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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, 2001
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: 1-13263
CASTLE DENTAL CENTERS, INC.
Delaware
(State or other jurisdiction of incorporation or organization)
76-0486898
(I.R.S. Employer Identification No.)
3701 Kirby Drive, Suite 550
Houston, Texas
(Address of principal executive offices)
77098
(Zip Code)
(713) 490-8400
(Registrant's telephone number, including area code)
Securities Registered Pursuant to Section 12(b) of the Act: None
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $.001 Par Value
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes. [X] No. [_]
Indicate by check mark if the disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
As of March 31, 2002, there were 6,417,206 shares of Castle Dental Centers,
Inc. Common Stock, $.001 par value, issued and outstanding, of which 3,293,363,
having an aggregate market value of approximately $0.3 million, were held by
non-affiliates of the registrant.
Documents Incorporated by Reference: None
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TABLE OF CONTENTS
Page
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Item 1. Business............................................................... 1
The Company............................................................ 1
Recent Developments.................................................... 1
The Dental Industry.................................................... 3
Business Strategy...................................................... 3
Dental Network Development............................................. 4
Management Services Agreement.......................................... 5
Dentist Employment Agreements.......................................... 5
Services............................................................... 6
Operations............................................................. 6
Sales and Marketing.................................................... 7
Managed Care Contracts................................................. 7
Competition............................................................ 8
Management Information Systems......................................... 8
Regulation............................................................. 9
Employees.............................................................. 10
Corporate Liability and Insurance...................................... 11
Item 2. Properties............................................................. 11
Item 3. Legal Proceedings...................................................... 11
Item 4. Submission of Matters to a Vote of Security Holders.................... 12
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.. 13
Item 6 Selected Financial Data................................................ 14
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.......................................................... 15
Introduction........................................................... 15
Components of Revenues and Expenses.................................... 15
Results of Operations.................................................. 16
Liquidity and Capital Resources........................................ 20
Critical Accounting Issues............................................. 22
Inflation.............................................................. 24
Recent Accounting Pronouncements....................................... 24
Item 7A. Quantitative And Qualitative Disclosures About Market Risk............. 24
Item 8. Financial Statements and Supplementary Data............................ 24
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure................................................... 24
Item 10. Directors and Executive Officers of the Registrant..................... 25
Item 11. Executive Compensation................................................. 27
Item 12. Security Ownership of Certain Beneficial Owners and Management......... 29
Item 13. Certain Relationships and Related Transactions......................... 30
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K........ 32
i
NOTE ON FORWARD-LOOKING STATEMENTS
This Form 10-K contains "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. All statements other than
statements of historical facts included in this Form 10-K are forward-looking
statements. When used in this document, the words, "anticipate," "believe,"
"estimate" and "expect" and similar expressions are intended to identify such
forward-looking statements. Such statements reflect the Company's current views
with respect to future events and are subject to certain uncertainties and
assumptions. Important factors that could cause actual results to differ
materially from expectations ("Cautionary Statements") are disclosed in this
Form 10-K, including without limitation in conjunction with the forward-looking
statements included in this Form 10-K. Should one or more of these uncertainties
materialize, or should underlying assumptions prove incorrect, actual results
may vary materially from expectations. All subsequent written and oral forward-
looking statements attributable to the Company or persons acting on its behalf
are expressly qualified in their entirety by the Cautionary Statements.
ii
Item 1. Business
The Company
The Company manages and operates integrated dental networks through
contractual affiliations with general, orthodontic and multi-specialty dental
practices in the United States. The Company currently conducts operations in the
states of Texas, Florida, Tennessee and California. The Company does not engage
in the practice of dentistry but rather establishes integrated dental networks
by entering into management services agreements with affiliated dental practices
to provide, on an exclusive basis, management and administrative services to
affiliated dental practices. The Company seeks to achieve operating efficiencies
by consolidating and integrating affiliated practices into regional networks,
realizing economies of scale in such areas as marketing, administration and
purchasing and enhancing the revenues of its affiliated dental practices by
increasing both patient visits and the range of specialty services offered. As
of December 31, 2001, the Company provided management services to 88 dental
centers with approximately 190 affiliated dentists, orthodontists and other
dental specialists.
The Company's objective is to make each of its dental networks the leading
group dental care provider in each market it serves. Since its formation, the
Company has applied traditional retail principles of business and marketing
techniques to the practice of dentistry, including locating practices in high-
profile locations, offering more affordable fees and payment plans, expanding
the range of services offered, increasing market share through targeted
advertising and offering extended office hours. By using the Castle Dental
Centers' approach to managing affiliated dental practices, the Company believes
it enables affiliated dentists, orthodontists and other dental specialists to
focus on delivering quality patient care and realize significantly greater
productivity than traditional individual and small-group dental practices.
The Company believes that the provision of a full range of dental services
through an integrated network is attractive to managed care payers and intends
to continue to pursue managed care contracts. The Company negotiates capitated
managed care contracts on behalf of its affiliated dental practices, which
maintained an aggregate of 41 capitated managed care contracts covering
approximately 172,000 members at December 31, 2001. The Company believes that
the continued development of its networks will assist it in negotiating national
and regional capitated arrangements with managed care payors on behalf of the
affiliated practices.
The Company intends to establish a consistent national identity for its
business by implementing common practice management policies and procedures in
all of its dental centers and affiliated dental practices nationwide. Moreover,
the Company believes that its experience and expertise in managing multi-
specialty dental group practices, as well as the development of name recognition
associated with the name "Castle Dental Centers" will provide its affiliated
dental practices with a competitive advantage in attracting and retaining
patients and realizing practice efficiencies.
