlliance and have ceased remitting service fees to OrthAlliance (the
"Excluded OrthAlliance Affiliated Practices"). The purchase price has been
allocated to the acquired assets, including identifiable intangible assets, and
liabilities assumed based on their estimated fair values as of November 9, 2001.
These allocations are preliminary and, therefore, subject to change as the
Company obtains more information and as certain pre-acquisition contingencies,
particularly those related to litigation, are resolved.
Following the announcement of the merger agreement with OrthAlliance, a number
of OrthAlliance's affiliated practices commenced litigation against
OrthAlliance, alleging, among other things, that OrthAlliance breached the terms
of their Service Agreements by failing to provide certain services and/or that
certain provisions of their Service Agreements may be unenforceable. In
determining the purchase price allocation, the Company has assigned no value to
advances to affiliated practices, property, equipment and improvements, notes
receivable, and Service Agreements relating to certain OrthAlliance affiliated
practices that are parties to such pending litigation and have ceased paying
service fees to OrthAlliance, because of the inherent uncertainties of the
litigation process, the relatively early stages of these lawsuits and the
recentness of the merger, all of which create uncertainties with respect to the
recoverability of these assets. Also, the allocation does not reflect any
proceeds that may be received by OrthAlliance from these affiliated practices in
consideration for certain assets or termination of their Service Agreements.
Therefore, the estimated values are preliminary and may change as more facts
become known. The assignment of no value to assets related to these affiliated
practices does not reflect a belief by management that these lawsuits have merit
or that the plaintiffs will ultimately prevail in these actions. In connection
with the OrthAlliance merger, the Company acquired a liability for certain
estimated additional merger-related costs that may be incurred by the Company,
including estimated attorneys fees and legal expenses anticipated to be incurred
in connection with these lawsuits.
Intangible assets represent the costs of obtaining Service Agreements, pursuant
to which the Company obtains the exclusive right to provide business operations,
financial, marketing and administrative services to the Affiliated Practices
during the term of the Service Agreements. The intangible assets are being
amortized on a straight-line basis over the lives of the Service Agreements (up
to 25 years), with a weighted-average life of 20 years. Part of the amortization
generated by these intangible assets is not deductible for income tax purposes.
OrthAlliance's Service Agreements are with a professional corporation or other
entity owned by an orthodontist or pediatric dentist. OrthAlliance's Service
Agreements generally provide that the professional corporation or other entity
is responsible for providing orthodontic or pediatric dental services and for
hiring orthodontists or pediatric dentists. These Service Agreements also
generally
10
provide that OrthAlliance services are feasible only if the professional entity
operates an active orthodontic or pediatric dental practice to which it and each
orthodontist associated with the professional entity devotes their full time and
attention. These Service Agreements also generally require that the professional
entity enter into an employment agreement with the owner of the professional
entity and other practitioners providing services in the respective practice.
These employment agreements are generally for a term of five years, which
generally automatically renew for one year terms unless earlier terminated. The
weighted-average remaining life of the terms of the existing employment
agreements is approximately 3 years. Under these employment agreements, the
orthodontist or pediatric dentist may generally terminate their employment
(subject to a covenant not to compete) following the initial term of the
agreement by giving at least one year's prior written notice. Approximately five
of OrthAlliance's affiliated practitioners formerly affiliated with New Image
Orthodontic Group, Inc. ("New Image") (not including nine of the Excluded
OrthAlliance Affiliated Practices) may terminate their employment agreement
prior to expiration of their term by giving at least one year's prior written
notice and by paying a termination fee ranging from $300,000 to $1,000,000.
In connection with the OrthAlliance merger, the Company assumed liabilities for
estimated employee severance and for operating lease agreements expected to be
terminated. The severance accrual relates to approximately 30 OrthAlliance
corporate employees. The operating lease payment accrual relates to facility
leases assumed by the Company for facilities that have been vacated. Amounts
accrued represent management's estimates of the cost to exit these leases.
Components and activity for the liabilities assumed are as follows:
DECEMBER 31, CHARGES AND MARCH 31,
2001 ADJUSTMENTS 2002
------------ ----------- ---------
(in thousands)
Accrued severance liability ................. $2,579 $ 313 $2,266
------ ------ ------
Accrued operating facility leases ........... $1,203 $ 145 $1,058
------ ------ ------
$3,782 $ 458 $3,324
====== ====== ======
7. COMMITMENTS AND CONTINGENCIES
On May 12, 2000, two plaintiffs filed an action against the Company, in which
they alleged that the Company breached an agreement to settle an earlier lawsuit
by one of these plaintiffs regarding a proposed, but never completed,
affiliation with that plaintiff, and that the Company fraudulently induced the
plaintiff to settle the earlier lawsuit. The plaintiffs sought specific
enforcement of the settlement agreement and unspecified compensatory and
punitive damages and attorneys' fees. A trial in this action was completed on
March 13, 2002, and a judgment was rendered in favor of the plaintiffs, who were
awarded compensatory and punitive damages and attorneys fees. On March 27, 2002,
the Company filed an appeal challenging these results. The Company believes that
the estimated outcome of this lawsuit will not have a material adverse effect on
the Company's financial position and results of operations.