The Company was formed in 1981 as a single location, multi-specialty dental
practice in Houston, Texas. From 1982 through 1996, the Company expanded to a
total of 10 locations with 39 dentists in the Houston metropolitan area. During
this period the Company developed, implemented and refined the integrated dental
network approach that it utilized as a basis for its expansion. In the period
from 1996 through the first half of 2000, the Company expanded through the
acquisition of dental practices and the development of new ("de novo") dental
centers in its markets. Practices were acquired in Tennessee, Florida, Austin,
Fort Worth and San Antonio in Texas, and in Los Angeles, California. A total of
33 de novo dental centers were opened during this period while 8 dental centers
were closed or consolidated in 1999 and 2000. In 2001, as part of its
restructuring and cost reduction program, the Company closed or consolidated an
additional 10 dental centers, 6 of which were de novo centers that had been
built in 1998 and 1999. At December 31, 2001, the Company operated 58, 10, 15
and 5 dental centers in Texas, Tennessee, Florida and California, respectively.
Recent Developments
The Company has been in default of its senior bank credit agreement (the
"Credit Agreement"), its senior subordinated note agreement ("Subordinated Note
Agreement") and a subordinated convertible note agreement ("Convertible Note
Agreement" and, together with the Credit Agreement and Subordinated Note
1
Agreement, the "Debt Agreements") since June 2000.
On February 15, 2001, the Company retained Getzler and Co., a New York
based turnaround specialist, to assist the Company in addressing its operational
issues and restructuring of the Company's debt. The Company's board of directors
appointed Getzler's designee, Ira Glazer, to serve as the Company's interim
Chief Executive Officer and initiated an executive search for a permanent Chief
Executive Officer. The Company's President and Chief Operating Officer resigned
to pursue other opportunities. Jack Castle, Jr., the Company's former Chief
Executive Officer, continued to serve as the Chairman of the Board until July 1,
2001. On July 1, 2001, the Company hired James M. Usdan as its President and
Chief Executive Officer to replace Mr. Glazer. Mr. Usdan was also appointed to
Castle Dental's board of directors. On January 15, 2002, the Company hired
Joseph P. Keane as its Chief Financial Officer. John M. Slack, the former Chief
Financial Officer remains as Vice President - Chief Administrative Officer.
Elizabeth A. Tilney, Jack H. Castle, D.D.S. and Jack H. Castle, Jr. resigned
from the Board of Directors of the Company on February 1, 2001, July 1, 2001 and
April 8, 2002, respectively.
The Company has continued to pay interest (other than default interest) on
the amounts outstanding under the Credit Agreement, but has not made scheduled
principal payments of $11.3 under the Credit Agreement, nor made interest or
principal payments of $5.8 million owed to subordinated creditors since July
2000. During the last half of 2001, the Company negotiated with its creditors
and an unrelated third party concerning a potential equity investment and the
restructuring of the bank credit facility, the subordinated notes and other
Company debt. However, due to the deterioration in operating results in the
fourth quarter 2001, the discussions concerning the potential equity investment
were terminated in January 2002 and the Company has continued negotiations with
the senior and subordinated lenders concerning a forbearance agreement or a
restructuring of the Company's debt. However, these negotiations have not
resulted in a forbearance agreement or restructuring of the debt as of April 15,
2002. There can be no assurance that the Company's lenders will consent to the
restructuring necessary to allow the Company to continue to operate. If the
Company and its lenders cannot reach an agreement, it may be necessary for the
Company to seek protection under Chapter 11 of the Bankruptcy Code. These
factors, among others, may indicate that the Company will be unable to continue
as a going concern for a reasonable period of time.
During 2001, the Company implemented a plan to allow it to continue to
operate without the need for additional borrowings. Components of this plan
included: (i) reorganization of field management to improve efficiency and
reduce regional overhead costs; (ii) reduction in corporate general and
administrative costs through job eliminations and reduction in other overhead
expenses; (iii) closing of unprofitable and under-performing dental centers;
(iv) realignment of accounts receivable management to focus on improved
collection of insurance and patient receivables; (v) restructuring of
compensation for management to emphasize performance-based incentives; and, (vi)
cancellation of further de novo development and reducing capital expenditures to
maintenance levels. While the plan resulted in lower operating costs during the
last half of the year, patient revenues were adversely affected by slower
general economic activity in the second half of 2001, the negative impact on
retail sales caused by the tragic events of September 11, and higher than
anticipated attrition of dentists during the year. This resulted in lower than
anticipated patient revenues, particularly in the fourth quarter 2001, that
resulted in operating losses and severely reduced cash flows.
For 2002, the Company plans to focus on: (i) increased hiring of new
dentists and improving dentist retention; (ii) continuing to monitor and close
unprofitable and under performing dental centers; (iii) refurbishing and
modernizing existing dental centers within capital expenditure constraints of
$1.5 million; (iv) upgrading dental office management personnel; and (v)
improving patient services in order to increase patient retention rates.
However, there can be no assurance that these efforts will improve
operating results or that cash flows will be sufficient to allow the Company to
meet its obligations in a timely manner. Therefore, there is substantial doubt
about the Company's ability to continue in existence.
2
The Dental Industry
Dental care services in the United States are generally delivered through a
fragmented system of local providers, primarily sole practitioners, or small
groups of dentists, orthodontists or other dental specialists, practicing at a
single location with a limited number of professional assistants and business
office personnel. According to the American Dental Association 1999 Survey of
Dental Practice ("ADA Survey"), there were approximately 152,000 actively
practicing dental professionals in the U.S., of which approximately 8,900 were
practicing orthodontists. Nearly 85% of the nation's private practitioners work
either as sole practitioners or in a practice with one other dentist. The
balance of these dentists practice in about 5,000 groups of three or more
dentists. However, dental, orthodontic and other specialty practices have
followed the trend of the health care industry generally and are increasingly
forming larger group practices.
The annual aggregate domestic market for dental services was estimated by
the Health Care Financing Administration, Health Care Financing Review (1999) to
be approximately $65.4 billion for 2001, and is projected to reach $109 billion
by 2010. Within the total market for dental services in the United States, there
are, in addition to general dentistry, a number of specialties, including
orthodontics (the straightening of teeth and remedy of occlusion), periodontics
(gum care), endodontics (root canal therapy), oral surgery (tooth extraction)
and pedodontics (care of children's teeth). The dental services market has grown
at a compound annual growth rate of approximately 8% from 1980 to 2000, and is
projected to grow at a compound annual growth rate of approximately 6% through
the year 2010. In contrast to other health care expenditures, dental services
are primarily paid for by the patient. According to the U.S. Department of
Health and Human Services, in 1998, consumer out-of-pocket expenditures
accounted for 48% of the payment for dental services, compared to 16% for other
medical services.