On October 17, 2000, the Company filed an action against a former employee in
the U.S. District Court for the Southern District of California on October 17,
2000. In the Company's complaint, it alleged that the former employee breached
the terms of his employment agreement and failed to satisfy a condition to the
Company's performance under the employment agreement by failing and refusing to
affiliate his orthodontic practice with the Company. The Company sought a
declaratory judgment that it had no further obligations under the employment
agreement due to the former employee's failure to affiliate his practice with
the Company, his failure to recruit a minimum number of affiliated orthodontists
and the Company's termination of his employment for cause, and that, if the
former employee was found to be entitled to additional compensation, it should
take the form of stock options. The Company also sought repayment of loans and
other amounts owed to it by the former employee. The former employee filed a
counterclaim against the Company on November 1, 2000, in which he alleged that
the Company had breached the terms of his employment agreement and an alleged
oral agreement or modification to the employment agreement to convert his loans
to an interest-free basis and, at his option, compensation, and to waive his
obligation to affiliate his practice with the Company. The former employee
sought an unspecified amount of money damages or shares of the Company's common
stock. The parties reached agreement on the amounts payable to the former
employee for his prior recruiting services, and, on May 10, 2002, the litigation
was dismissed. The Company will allocate amounts paid to the former employee to
the intangible assets relating to Service Agreements with Affiliated Practices
which the former employee assisted in recruiting. Settlement of this action did
not have a material adverse effect on the Company's financial condition or
results of operations.
Certain affiliated practices of OrthAlliance are parties to litigation pending
against OrthAlliance as previously disclosed in Note 12 of the Company's 2001
Form 10-K. On April 22, 2002, the U.S. District Court for the Northern District
of Indiana, in ruling on motions for summary judgment, held that a service
agreement between OrthAlliance and one of OrthAlliance's affiliated practices
(the "PC") was valid and enforceable, in that the service agreement did not
violate Indiana laws prohibiting the unauthorized practice of dentistry. The PC
filed an action against OrthAlliance on August 21, 2001, alleging, among other
things, that the service agreement was illegal under Indiana law and therefore
void and unenforceable, and that OrthAlliance had breached the service
agreement. In its ruling, the court found that the service agreement did not
call for OrthAlliance to engage in the unauthorized practice of dentistry;
rather, the court found that OrthAlliance had a contractual obligation under the
service agreement to provide business services and business personnel to the
practice, without violating Indiana laws regulating the practice of dentistry.
The court confirmed that OrthAlliance does not control the PC's orthodontic
practice, noting that one of the orthodontist-owners of the PC had made
statements that indicated his understanding that he and the other
orthodontist-owner retained control over their practice. The court also held
that OrthAlliance was a third party beneficiary of portions of the employment
agreements between the PC and its orthodontist-owners, including the
orthodontists' covenants not to compete, and that the PC and its
orthodontist-owners may not amend those provisions without OrthAlliance's
consent if OrthAlliance has approved, sued upon or justifiably relied on the
provisions. OrthAlliance has filed an amended counterclaim with the court, which
OrthAlliance believes further and clearly indicates that it has met these
requirements. A trial date for the remaining issues in this case has not been
set. There has not been any other material changes to litigation pending against
OrthAlliance.
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion summarizes the financial position of Orthodontic
Centers of America, Inc. ("we," "OCA" or the "Company") at March 31, 2002, and
the results of operations for the three-month period ended March 31, 2002, and
should be read in conjunction with the condensed consolidated financial
statements and related notes included elsewhere in this Report.
GENERAL
Our business was established in 1985. At March 31, 2002, we provided business
services to 367 orthodontic and pediatric dental practices operating in 869
orthodontic and pediatric dental centers in which 617 orthodontists, pediatric
dentists and general dentists were practicing as of March 31, 2002. These
amounts do not include the Excluded OrthAlliance Affiliated Practices, which are
49 orthodontists and pediatric dentists as of March 31, 2002, which are involved
in litigation with OrthAlliance and have ceased paying service fees to
OrthAlliance.
Generally, when we develop a new center, all patients treated at the center are
new patients and, in the first several months after commencing operations, the
center is open only for a limited number of days each month as new patients are
added. Our affiliated centers have generally become increasingly more productive
and profitable as more new patients are added and existing patients return for
monthly follow-up visits. After approximately 26 months of operations, a
center's growth in patient base has typically begun to stabilize as the initial
patients complete treatment. At that point, a center can increase the number of
patients treated by improving the efficiency of its clinical staff, increasing
patient treatment intervals and adding operating days or practitioners. Our
affiliated centers may also increase revenue by implementing periodic price
increases. Established practices with which we have affiliated have typically
increased their revenue by applying our operating strategies and systems,
including increased advertising and efficient patient scheduling.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
We provide integrated business services to orthodontic and pediatric dental
practices, and our consolidated financial statements include service fees earned
under our service and consulting agreements and the expenses of providing these
services. We do not consolidate the patient revenue and other operations and
accounts of our affiliated practices. The preparation of financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
During the three months ended March 31, 2002, there were no material changes to
or in the application of the Company's critical accounting policies presented in
the Company's Annual Report on Form 10-K for the year ended December 31, 2001.
For further discussion on our accounting policies, see Note 2 to our Condensed
Consolidated Financial Statements included elsewhere in this Report, primarily
related to revenue recognition.
12
REVENUE RECOGNITION
We recognize fee revenue based on a straight-line allocation of patient contract
revenue over the terms of our affiliated practices' patient contracts (which,
for orthodontic patients, average about 26 months), minus the portion of that
straight-line allocation retained or to be retained by our affiliated practices.
Amounts retained or to be retained by an affiliated practice equal the
practice's proportionate share of the portion of that straight-line allocation
of patient contract revenue that is collected during the relevant period, and
the patient receivables that represent the uncollected portion of that
straight-line allocation of patient contract revenue. Amounts retained or to be
retained are reduced by any operating losses, depreciation, interest on
outstanding loans, bad debt or other expenses that we have incurred but for
which we have not been reimbursed by the practice; however, these unreimbursed
expenses reduce amounts retained by an affiliated practice only up to the
amounts that would otherwise be retained by the practice. Any remaining
unreimbursed expenses would reduce amounts retained or to be retained by the
practice in subsequent periods. For OCA's general form of service and consulting
agreements (under which service fees are generally determined, at least in part,
based upon a percentage of practice operating profit), the amounts retained or
to be retained by an affiliated practice are estimated using the percentage of
practice operating profits that may be retained by the practice under the
service or consulting agreement. For OrthAlliance's service, management service
and consulting agreements (under which service fees are generally determined, at
least in part, based upon a percentage of practice revenue and reimbursement of
practice related expenses), amounts retained or to be retained by an affiliated
practice are estimated using the percentage of practice revenue that may be
retained by the practice under the terms of the service, management service or
consulting agreement, minus the estimated amount of practice related expenses
for which OrthAlliance may be reimbursed under that agreement.
Many of OrthAlliance's affiliated practices require that their patients pay a
down payment of approximately 25% of the total treatment fee at the commencement
of treatment. This results in us receiving cash in advance of incurring certain
practice related expenses and recognizing certain service fees as fee revenue,
which are deferred and recorded as service fee prepayments. Service fee
prepayments represent cash received in excess of service fees that have been
recognized as fee revenue, less an estimate of the portion of that cash that the
applicable affiliated practice is to retain and practice related expenses that
have not yet been incurred.
EXPENSES
Operating expenses of our affiliated centers are our expenses and are recognized
as incurred. Employee costs consist of wages, salaries and benefits paid to all
of our employees, including orthodontic assistants, business staff and
management personnel. General and administrative expenses consist of, among
other things, provision for losses on service fees receivable, professional
fees, maintenance and utility costs, office supply expense, telephone expense,
taxes, license fees, printing expense and shipping expense.
OVERVIEW OF SERVICE AND CONSULTING AGREEMENTS
We provide a wide range of services to our affiliated practices, including
marketing and advertising, management information systems, staffing, supplies
and inventory, scheduling, billing, financial reporting, accounting and other
administrative and business services. These services are provided under
long-term agreements with affiliated orthodontists and pediatric dentists and/or
their wholly-owned professional corporation or other entity, with terms that
generally range from 20 to 40 years.
The specific form of agreement is based upon the dental regulatory provisions of
the particular state in which an affiliated practice is located. In most states,
we use a form of service agreement, with some minor variations from state to
state. In a small number of states with particularly stringent laws relating to
the practice of dentistry, we use a consulting agreement, which also varies
somewhat from state to state. OrthAlliance and its affiliated practices are
parties to service, management service and consulting
13
agreements that differ in some respects from the service and consulting
agreements that OCA has historically used.
OCA Service Agreements
Under OCA's general form of service agreement, we provide affiliated practices
with a wide range of business services in exchange for monthly service fees
based upon the result of about 24% of new patient contract balances in the first
month of treatment plus the balance of the patient contract balances allocated
equally over the remaining terms of the patient contracts (which average about
26 months), minus amounts retained by the affiliated practice. The amounts
retained by an affiliated practice are based on a percentage of the operating
profits of the practice on a cash basis, generally cash collections minus
expenses during the period (in some cases, after reduction for any hourly-based
service fees or hourly-based amounts retained by the affiliated practice), plus,
in some cases, certain hourly-based amounts. These service fees generally
represent reimbursement for direct and indirect expenses that we incur in
providing services to an affiliated practice (including employee costs,
marketing and advertising costs, office rent, utilities expense, supply costs
and general and administrative expenses), a portion of the operating profits of
the affiliated practice on a cash basis, a percentage of the affiliated
practice's revenue, a fee amount dependent on the affiliated practice's revenue
and expenses, and in some cases, hourly-based service fees. Excluding
reimbursement of direct and indirect expenses and any hourly-based service fees,
service fees based on the operating profits of the affiliated practice generally
range from 40% to 50% of a mature practice's cash operating profits (in some
cases, after reduction for any hourly-based service fees or hourly-based amounts
retained by an affiliated practice).
OCA Consulting Agreements
Under OCA's general form of consulting agreement, the types of services we
provide to affiliated practices are generally similar to the services we provide
under our general form of service agreement. Fees paid to us under the
consulting agreements generally are a combination of, depending on the service
being performed, cost-based types of fees, flat monthly fees and hourly fees.
OrthAlliance Service, Management Service and Consulting Agreements
Under OrthAlliance's general form of service agreements, OrthAlliance generally
must provide or arrange for certain services for its affiliated practices, and
advise and assist the practices with respect to certain other services. These
services are generally similar to those provided under OCA's service agreements.
OrthAlliance is generally responsible for paying certain practice expenses, for
which it is to be reimbursed by the affiliated practice. If the practice's
collections are insufficient to fund the practice's current practice expenses,
then OrthAlliance is generally obligated to advance funds for those expenses.
Under these service agreements, OrthAlliance generally receives service fees
based on either (i) a percentage of adjusted practice revenue (generally about
17%), which is to be earned by OrthAlliance on an accrual basis of accounting
and received on a cash basis, subject, in some cases, to a minimum dollar amount
of annual service fees during the first five years of the agreement, (ii) a
percentage of adjusted practice revenue (generally about 17%), which is to be
earned by OrthAlliance on an accrual basis of accounting, and received on a cash
basis, subject to annual adjustments based upon improvements in the affiliated
practice's operating margin, and, in some cases, subject to a minimum dollar
amount of annual service fees during the first five years of the agreement, or
(iii) a flat monthly fee with annual fixed-dollar increases.
Under OrthAlliance's general form of consulting agreements, OrthAlliance must
provide certain specified services to its affiliated practices, provide other
services at the request of the practices and consult with or advise the
affiliated practices with respect to other services. These services are
generally similar to those provided under OCA's service agreements. Under these
agreements, OrthAlliance receives a consulting
14
fee based on one of the three fee structures described above with respect to
OrthAlliance's service agreements.