Management believes that the growth in the dental industry has largely been
driven by four factors: (i) an increase in the availability and types of dental
insurance; (ii) an increasing demand for dental services from an aging
population; (iii) the evolution of technology which makes dental care less
traumatic; and (iv) an increased focus on preventive and cosmetic dentistry.
Concerns over the accelerating cost of health care have resulted in the
increasing importance of various forms of insurance coverage in the dental
industry. The National Association of Dental Plans ("NADP") estimates that 153
million people, or 56% of the U.S. population was covered by some form of dental
care plan in 1999, compared to 47% of the population that had dental insurance
in 1995. These insurance plans include indemnity insurance, preferred provider
("PPO") plans and capitated managed care plans. Patients covered by indemnity
insurance plans typically are charged the same fees for dental services that are
charged to uninsured patients. Under a PPO plan, the dentist charges a
discounted fee for each service based on a fee schedule negotiated with the
insurance provider. Capitated managed care plans provide a fixed monthly fee
for each enrolled member that selects the dentist as his or her dental care
provider, plus supplemental or patient co-payments based on the type of service
provided. According to the NADP, of the estimated 153 million people covered by
dental benefits in 1999, approximately 43% were covered by indemnity plans, 39%
were covered by PPO plans and 18% were enrolled in capitated managed care
programs.
Business Strategy
The Company's strategy is to develop integrated networks for the provision
of a broad range of dental services that provide high-quality, cost-effective
dental care in target markets. Key elements of this strategy are to:
Provide High-Quality, Comprehensive, One-Stop Family Dental Health
Care. The prototypical Castle Dental Center provides general dentistry as
well as a full range of dental specialties (including orthodontics,
pedodontics, periodontics, endodontics, oral surgery and implantology),
thereby allowing the majority of specialty referrals to remain in-house
within the Company's network of facilities. By bringing together multi-
specialty dental services within a single practice, the Company is able to
realize operating efficiencies and economies of scale and to promote
increased productivity, higher utilization of professionals and facilities,
and the sharing of dental specialists among multiple locations. The
Company's practice model also incorporates quality assurance and quality
control programs, including peer review and continuing education and
technique enhancement. The Company believes that its multi-
3
specialty strategy differentiates it from both individual and multi-center
practices that typically offer only general dentistry, orthodontics or
other single specialty dental services.
Develop Comprehensive Dental Networks in Target Markets. The Company
seeks to consolidate and integrate its affiliated practices to establish
regional dental care networks. The Company believes this network system
will enable it to reduce the operating costs of its affiliated practices by
centralizing certain functions such as telemarketing and advertising,
billing and collections, payroll and accounting and by negotiating regional
and national contracts for supplies, equipment, services and insurance.
Once practice affiliations are established in a market, the Company seeks
to assist the affiliated practices in expanding their range of services to
make available specialty dental services not previously offered.
Apply Traditional Retail Principles of Business to Dental Care. The
Company believes it can enhance revenues and profitability by applying
traditional retail principles of business to the provision of dental
services in its target markets. These principles include professionally
produced broadcast and print advertisements targeting specific audiences,
and extended hours of operation which are convenient for patients,
including weekend and evening hours. As part of its retail-oriented
strategy, the Company seeks to establish or, where appropriate, relocate
each Castle Dental Center in a convenient location in or near a high-
profile neighborhood retail area and utilizes innovative sales and
marketing programs designed to create strong name recognition and increase
patient visits. In addition, the Company stresses the breadth and
affordability of its services and works closely with patients to establish
treatment schedules and affordable payment plans tailored to the patients'
needs.
Dental Network Development
Prior to 1999, the Company expanded into new markets through the
acquisition of multi-location group dental practices. Once the market entry
acquisition was made, the Company expanded within its target markets primarily
through the de novo development of new dental centers. During 1999 and 2000, the
Company expanded solely through the development of de novo centers and did not
complete any acquisitions of dental practices. In 2000, four de novo dental
centers were opened, four dental centers were closed and two dental centers in
Houston were consolidated into a new dental center. The Company developed no new
dental centers in 2001 and has no plans to develop any de novo dental centers in
2002. In 2001, as part of its restructuring and cost reduction program, the
Company closed or consolidated 10 unprofitable or under performing dental
centers, 6 of which were de novo centers that had been built in 1998 and 1999.
De novo Development
The Company has opened 33 newly developed dental centers since 1997; seven
in Houston, four in Austin, five in Dallas/Fort Worth, five in San Antonio, two
in Corpus Christi, Texas, seven in Nashville, Tennessee and three in the
Tampa/Clearwater area in Florida. All of the new centers were located in leased
facilities in neighborhood retail shopping centers areas. Development of each de
novo dental center cost approximately $315,000 in leasehold improvements,
signage, and dental and office equipment, depending primarily on the size of the
dental facility. All new dental centers in the Company's existing markets
utilize the Castle Dental Centers name and logo. Six of the de novo dental
centers were closed in 2001 as part of the restructuring and cost reduction
program that was implemented in the first quarter of that year. The Company is
continually monitoring the performance of all its dental centers to determine if
additional closings will be necessary.
The Company expanded through development of de novo dental centers in
existing markets because management believes that opening new dental centers
that conform to the Company's operating model is more effective in creating
brand awareness and increasing market share in existing markets than acquiring
dental practices that have different operating characteristics. In addition, the
cost of building and equipping a new dental center has generally been less than
the cost of acquiring dental centers. Due to the lack of capital necessary for
continued expansion, the Company ceased development of new dental centers in
early 2000, and did not have any centers under construction at December 31,
2001. Until the Company's liquidity improves, the Company anticipates that it
will not open or acquire any additional dental centers, although the Company may
refurbish or relocate existing dental centers based on the availability of
capital to do so.