Under OrthAlliance's general form of management service agreements, which are
used for practices that were affiliated with New Image prior to OrthAlliance's
acquisition of those agreements in March 2000, OrthAlliance is to provide and
remit payment for a wide range of services for its affiliated practices,
including providing facilities, equipment, support personnel, utilities,
supplies, bookkeeping, marketing and billing and collections services. These
management service agreements generally provide for a service fee that varies
from month to month depending on the particular practice's practice revenue and
operating expenses. Service fees are calculated based on two grids set forth in
the management service agreement that determine the portion of practice revenue,
on a cash basis, that is to be retained by the affiliated practice. One grid
determines a percentage of practice revenue, on a cash basis, to be retained by
the affiliated practice based on the amount of such practice revenue during the
prior calendar quarter. Pursuant to this grid, OrthAlliance's service fees
generally increase if the affiliated practice's practice revenue increases and
the service fees generally decrease if the affiliated practice's practice
revenue decreases. The other grid determines an offsetting or additional
percentage of such practice revenue to be retained by the affiliated practice,
based on the practice's operating expenses during the prior calendar quarter.
Pursuant to this grid, OrthAlliance's service fees generally decrease if the
affiliated practice's operating expenses increase and the service fees generally
increase if the affiliated practice's operating expenses decrease. The
management service agreements generally provide for maximum service fees of
19.5% of the practice's practice revenue on a cash basis. A few of
OrthAlliance's management service agreements provide for a fixed percentage
service fee.
SEASONALITY
Our affiliated practices have experienced their highest volume of new cases in
the summer and other periods when schools are not typically in session. During
these periods, children have a greater opportunity to visit an orthodontist or
pediatric dentist to commence treatment. Consequently, our affiliated practices
have experienced higher revenue during the first and third quarters of the year
as a result of increased patient starts. During the Thanksgiving and Christmas
seasons, our affiliated practices have experienced reduced volume and fourth
quarter revenue for our affiliated practices has been generally lower as
compared to other periods. Seasonality in recent periods has been mitigated by
the impact of additional practices.
EMERGING ISSUES TASK FORCE ISSUE NO. 97-2
We do not have a controlling financial interest in our affiliated practices. In
accordance with guidance in Emerging Issues Task Force Issue No. 97-2, we do not
consolidate the patient revenue and other operations and accounts of our
affiliated practices within our financial statements.
BUSINESS COMBINATION WITH ORTHALLIANCE
OrthAlliance became our wholly-owned subsidiary in a stock-for-stock merger in
November 2001. The OrthAlliance merger was accounted for using the purchase
method of accounting, and the results of operations of OrthAlliance have been
included in our consolidated financial statements for the period from November
9, 2001 through December 31, 2001 and the three months ended March 31, 2002.
However, our condensed consolidated financial statements for 2002 do not include
any results of operations associated with the Excluded OrthAlliance Affiliated
Practices, which are engaged in litigation with OrthAlliance and have ceased
paying service fees to OrthAlliance.
We believe that the OrthAlliance merger is a strategically important
transaction, which we believe will provide opportunities for growth in our fee
revenue and increases in our operating margin. Our objective is to build sound,
long-term business relationships with OrthAlliance's affiliated practices, and
to increase
15
the number of these practices that use our suite of integrated business systems
and services. Since entering into a merger agreement with OrthAlliance in May
2001, we have devoted substantial resources to attempting to integrate their
practices into our network of other affiliated practices. Some of OrthAlliance's
affiliated practices began using part of our computer and business systems prior
to the merger, under a license that we granted to OrthAlliance in October 2001.
In addition, approximately 66 of OrthAlliance's affiliated practices (not
including six of the Excluded OrthAlliance Affiliated Practices) agreed, in
amendments to their service, management service or consulting agreements with
OrthAlliance, to use our proprietary computer software and business systems in
their practices. During 2002, we hope to fully implement our business systems
for these practices. We also intend to continue to inform other OrthAlliance
affiliated practices about the quality and benefits of our systems and services,
which we hope will persuade additional practices to use a wide range of these
systems and services.
Before we entered into the merger agreement with OrthAlliance, we anticipated
that some portion of OrthAlliance's affiliated practices would oppose such a
merger because of, among other things, disappointment with the market price of
OrthAlliance's common stock (which many practices received in connection with
their affiliation with OrthAlliance), unwillingness to affiliate with a
competitor of OrthAlliance or perceived differences in the companies' cultures
and operating strategies. Accordingly, we factored the likelihood of a number of
dissident practices into our analysis of the economic merits of the merger, and
into the structure of the merger agreement and merger consideration (which was
based on the number of practices that entered into amendments to their
employment agreements and service, management service and consulting agreements
with OrthAlliance prior to the merger). Following the announcement of the merger
agreement with OrthAlliance in May 2001, a number of OrthAlliance's affiliated
practices did, in fact, file lawsuits against OrthAlliance and/or notify
OrthAlliance that it was in default under their service, management service and
consulting agreements, in response to which OrthAlliance engaged outside counsel
to represent its interests. We believe that, despite these lawsuits, the
OrthAlliance merger has financial merit and was a positive development for our
company.
In a recent decision rendered on April 22, 2002, the U.S. District Court of
Northern District of Indiana ruled that a service agreement between OrthAlliance
and one of its affiliated practices was valid and enforceable, in that it did
not violate Indiana laws prohibiting the unauthorized practice of dentistry. The
court also ruled that OrthAlliance was a third party beneficiary of portions of
the employment agreements between the practice and its orthodontist-owners,
including the orthodontists' covenant not to compete. We view the federal
court's ruling as a positive development and, although not binding in courts in
which other OrthAlliance actions are pending, a testimony to the strength of our
legal positions in these cases. OrthAlliance intends to defend each of these
lawsuits vigorously, and to continue to demand that these practices honor their
commitments under their agreements with OrthAlliance. We believe that the
plaintiffs' claims in these actions lack merit, and that OrthAlliance has
meritorious claims against each of these plaintiffs.