4
Management Services Agreement
The Company has entered into a management services agreement with each of
its affiliated dental practices pursuant to which the Company becomes the
exclusive manager and administrator of all non-dental services relating to the
operation of the practice. The amount of the management fee charged by the
Company to an affiliated dental practice is intended to reflect and is based on
the fair value of the management services rendered by the Company to the
affiliated dental practice. Subject to applicable law, the Company is paid a
monthly management fee comprised of three components: (i) the costs incurred by
it on behalf of the affiliated practice; (ii) a base management fee in an amount
ranging from 12.5% to 20.0% of adjusted gross revenues; and (iii) a performance
fee equal to the patient revenues of the affiliated dental practice less (a) the
expenses of the affiliated dental practice and (b) the sum of (i) and (ii), as
described in each agreement. In California, the Company is paid a monthly
management fee comprised of two components: (i) the costs incurred by it on
behalf of the affiliated practice and (ii) a management fee in an amount ranging
from 15.0% to 30.0% of net patient revenues. With respect to three of the
California professional corporations, the Company is paid a bonus equal to 30%
of patient revenues in excess of average monthly patient revenues over the prior
two-year period. The amount of the management fee is reviewed by the Company and
the affiliated dental practice not less frequently than annually in order to
determine whether such fee should be adjusted, up or down, to continue to
reflect the fair value of the management services rendered by the Company.
The obligations of the Company under its management services agreements
include assuming financial and other responsibility, for the following (subject
to limitations imposed by applicable state law): facilities, equipment and
supplies; advertising, marketing and sales; training and development; operations
management; provision of support services; risk management and utilization
review; application and maintenance of applicable local licenses and permits;
negotiation of contracts between the affiliated dental practice and third
parties, including third-party payors, alternative delivery systems and
purchasers of group health care services; establishing and maintaining billing
and collection policies and procedures; fiscal matters, such as annual
budgeting, maintaining financial and accounting records, and arranging for the
preparation of tax returns; and maintaining insurance. The Company does not
assume any authority, responsibility, supervision or control over the provision
of dental services to patients or for diagnosis, treatment, procedure or other
health care services, or the administration of any drugs used in connection with
any dental practice.
The typical management services agreement is for an initial term of 25 to
40 years, and is automatically renewed for successive five-year terms unless
terminated at least 90 days before the end of the initial term or any renewal
term. As part of the management services agreement, the Company requires that
the majority shareholder of the affiliated dental practice execute an option
agreement that grants the Company's designee the right to acquire all the
shareholder's interest in the practice at a nominal cost. Upon the occurrence of
certain events, the Company can exercise the option at any time with 10 days
written notice. The Company may nominate without restriction any licensed
dentist as its designee and may transfer the option at any time to any qualified
person, subject to applicable state regulations governing the practice of
dentistry. The management services agreement does not limit the number of times
that the option may be exercised. At December 31, 2001, each of the Company's
affiliated dental practices was wholly owned by an individual dentist.
Additionally, the management services agreement may be terminated by the Company
or the affiliated dental practice only in the event of default in the
performance of the material duties of the non-terminating party.
Dentist Employment Agreements
Each affiliated dental practice has entered into employment agreements with
substantially all of its full-time dentists, orthodontists and other dental
specialists. Although the form of contract varies somewhat among practices and
among dentists with different specialties, the typical contract for a full-time
dentist provides for a defined compensation arrangement, including performance-
based compensation and, where market conditions permit and to the extent deemed
enforceable under applicable law, a covenant not to compete. Each full-time
dentist, whether or not a party to a dentist employment agreement, is required
to maintain professional liability insurance, and mandated coverage limits are
generally at least $1.0 million per claim and $3.0 million in the aggregate. In
addition, many affiliated dental practices employ part-time dentists. Not all
part-time dentists have employment agreements, but all part-time dentists are
required to carry professional liability
5
insurance in specified amounts. Certain part-time dentists retained by some of
the affiliated dental practices are independent contractors and have entered
into independent contractor agreements.
Services
The Company provides management expertise, marketing, information systems,
capital resources and acquisition services to its affiliated dental practices.
As a result, the Company is involved in the financial and administrative
management of the affiliated dental practices, including legal, financial
reporting, cash management, human resources and insurance assistance. The
Company's goals in providing such services are (i) to allow the dentists
associated with affiliated dental practices to dedicate their time and efforts
more fully to patient care and professional practice activities; (ii) to improve
the performance of affiliated dental practices in these administrative and sales
activities; and (iii) to enhance the financial return to the Company.
Aside from the centralization of functions mentioned above, the affiliated
dental practices are encouraged to administer their practices in accordance with
the needs of their specific patient populations. The practice of dentistry at
each affiliated dental practice is under the exclusive control of the dentists
who practice at those locations.
The majority of services provided by the Company's affiliated dental
centers are classified as general dentistry. General dentistry includes
diagnostics, treatment planning, preventive care, removal of infection,
fillings, crowns, bridges, partials, dentures, and extractions, all of which are
currently being provided by the affiliated dental practices. Within its
networks, the Company provides a wide range of specialty dental services. The
Company seeks to expand the services offered by affiliated practices beyond
general dentistry to include other dental specialty services and to improve
efficiency by improving appointment availability, increasing practice visibility
and assisting the practices in adding complementary services. These
complementary services include orthodontics, periodontics (the diagnosis,
treatment and prevention of infection of the gums and supporting bone around the
teeth), endodontics (the diagnosis, treatment and prevention of infection of the
oral tissues), oral surgery and implantology (the placement of abutments
(implants) in the jaw bones to support tooth replacement). By adding these
complementary services to the practice, the affiliated dental practices will
retain the majority of specialty service referrals in-house, thereby increasing
patient revenues.
Operations
Center Design and Location
The Company's dental centers are generally located in retail environments.
Many of the dental centers include semi-private general dentistry treatment
rooms, private treatment rooms and orthodontic bays. Currently, the Company's
dental centers include from four to 22 treatment rooms and range in size from
approximately 1,000 square feet to approximately 6,000 square feet. New dental
centers, developed by the Company, range in size from 1,600 square feet to 4,000
square feet, and have from five to fourteen operatories.
Since its formation, the Company has adapted its locations to accommodate
the full range of dental specialties, where feasible. The Company believes the
application of its method of designing and locating dental centers will
facilitate the expansion of services offered by the acquired practices. Where a
dental center is not able, due to limitations of floor space, zoning or other
reasons, to accommodate new services or specialists, the Company may seek to
relocate such dental center to a more desirable retail location as soon as
practicable.
Staffing and Scheduling
The Company believes that making its facilities available at times which
are convenient to its patients is an important element of its strategy. As a
result, the affiliated dental practices maintain extended hours of operation,
with many dental centers opening as early as 7:00 a.m. and closing as late as
9:00 p.m. on weekdays and 5:00 p.m. on Saturdays. The dental centers are staffed
with dentists and dental assistants every day they are open, with orthodontists
and other specialists rotating among several centers in order to utilize their
time optimally. Each patient typically is assigned to and sees the same dentist
or specialist on all visits to the center. Each dental center is also regularly
staffed with an office manager, front office staff and other support staff.
6
Fees and Payment Plans
The Company believes that fees charged by its affiliated practices are
typically lower than usual and customary fees within their respective markets.
The affiliated practices generally provide a wide range of payment options,
including cash, checks, credit cards, third party insurance and various forms of
credit. In general, most general dentistry and specialty services, other than
orthodontics, are paid for by the patient, or billed to the patient's insurance
carrier, on the date the service is rendered. In some instances, the Company
will extend credit in accordance with its established credit policies. The
Company believes that its lower fees and ability to assist patients in obtaining
financing provides it with a competitive advantage compared to sole
practitioners and small group practices.
The Company's typical orthodontic payment plan consists of no initial down
payment and equal monthly payments during the term of treatment of $98 per
month, with an average contract period of approximately 26 months. After
consultation with the orthodontic staff at the initial visit, the patient signs
a contract outlining the terms of the treatment, including the anticipated
length of treatment and the total fees. The number of required monthly payments
is fixed at the beginning of the case and corresponds to the anticipated number
of monthly treatments. In 1999, the Company adopted a payment policy requiring
that new orthodontic patients arrange for an automatic monthly bank draft.
Quality Assurance
Affiliated dental practices are solely responsible for all aspects of the
practice of dentistry. The Company has responsibility for the business and
administrative aspects of the practices and exercises no control over the
provision of dental services. The Company's management structure is designed to
assist its affiliated dental practices in their recruiting and professional
training. The Company expects that the increased visibility of the Company, the
ability to offer career paths previously unavailable to dentists and the ability
to recruit for multiple markets will give it an advantage in recruiting and
retaining dentists. In addition, the Company believes that the ability to offer
dentists in private practice the chance to practice in an environment where they
do not assume capital risks and administrative burdens normally associated with
private practice will make joining the Company an attractive choice for private
practitioners.
Sales and Marketing
The Company has established a consistent national identity for its business
and utilizes the "Castle Dental Centers" name and logo at all its dental
centers. As of December 31, 2001, the Castle Dental Centers name had been
implemented at all affiliated locations except for two dental centers in
California. The Company applies traditional retail principles of business to
the provision of dental care. These principles include network development,
extended hours of operation, location optimization, signage, customized
treatment schedules, affordable fees and payment plans. The Company uses both
print advertising and professionally produced broadcast advertising to market
its dental services to potential patients.
The Company has also established a national telemarketing system in
Houston, Texas to field calls generated by advertising, to confirm upcoming
scheduled patient visits and to encourage patients to return for follow-up
visits. The national telemarketing system is based on a national 800 number (1-
800-TO SMILE) and utilizes state-of-the-art software to identify patients and
direct them to the nearest Company operated dental center. The telemarketers can
enter all relevant information into the practice management information system
for patients making appointments for an initial visit, including pre-screening
patients for insurance and other credit information.
Managed Care Contracts
The Company negotiates, on behalf of its affiliated dental practices,
contracts with dental healthcare maintenance organizations, insurance companies,
self insurance plans and other third-party payers pursuant to which services are
provided on some type of discounted fee-for-service or capitated basis. Under
capitated contracts the affiliated dental practice receives a predetermined
amount per patient per month in exchange for providing certain necessary covered
services to members of the plan. Usually, the capitated plans also provide for
supplemental payments and/or co-payments by members for certain higher cost
procedures such as crowns, root canal therapy and dentures. These contracts
typically result in lower average fees for services than the
7
usual and customary fees charges by the Company's affiliated dental practices
and may, in certain instances, expose the Company to losses on contracts where
the total revenues received are less than the costs of providing such dental
care. The Company generally bears the risk of such loss because it consolidates
the financial results of its affiliated dental practices. However, most of these
contracts are cancelable by either party on 60 to 90 days written notice thereby
reducing the risk of long-term adverse impact on the Company.
At December 31, 2001, the Company and its affiliated dental practices
maintained an aggregate of 41 capitated managed care contracts covering
approximately 172,000 members. Capitation fees, including supplemental fees and
excluding co-payments by members, totaled $9.6 million, or approximately 9.8%
of net patient revenues in 2001. One managed care contract with a national
insurance company accounted for $7.2 million in revenues ($3.6 million in
capitation payments and $3.6 million in patient co-payments) in 2001, equal to
7.4% of total net patient revenues. The Company periodically evaluates its
capitated managed care contracts by comparing the average reimbursement per
procedure plus the total capitation fees per contract to the usual and customary
fees charged by the affiliated dental practice. If the aggregate reimbursement
percentage for the capitated contract exceeds 55% of the usual and customary
fees, the Company believes that the incremental costs of providing covered
services are being recovered. Management believes that capitated managed care
contracts, in the aggregate, are profitable, however, the Company plans to
selectively review its contracts with managed care companies in order to improve
the financial performance of these plans and to limit the growth of enrolled
members in such plans to levels no higher than at year-end 2001.
Competition
The dental care industry is highly fragmented, comprised principally of
sole practitioners and group practices of dental and orthodontic services. The
dental practice management industry is subject to continuing changes in the
provision of services and the selection and compensation of providers. The
Company is aware of several dental practice management companies, both publicly-
traded and privately owned, that it competes with in its markets. Publicly
traded dental practice management companies that compete with the Company
include Monarch Dental Corporation, American Dental Partners, Inc., Interdent,
Inc., and Coast Dental Services, Inc., as well as others. Certain of these
competitors are larger and better capitalized, may provide a wider variety of
services, may have greater experience in providing dental care management
services and may have longer established relationships with buyers of such
services.