Based on our prior experience and discussions with some of these litigating
practices or their representatives, we currently believe that some of these
practices will settle their lawsuits by paying us an amount of cash in exchange
for termination or modification of their service, management service and
consulting agreements with OrthAlliance, depending upon the parties' ability to
reach an agreement as to the amount to be paid. We cannot assure you that such
an agreement or settlement will be reached in any of these lawsuits. We also
cannot, at this time, predict the outcome of these lawsuits or assure you that
we will prevail in any of them, nor can we estimate at this time the amount of
damages that we might incur or receive in these actions. Due to the uncertainty
of this litigation, we have currently assigned no value to service, management
service and consulting agreements with the Excluded OrthAlliance Affiliated
Practices, which were engaged in litigation with OrthAlliance and which had
ceased to pay service fees to OrthAlliance as of March 31, 2002, for purposes of
allocating the purchase price that we paid in the OrthAlliance merger.
16
RESULTS OF OPERATIONS
The following table provides information about the percentage of fee revenue
represented by some of the items in our condensed consolidated statements of
income.
Three months ended
March 31,
--------------------
2002 2001
----- -----
Fee revenue .......................................... 100.0% 100.0%
----- -----
Direct expenses:
Employee costs .................................. 28.6 28.8
Orthodontic supplies ............................ 8.6 8.0
Rent ............................................ 9.1 8.8
Marketing and advertising ....................... 8.0 8.1
----- -----
Total direct expenses ....................... 54.3 53.7
General and administrative ........................... 12.9 10.7
Depreciation and amortization ........................ 4.9 5.7
Operating profit ..................................... 27.9 29.9
Interest (income) expense ............................ 1.2 1.3
Income before income taxes ........................... 26.7 28.6
Provision for income taxes ........................... 10.1 10.8
----- -----
Net income ........................................... 16.6% 17.8%
===== =====
THREE MONTHS ENDED MARCH 31, 2002 COMPARED TO THREE MONTHS ENDED MARCH 31, 2001
OVERVIEW. Our net income was $18.5 million for the three months ended
March 31, 2002, compared to net income of $13.8 million for the three months
ended March 31, 2001, an increase of 34.1%. This increase was primarily due to a
significant increase in fee revenue during the first quarter of 2002, as
compared to the same period of 2001, including increases resulting from our
merger with OrthAlliance. For the three months ended March 31, 2002, our
operating margin (or operating profits as a percentage of fee revenue) decreased
to 27.9% from 29.9% for the three months ended March 31, 2001. Our fee revenue
increased 43.7% to $111.3 million for the three months ended March 31, 2002,
from $77.5 million for the three months ended March 31, 2001. Our direct
expenses increased 45.2% to $60.4 million for the three months ended March 31,
2002, from $41.6 million for the three months ended March 31, 2001. As a
percentage of fee revenue, our direct expenses slightly increased to 54.3% for
the three months ended March 31, 2002 from 53.7% for the three months ended
March 31, 2001.
FEE REVENUE. Fee revenue increased $33.8 million, or 43.7%, to $111.3
million for the three months ended March 31, 2002 from $77.5 million for the
three months ended March 31, 2001. We attribute $27.4 million of this increase
to the growth in fee revenue of centers open throughout both periods and to the
contribution to fee revenue from practices affiliated with OrthAlliance, and
$6.4 million of this increase to centers opened since January 1, 2001.
OrthAlliance contributed to this increase in fee revenue as we acquired it in
November 2001. The increase in fee revenue during the first quarter of 2002, as
compared to the first quarter of 2001, was also due to an increase in the number
of patients being treated by our affiliated practices and an increase in the
average amount of fees that patients were charged for treatment. During the
three months ended March 31, 2002, our affiliated practices initiated treatment
of about 58,700 patients, an increase of 32.1% from about 44,400 patients during
the three months ended March 31, 2001, representing new patient contract
balances of $188.0 million at March 31, 2002, compared to $138.5 million at
March 31, 2001. At March 31, 2002, our affiliated practitioners were treating a
total of 499,200 patients, an increase of 38.7% from approximately 359,900
patients at
17
March 31, 2001. The Company adopted a change in accounting for revenue effective
January 1, 2000 and recorded a cumulative effect of change in accounting
policies of $50.6 million, net of an income tax benefit. During the three months
ended March 31, 2001, the Company recognized revenue of $5.8 million that was
included in the cumulative effect of change in accounting principle. The amounts
in this section exclude the Excluded OrthAlliance Affiliated Practices.
EMPLOYEE COSTS. Employee costs increased $9.5 million, or 42.4%, to
$31.8 million for the three months ended March 31, 2002 from $22.3 million for
the three months ended March 31, 2001. This increase primarily resulted from the
addition of additional employees through the OrthAlliance merger. As a
percentage of fee revenue, employee costs decreased to 28.6% for the three
months ended March 31, 2002 from 28.8% for the three months ended March 31,
2001. As a result of developments in orthodontic technology, a patient may be
seen every six to eight weeks, rather than the traditional four weeks, without
compromising quality of care. Consistent with industry trends, our affiliated
orthodontists have begun increasing the intervals between patient treatments.
During the three months ended March 31, 2002, patients in our affiliated
orthodontic centers averaged 47.5 days between office visits, compared to an
average of 45.3 days during the three months ended March 31, 2001. This increase
in patient treatment interval reduces the number of office visits during the
term of a patient's treatment, which continues to average about 26 months, and
results in lower employee costs per patient. The increased interval does not,
however, reduce the amount of treatment fees per patient. Therefore, the
increased interval reduces the employee costs incurred with respect to an
individual patient relative to the patient's treatment fee.
ORTHODONTIC SUPPLIES. Orthodontic supplies expense increased $3.3
million, or 53.6%, to $9.5 million for the three months ended March 31, 2002
from $6.2 million for the three months ended March 31, 2001. As a percentage of
fee revenue, orthodontic supplies expense increased to 8.6% for the three months
ended March 31, 2002 from 8.0% for the three months ended March 31, 2001. This
increase was primarily due to increases in prices charged for orthodontic
supplies by certain of our vendors beginning in the fourth quarter of 2001.
RENT. Rent expense increased $3.3 million, or 48.0%, to $10.1 million
for the three months ended March 31, 2001 from $6.8 million for the three months
ended March 31, 2001. This increase was primarily due to centers acquired,
affiliated, opened or relocated after March 31, 2001, including OrthAlliance
affiliated practices. As a percentage of fee revenue, rent expense increased to
9.1% for the three months ended March 31, 2002 from 8.8% for the three months
ended March 31, 2001. The increase was primarily attributable to rent increase
in certain markets and to an overall increase in common area maintenance charges
for 2002 compared to 2001.
MARKETING AND ADVERTISING. Marketing and advertising expense increased
$2.7 million, or 43.4%, to $9.0 million for the three months ended March 31,
2002 from $6.2 million for the three months ended March 31, 2001. The increase
in this expense primarily resulted from increases in marketing and advertising
related to growth in fee revenue for existing centers as well as marketing and
advertising for centers added after March 31, 2001. As a percentage of fee
revenue, marketing and advertising expense decreased slightly to 8.0% for the
three months ended March 31, 2002 from 8.1% for the three months ended March 31,
2001.
GENERAL AND ADMINISTRATIVE. General and administrative expense
increased $6.1 million, or 74.3%, to $14.4 million for the three months ended
March 31, 2002 from $8.3 million for the three months ended March 31, 2001. As a
percentage of fee revenue, general and administrative expense increased to 12.9%
for the three months ended March 31, 2002 from 10.7% for three months ended
March 31, 2001. The increase in general and administrative expense primarily
resulted from costs incurred to install DSL lines for our affiliated centers,
increase in office supplies expense and the impact of OrthAlliance affiliated
practices on our general and administrative expense. The DSL connection allows
for certain software applications to be provided through a World Wide Web
interface, which enables affiliated practices to access and update patient
records, accounting records and other data from
18
any location. The increase in office supplies expense was primarily attributable
to price increases by certain vendors beginning in the fourth quarter of 2001
and an increase in office supplies use due to an increased number of patients
and affiliated practices during the three months ended March 31, 2002.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense
increased $1.1 million, or 24.3%, to $5.5 million for the three months ended
March 31, 2002 from $4.4 million for the three months ended March 31, 2001. The
increase in this expense is a result of the fixed assets acquired and service
agreements entered into for centers developed, acquired or relocated after 2001.
As a percentage of fee revenue, depreciation and amortization expense decreased
to 4.9% for the three months ended March 31, 2002 from 5.7% for the three months
ended March 31, 2001, primarily due to an increase in fee revenue at the
comparable centers that did not require the Company to invest in fixed assets or
service agreements since the quarter ended March 31, 2001. There was no
amortization of the goodwill amount recorded as a result of the OrthAlliance
acquisition.
OPERATING PROFIT. Operating profit increased $7.8 million, or 33.8%, to
$31.0 million for the three months ended March 31, 2002 from $23.2 million for
the three months ended March 31, 2001. As a percentage of fee revenue, operating
profit was 27.9% and 29.9% for the three months ended March 31, 2002 and 2001,
respectively, as a result of the factors discussed above.
INTEREST. Net interest expense increased $200,000, or 22.7%, to $1.3
million for the three months ended March 31, 2002 from $1.1 million for the
three months ended March 31, 2001. As a percentage of fee revenue, net interest
expense decreased to 1.2% for the three months ended March 31, 2002 from 1.3%
for the three months ended March 31, 2001.
PROVISION FOR INCOME TAXES. Provision for income taxes increased $2.8
million, or 33.8%, to $11.2 million for the three months ended March 31, 2002
from $8.4 million for the three months ended March 31, 2001. Our effective
income tax rate was 37.8% for the three months ended March 31, 2002 and 2001.
NET INCOME. For the three months ended March 31, 2002, our net income
increased $4.7 million, or 34.1%, to $18.5 million, compared to net income of
$13.8 million for the three months ended March 31, 2001, primarily due to a
significant increase in fee revenue during the three months ended March 31,
2002, compared to the three months ended March 31, 2001, including increases
relating to our acquisition of OrthAlliance. As a percentage of fee revenue, net
income for the three months ended March 31, 2002 decreased to 16.6% as compared
to 17.8% for the three months ended March 31, 2001, as a result of the factors
discussed above.
LIQUIDITY AND CAPITAL RESOURCES
The following table summarizes cash flow information for the three months ended
March 31, 2002 and 2001:
Three Months Ended
March 31,
------------------------
2002 2001
-------- --------
(in thousands)
Net cash provided by operating activities ...... $ 20,764 $ 17,480
Net cash used in investing activities .......... (9,071) (9,699)
Net cash used in financing activities .......... (7,525) (216)
Net cash provided by operating activities was $20.8 million for the three months
ended March 31, 2002 compared to $17.5 million for the three months ended March
31, 2001. Net cash provided by operating
19
activities during the three months ended March 31, 2002 were positively impacted
by increases of $4.7 million in net income and $6.1 million in accounts payable
and other current liabilities. Offsetting these positive impacts were increases
of $9.1 million in service fees receivable and prepayments and $1.3 million in
amounts payable to affiliated practices. The increase in service fees receivable
and prepayments was primarily attributable to an increase in the number of
patients being treated by our affiliated practices. Our working capital at March
31, 2002 was $59.7 million, including cash and cash equivalents of $16.5
million, compared to working capital at December 31, 2001 of $51.9 million,
including cash and cash equivalents of $14.2 million. The increase in working
capital, excluding the impact of cash and cash equivalents was primarily due to
an increase of $8.4 million in service fees receivable partially offset by the
timing of the Company's estimated income tax payments.
Net cash used in investing activities was $9.1 million for the three months
ended March 31, 2002 compared to $9.7 million for the three months ended March
31, 2001. The Company used $3.2 million less cash to acquire service or
consulting agreements during the three months ended March 31, 2002, as compared
to the comparable period in 2001. This decrease was partially offset by an
increase of $2.5 million invested in property, equipment and improvements.