In certain markets, the demand for dental care professional personnel
presently exceeds the supply of qualified personnel. As a result, the Company
experiences competitive pressures for the recruitment and retention of qualified
dentists to deliver their services. The Company's future success depends in part
on its ability to continue to recruit and retain qualified dentists to serve as
employees or independent contractors of the affiliated dental practices. There
can be no assurance that the Company will be able to recruit or retain a
sufficient number of competent dentists to continue to expand its operations.
Management Information Systems
During 1999, the Company completed the integration of the dental practice
management systems in all its dental centers into a single practice management
system, provided by a third party, that is centralized in Houston. This system
monitors and controls patient treatment, scheduling, invoicing of patients and
insurance companies, productivity of clinical staffs and other practice related
activities. During the third quarter of 1999 the Company implemented a web-based
purchase order system to enable management to monitor and control dental and
office supplies purchasing.
The Company also utilizes centralized financial information and accounting
systems. These systems are linked to the practice management systems allowing
for automatic transfer of data between the practice management and financial
information systems.
8
Regulation
General
The practice of dentistry is highly regulated, and there can be no
assurance that the regulatory environment in which the affiliated dental
practices and the Company operate will not change significantly in the future.
In general, regulation of health care related companies also is increasing.
Every state imposes licensing and other requirements on individual dentists
and dental facilities and services. In addition, federal and state laws regulate
health maintenance organizations and other managed care organizations for which
dentists may be providers. Consequently the Company may become subject to
compliance with additional laws, regulations and interpretations or enforcement
thereof. The ability of the Company to operate profitably will depend in part
upon the Company and its affiliated dental practices obtaining and maintaining
all necessary licenses, certifications and other approvals and operating in
compliance with applicable health care regulations.
Dental practices must meet federal, state and local regulatory standards in
the areas of safety and health. Historically, those standards have not had any
material adverse effect on the operations of the dental practices managed by the
Company. Based on its familiarity with the operations of the dental practices
managed by the Company, management believes that it, and the practices it
manages, are in compliance in all material respects with all applicable federal,
state and local laws and regulations relating to safety and health.
Medicare and Medicaid Fraud and Abuse
Federal law prohibits the offer, payment, solicitation or receipt of any
form of remuneration in return for, or in order to induce, (i) the referral of a
person for services, (ii) the furnishing or arranging for the furnishing of
items or services or (iii) the purchase, lease or order or arranging or
recommending purchasing, leasing or ordering of any item or service, in each
case, reimbursable under Medicare or Medicaid. Because dental services are
covered under various government programs, including Medicare, Medicaid or other
federal and state programs, the law applies to dentists and the provision of
dental services. Pursuant to this anti-kickback law, the federal government
announced a policy of increased scrutiny of joint ventures and other
transactions among health care providers in an effort to reduce potential fraud
and abuse related to Medicare and Medicaid costs. Many states have similar anti-
kickback laws, and in many cases these laws apply to all types of patients, not
just Medicare and Medicaid beneficiaries. The applicability of these federal and
state laws to many business transactions in the health care industry, including
the Company's operations, has not yet been subject to judicial interpretation.
Significant prohibitions against physician self-referrals, including those
by dentists, for services covered by Medicare and Medicaid programs were
enacted, subject to certain exceptions, by Congress in the Omnibus Budget
Reconciliation Act of 1993. These prohibitions, commonly known as "Stark II"
amended prior physician and dentist self-referral legislation known as "Stark I"
(which applied only to clinical laboratory referrals) by dramatically enlarging
the list of services and investment interests to which the referral prohibitions
apply. Effective January 1, 1995 and subject to certain exceptions, Stark II
prohibits a physician or dentist or a member of his immediate family from
referring Medicare or Medicaid patients to any entity providing "health
services" in which the physician or dentist has an ownership or investment
interest, or with which the physician or dentist has entered into a compensation
arrangement, including the "physician's or dentist's" own group practice unless
such practice satisfies the group practice exception. The designated health
services include the provision of clinical laboratory services, radiology and
other diagnostic services (including ultrasound services), radiation therapy
services, physical and occupational therapy services, durable medical equipment,
parenteral and enteral nutrients, certain equipment and supplies, prosthetics,
orthotics, outpatient prescription drugs, home health services and inpatient and
outpatient hospital services. A number of states also have laws that prohibit
referrals for certain services such as x-rays by dentists if the dentist has
certain enumerated financial relationships with the entity receiving the
referral, unless an exception applies.
Noncompliance with, or violation of, the federal anti-kickback legislation
or Stark II can result in exclusion from Medicare and Medicaid as well as civil
and criminal penalties. Similar penalties are provided for violation of state
anti-kickback and self-referral laws. To the extent that the Company or any
affiliated dental practice is deemed to be subject to these federal or similar
state laws, the Company believes
9
its intended activities will comply in all material respects with such statutes
and regulations.
State Legislation
In addition to the anti-kickback laws and anti-referral laws noted above,
the laws of many states prohibit dentists from splitting fees with non-dentists
and prohibit non-dental entities such as the Company from engaging in the
practice of dentistry and from employing dentists to practice dentistry. The
specific restrictions against the corporate practice of dentistry, as well as
the interpretation of those restrictions by state regulatory authorities, vary
from state to state. However, the restrictions are generally designed to
prohibit a non-dental entity from controlling the professional assets of a
dental practice (such as patient records, payer contracts and, in certain
states, dental equipment), employing dentists to practice dentistry (or, in
certain states, employing dental hygienists or dental assistants), controlling
the content of a dentist's advertising or professional practice or sharing
professional fees. The laws of many states also prohibit dental practitioners
from paying any portion of fees received for dental services in consideration
for the referral of a patient. In addition, many states impose limits on the
tasks that may be delegated by dentists to dental assistants.