Financing activities for the three months ended March 31, 2002 had an increase
of cash use of $7.3 million, compared to the three months ended March 31, 2001.
The increase in net cash used was primarily due to the repayment of $5.0 million
of indebtedness outstanding under our bridge credit facility and $3.8 million of
notes payable to affiliated practices during the first quarter of 2002.
Our capital expenditures consist primarily of the costs associated with the
development of additional affiliated centers. The average cost of developing a
new orthodontic center in the United States is about $325,000, including the
cost of equipment, leasehold improvements, working capital and start-up losses
associated with the initial operations of the orthodontic center. These costs
are shared by us and the particular affiliated practice. We generally bear an
affiliated practice's share of these costs until we are reimbursed by the
practice. In some cases, we assist our practices in obtaining financing for
their share of these costs by providing a guaranty of loans from our primary
lender. At March 31, 2002 and December 31, 2001, the outstanding balance of
these amounts that we guaranteed was about $1.9 million. We also intend to
continue to make advances of about $40,000 to newly-affiliated practices during
the first year of an affiliated center's operations, which advances bear no
interest and typically are repaid during the second year of the affiliated
center's operations. We intend to fund these advances and any continued
financing through a combination of bank borrowings and cash from operations.
We maintain a $100.0 million revolving line of credit, of which $67.8 million
was outstanding at March 31, 2002, with a lending group that consists of
Wachovia Bank, N.A., Bank of America FSB, Bank One, N.A., and Hibernia National
Bank. The revolving line of credit, which expires in October 2003, provides
funding for our general working capital and expansion of the number of
affiliated centers, and bears interest at varying rates above the lender's prime
rate or LIBOR. Amounts borrowed under the line of credit are secured by a
security interest in our ownership interests in our operating subsidiaries.
In November 2001, we obtained a $50.0 million bridge credit facility from Bank
of America FSB of which $45.0 million was outstanding at March 31, 2002.
Borrowings under this bridge credit facility bear interest at varying rates
above the lender's prime rate or LIBOR. Under the bridge credit facility, we
have the right, upon written notice at least 30 days prior to November 9, 2002,
to extend the bridge credit facility to October 7, 2003. We anticipate that we
will further repay a portion of the bridge credit facility through cash flow
from operations, enter into a new long-term financing arrangement to replace the
bridge credit facility or extend the term of the bridge credit facility to
October 2003. We are currently reviewing our projections for cash needs and the
possibility of obtaining a new long-term financing arrangement providing more
favorable interest rates and terms.
20
Our revolving line of credit and our bridge credit facility require that we
maintain certain financial and nonfinancial covenants under the terms of the
credit agreements, including a maximum leverage ratio, minimum fixed charge
coverage ratio and minimum consolidated net worth ratio. These credit agreements
also impose restrictions on our acquisitions, investments, dividends and other
aspects of our business. If we do not comply with these covenants and
restrictions, the lenders could demand immediate payment of all amounts borrowed
under both the revolving line of credit and the bridge credit facility, and
terminate our ability to borrow funds under those credit facilities. At March
31, 2002 we were in compliance with these covenants and restrictions.
We believe that our cash needs will primarily relate to development of
additional centers and affiliation with additional practices in the United
States and other countries, capital expenditures for our affiliated centers and
computer systems, repayment of amounts owing under our bridge credit facility
and other indebtedness, payment of income taxes, potential acquisitions of other
companies or assets and general corporate purposes. Our cash needs could vary
significantly depending upon our growth, results of operations and ability to
affiliate with additional centers and practices, as well as the outcome of
pending litigation and other contingencies. We expect to fund these cash needs
through a combination of cash flow from our operations and funds available under
our revolving line of credit, as well as a replacement or extension of our
bridge credit facility. We currently believe that we will be able to meet our
anticipated funding requirements for at least the next 12 months; however, our
ability to meet these funding needs could be adversely affected if we were to
suffer adverse results from our operations or lose a material portion of our
affiliated practices, if our affiliated practices were to suffer adverse results
of operations or a material loss of patients, if we suffer adverse outcomes from
pending litigation and other contingencies, if we are unable to replace our
bridge credit facility on favorable terms or if we violate the covenants and
restrictions to which we are subject under our revolving line of credit and
bridge credit facility.
NEW ACCOUNTING PRONOUNCEMENTS
On January 1, 2002, the Company adopted Statement of Financial Accounting
Standards (SFAS) No. 141, "Business Combinations," SFAS No. 142, "Goodwill and
Other Intangible Assets," and SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets," except for provisions in SFAS No. 141 and SFAS
No. 142 related to the business combination with OrthAlliance which were adopted
on November 9, 2001, issued by the Financial Accounting Standards Board (FASB).
SFAS No. 141 and SFAS No. 142 is effective for fiscal years beginning after
December 31, 2001. SFAS No. 141 requires that the purchase method of accounting
be used for all business combinations initiated after June 30, 2001, and
prohibits the use of the pooling-of-interests method for such transactions. SFAS
No. 142 requires that goodwill and intangible assets with indefinite lives,
including such assets recorded in past business combinations, no longer be
amortized to earnings, but instead be tested for impairment by measuring the
reporting unit at fair value with the initial impairment test performed within
six months from the beginning of the year in which the standard is adopted. SFAS
No. 142 also requires that the impairment test be performed at least annually
thereafter, with interim testing required if circumstances warrant. Intangible
assets with finite lives will continue to be amortized over their useful lives
and reviewed for impairment. We applied provisions of SFAS No. 141 and SFAS No.