State dental boards do not generally interpret these prohibitions as
preventing a non-dental entity from owning non-professional assets used by a
dentist in a dental practice or providing management services to a dentist
provided that the following conditions are met: a licensed dentist has complete
control and custody over the professional assets; the non-dental entity does not
employ or control the dentists (or, in some states, dental hygienists or dental
assistants); all dental services are provided by a licensed dentist; licensed
dentists have control over the manner in which dental care is provided and all
decisions affecting the provision of dental care. State laws generally require
that the amount of a management fee be reflective of the fair market value of
the services provided by the management company and certain states require that
any management fee be a flat fee or cost-plus fee based on the cost of services
performed by the Company. In general, the state dental practice acts do not
address or provide any restrictions concerning the manner in which companies
account for revenues from a dental practice subject to the above-noted
restrictions relating to control over the professional activities of the dental
practice, ownership of the professional assets of a dental practice and payments
for management services.
The Company does not control the practice of dentistry or employ dentists
to practice dentistry. Moreover, in states in which it is prohibited the Company
does not employ dental hygienists or dental assistants. The Company provides
management services to its affiliated practices, and the management fees the
Company charges for those services are consistent with the laws and regulations
of the jurisdictions in which it operates.
In addition, there are certain regulatory risks associated with the
Company's role in negotiating and administering managed care and capitation
contracts. The application of state insurance laws to reimbursement arrangements
other than various types of fee-for-service arrangements is an unsettled area of
law and is subject to interpretation by regulators with broad discretion. As the
Company or its affiliated practices contract with third-party payors, including
self-insured plans, for certain non-fee-for-service basis arrangements, the
Company or the affiliated dental practices may become subject to state insurance
laws. In the event that the Company or the affiliated practices are determined
to be engaged in the business of insurance, these parties could be required
either to seek licensure as an insurance company or to change the form of their
relationships with third-party payors, and may become subject to regulatory
enforcement actions. In such events, the Company's revenues may be adversely
affected.
Regulatory Compliance
The Company regularly monitors developments in laws and regulations
relating to dentistry. The Company may be required to modify its agreements,
operations or marketing from time to time in response to changes in the
business, statutory and regulatory environments. The Company plans to structure
all of its agreements, operations and marketing in compliance with applicable
law, although there can be no assurance that its arrangements will not be
successfully challenged or that required changes may not have a material adverse
effect on operations or profitability.
Employees
As of December 31, 2001, the Company and its affiliated dental practices
employed approximately 1,240
10
administrative and dental office personnel on a full-time or part-time basis,
and the affiliated dental practices employed approximately 190 general dentists
and specialists on a full-time or part-time basis. The affiliated dental
practices generally enter into employment or independent contractor agreements
with their affiliated dentists. The Company believes that its relations with its
employees are good.
Corporate Liability and Insurance
The provision of dental services entails an inherent risk of professional
malpractice and other similar claims. Although the Company does not influence or
control the practice of dentistry by dentists or have responsibility for
compliance with certain regulatory and other requirements directly applicable to
dentists and dental groups, the contractual relationship between the Company and
the affiliated dental practices may subject the Company to some medical
malpractice actions under various theories, including successor liability. There
can be no assurance that claims, suits or complaints relating to services and
products provided by managed practices will not be asserted against the Company
in the future. The availability and cost of professional liability insurance has
been affected by various factors, many of which are beyond the control of the
Company. Significant increases in the cost of such insurance to the Company and
its affiliated dental practices may have an adverse effect on the Company's
operations.
The Company requires each affiliated dental practice to maintain comprehensive
general liability and professional liability coverage covering the practice and
each dentist retained or employed by the affiliated dental practice, which
normally provide for comprehensive general liability coverage of $1.0 million
for each occurrence and $3.0 million annual aggregate, and professional
liability coverage of not less than $1.0 million for each occurrence and $3.0
million annual aggregate.
The Company maintains other insurance coverage including general liability,
property, business interruption and workers' compensation, which management
considers to be adequate for the size of the Company and the nature of its
business.
Item 2. Properties
The Company leases approximately 10,000 square feet of space for executive,
administrative, sales and marketing and operations offices in Houston, Texas.
The lease expires in July 2006 and is subject to renewal options.
All of the Company's existing dental centers are leased. Two of the dental
centers are owned by an affiliate of the Company and one dental center is owned
by a former director of the Company. On March 31, 2002, the Company closed the
dental center leased from the former director and is negotiating the termination
of the lease, which runs through December 2005.
The Company intends to lease centers or enter into build-to-suit arrangements
with third parties for dental centers to be leased by the Company. Certain
leases provide for fixed minimum rentals and provide for additional rental
payments for common area maintenance, insurance and taxes. The leases carry
varying terms expiring between 2002 and 2011 excluding options to renew.
The majority of the centers are located in retail locations. The Company
believes that its leased facilities are well maintained, in good condition and
adequate for its current needs. Furthermore, the Company believes that suitable
additional or replacement space will be available when required.
Item 3. Legal Proceedings
In December 1998, a dentist with whom the Company had entered into an
agreement to acquire his dental practice filed a demand for arbitration alleging
that the Company is liable for damages resulting from the failure to complete
the transaction. In August 2000, the arbitrator found that the subsidiaries had
breached a contractual agreement to complete the acquisition and awarded the
plaintiffs actual damages and costs of $442,000. In August 2000, the arbitrator
awarded the plaintiffs an additional $666,000 for attorney fees and costs,
resulting in a total judgment of $1,108,000 against the Company's subsidiaries.
This amount, as well as additional legal expenses incurred by the Company, was
included in the litigation expenses of $1.5 million recorded in June 2000. None
of the judgment amount awarded to the plaintiffs has been paid as of April 15,
2002, although the Company has reached a tentative agreement with the plaintiff
to pay the judgment
11
over a fifty-month period after receiving agreement from its senior bank
creditors to make such payments.
In October 2001, the former owners of Dental Centers of America filed suit in
Bexar County, Texas alleging that the Company breached a letter agreement
offering payment as settlement for past due amounts on two subordinated
promissory notes that were part of the purchase consideration for Dental Centers
of America. In March 2002, the plaintiffs obtained a judgment for $625,000 plus
interest and attorneys' fees, against the Company. The Company is currently
involved in settlement negotiations with the plaintiffs and none of the judgment
award has been paid as of April 15, 2002.