142 in accounting for the business combination with OrthAlliance on November 9,
2001, and did not amortize goodwill arising from the combination in accordance
with SFAS No. 142. On January 1, 2002, we adopted SFAS No. 141 and SFAS No. 142
which did not impact our financial position or results of operations. We have
not completed our initial evaluation of impairment of this goodwill required
under SFAS No. 142. Based on our preliminary evaluation, we do not believe that
our existing goodwill balance is currently impaired under the new standard;
however, no assurances can be given regarding future impairment. We anticipate
completing the initial evaluation by June 30, 2002, which is within the six
month transition period allowed under SFAS No. 142.
In August 2001, the FASB issued SFAS No. 144 which addresses the financial
accounting and reporting for the impairment or disposal of long-lived assets.
SFAS No. 144 is effective for fiscal years beginning
21
after December 15, 2001. SFAS No. 144 supersedes SFAS No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
Of," and provisions of APB Opinion No. 30, "Reporting the Results of Operations
- Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions," for
the disposal of a segment of a business. We adopted SFAS No. 144 on January 1,
2002, which did not impact our financial position or results of operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
During the three months ended March 31, 2002, there were no material changes
to the quantitative and qualitative disclosures about market risks presented in
the Company's Annual Report on Form 10-K for the year ended December 31, 2001.
22
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
As previously disclosed in our Annual Report on Form 10-K for the year ended
December 31, 2001, we filed an action against a former employee, Dr. Ronald M.
Roncone, in the U.S. District Court for the Southern District of California on
October 17, 2000. In our complaint, we alleged that Dr. Roncone breached the
terms of his employment agreement with us, and that he failed to satisfy a
condition to our performance under the employment agreement by failing and
refusing to affiliate his orthodontic practice with us. We sought a declaratory
judgment that we had no further obligations under the employment agreement due
to Dr. Roncone's failure to affiliate his practice with us, his failure to
recruit a minimum number of affiliated orthodontists and our termination of his
employment for cause, and that, if Dr. Roncone was found to be entitled to
additional compensation, it should take the form of stock options. We also
sought repayment of loans and other amounts that Dr. Roncone owed to us. Dr.
Roncone filed a counterclaim against us on November 1, 2000, in which he alleged
that we breached the terms of his employment agreement and an alleged oral
agreement or modification to the employment agreement to convert his loans to an
interest-free basis and, at his option, compensation, and to waive his
obligation to affiliate his practice with us. Dr. Roncone sought an unspecified
amount of money damages or shares of our common stock. We agreed to settle this
litigation on mutually acceptable terms and, on May 10, 2002, the litigation was
dismissed. Settlement of this action did not have a material adverse effect on
our financial condition or results of operations.
On April 22, 2002, the U.S. District Court for the Northern District of Indiana,
in ruling on motions for summary judgment, held that a service agreement between
OrthAlliance and Orthodontic Affiliates, P.C. (the "PC") was valid and
enforceable, in that the service agreement did not violate Indiana laws
prohibiting the unauthorized practice of dentistry. The PC filed an action
against OrthAlliance on August 21, 2001, alleging, among other things, that the
service agreement was illegal under Indiana law and therefore void and
unenforceable, and that OrthAlliance had breached the service agreement. In its
ruling, the court found that the service agreement did not call for OrthAlliance
to engage in the unauthorized practice of dentistry; rather, the court found
that OrthAlliance had a contractual obligation under the service agreement to
provide business services and business personnel to the practice, without
violating Indiana laws regulating the practice of dentistry. The court confirmed
that OrthAlliance does not control the PC's orthodontic practice, noting that
one of the orthodontist-owners of the PC had made statements that indicated his
understanding that he and the other orthodontist-owner retained control over
their practice. The court also held that OrthAlliance was a third party
beneficiary of portions of the employment agreements between the PC and its
orthodontist-owners, Dr. Thomas W. Surber and Dr. Randall A. Schmidt, including
the orthodontists' covenants not to compete, and that the PC and its
orthodontist-owners may not amend those provisions without OrthAlliance's
consent if OrthAlliance has approved, sued upon or justifiably relied on the
provisions. OrthAlliance has filed an amended counterclaim with the court, which
OrthAlliance believes further and clearly indicates that it has met these
requirements. A trial date for the remaining issues in this case has not been
set.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Exhibit number Description
3.1 Bylaws of the Registrant (incorporated by reference
to exhibits filed with the Registrant's Registration
Statement on Form S-1, Registration Statement No.
33-85326)
23
3.2 Restated Certificate of Incorporation of the
Registrant (incorporated by reference to exhibits
filed with the Registrant's Registration Statement
on Form S-1, Registration Statement No. 33-85326)
4 Specimen Stock Certificate (incorporated by
reference to exhibits filed with the Registrant's
Registration Statement on Form S-1, Registration
Statement No. 33-85326)
(b) REPORTS ON FORM 8-K
During the three months ended March 31, 2002, the Company filed the
following current report on Form 8-K:
(i) On January 25, 2002, the Company filed an amended report on Form
8-K reporting information under "Item 2. Acquisition or
Disposition of Assets" and certain financial information required
in "Item 7. Financial Statements and Exhibits" which it did not
include in its filing on Form 8-K on November 26, 2001.
24
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Orthodontic Centers of America, Inc.
------------------------------------
(Registrant)
Date: May 15, 2002 /s/ Bartholomew F. Palmisano, Sr.
------------------------------------
Bartholomew F. Palmisano, Sr.
Chairman of the Board, President
and Chief Executive Officer
/s/ John C. Glover
------------------------------------
John C. Glover
Chief Financial Officer
25
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
------- -----------
3.1 Bylaws of the Registrant (incorporated by reference to exhibits
filed with the Registrant's Registration Statement on Form S-1,
Registration Statement No. 33-85326)
3.2 Restated Certificate of Incorporation of the Registrant
(incorporated by reference to exhibits filed with the
Registrant's Registration Statement on Form S-1, Registration
Statement No. 33-85326)
4 Specimen Stock Certificate (incorporated by reference to
exhibits filed with the Registrant's Registration Statement on
Form S-1, Registration Statement No. 33-85326)