The Company also is a defendant in two lawsuits with landlords of two leased
properties that were abandoned by the Company in 2001 as part of its
restructuring plan. The leases had remaining terms of 42 and 68 months at
monthly rental rates of $3,800 and $4,700, respectively, at the time the Company
stopped paying rent on the leases. The Company is attempting to negotiate
settlements with the landlords.
The Company and certain of its subsidiaries are parties to a number of legal
proceedings that have arisen in the ordinary course of business. While the
outcome of these proceedings cannot be predicted with certainty, management does
not expect these matters to have a material adverse effect on the Company.
Item 4. Submission of Matters to a Vote of Security Holders
None
12
PART II
Item 5. Market For Registrant's Common Equity and Related Stockholder Matters
Prior to April 2001, the Company's common stock was traded in the over-the-
counter market and quoted on the Nasdaq National Market. Currently, the
Company's common stock is traded in the over-the-counter market and quoted on
the OTC Bulletin Board under the symbol "CASL.OB." The following table presents
the quarterly high and low sale prices as reported by the Nasdaq National Market
and, for periods after April, 2001, the quarterly high and low bid prices as
reported by the OTC Bulletin Board. These quotations reflect the inter-dealer
prices, without retail mark-up, markdown or commission and may not necessarily
represent actual transactions.
High Low
---- ----
2000:
----
First Quarter...................... 4.88 2.31
Second Quarter..................... 4.00 1.50
Third Quarter...................... 3.25 1.88
Fourth Quarter..................... 2.00 0.19
2001:
----
First Quarter...................... 0.38 0.13
Second Quarter..................... 0.28 0.10
Third Quarter...................... 0.29 0.19
Fourth Quarter..................... 0.20 0.07
As of March 31, 2002, there were 6,417,206 shares of the Company's Common
Stock outstanding held by approximately 42 stockholders of record. The Company
believes there are approximately 1,000 beneficial owners of the Common Stock.
The Company has never paid a cash dividend on its Common Stock. The Company
currently intends to retain earnings to finance the development of its business
and does not anticipate paying any cash dividends on the Common Stock in the
foreseeable future. In addition, the Company's bank credit facility prohibits
the payment of dividends while the Company is in default thereunder.
13
Item 6. Selected Financial Data
The selected financial data of the Company should be read in conjunction
with the related consolidated financial statements, notes thereto and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" appearing elsewhere herein.
Year Ended December 31,
-----------------------------------------------------------------
1997 1998 1999 2000 2001
-------- ------ ---- ----- ----
(in thousands, except per share data)
STATEMENT OF OPERATIONS DATA:
Net patient revenues....................................... $ 46,225 $ 74,823 $ 102,701 $ 106,023 $ 97,924
Expenses:
Dentist salaries and other professional costs............ 11,325 18,516 26,984 28,384 27,091
Clinical salaries........................................ 10,248 16,612 21,408 20,795 19,956
Dental supplies and laboratory fees..................... 4,335 7,197 9,641 11,730 11,760
Rental and lease expenses................................ 2,590 4,091 6,203 7,608 6,433
Advertising and marketing................................ 2,033 2,763 3,650 3,847 3,283
Depreciation and amortization............................ 1,987 3,535 5,792 6,796 6,593
Other operating expenses................................. 2,467 4,431 6,154 7,344 8,016
Bad debt expenses........................................ 1,847 2,545 4,160 15,325 4,948
Restructuring costs and other charges.................... -- -- -- -- 2,329
General and administrative............................... 5,929 8,145 10,909 13,128 11,291
Asset impairment......................................... - - - 3,567 2,929
-------- --------- ---------- --------- ---------
Total expenses....................................... 42,761 67,835 94,901 118,524 104,629
-------- --------- ---------- --------- ---------
Operating income (loss).................................. 3,464 6,988 7,800 (12,501) (6,705)
Litigation settlement.................................... - - 1,366 1,495 -
Interest expenses........................................ 2,937 1,969 4,369 7,751 7,960
Other (income) expenses.................................. (84) (57) 34 (28) (68)
-------- --------- ---------- --------- ---------
Income (loss) before provision (benefit) for income
taxes, extraordinary loss and cumulative effect
of change in accounting principle...................... 611 5,076 2,031 (21,719) (14,597)
Provision (benefit) for income taxes..................... 200 1,490 835 (2,595) -
-------- --------- ---------- ---------- ---------
Income (loss) before extraordinary loss and
cumulative effect of change in accounting principle.... 411 3,586 1,196 (19,124) (14,597)
Extraordinary loss....................................... (3,195) - - - -
Cumulative effect of change in accounting principle...... - - - - (250)
-------- --------- ---------- --------- ---------
Net income (loss)........................................ (2,784) 3,586 1,196 (19,124) (14,847)
Preferred stock dividends (1)............................ (1,930) - - - -
-------- --------- ---------- --------- ---------
Net income (loss) attributable to common stock........... $ (4,714) $ 3,586 $ 1,196 $ (19,124) $ (14,847)
======== ========= ========== ========= =========
Income (loss) per common share:
Basic and diluted:
Income (loss) before extraordinary loss and
cumulative effect of change in accounting principle.... $ 0.10 $ 0.54 $ 0.18 $ (2.96) $ (2.27)
Extraordinary loss......................................... (0.78) -- -- -- --
Cumulative effect of change in accounting principle........ -- -- -- -- (0.04)
-------- --------- ---------- --------- ---------
Net income (loss)....................................... $ (0.68) $ 0.54 $ 0.18 $ (2.96) $ (2.31)
======== ========= ========== ========= =========
Weighted average number of common and common equivalent
shares outstanding
Basic.................................................. 4,100 6,586 6,825 6,451 6,417
======== ========= ========== ========= =========
Diluted................................................ 4,132 6,608 6,850 6,451 6,417
======== ========= ========== ========= =========
14
Year Ended December 31,
---------------------------------------------------------------
1997 1998 1999 2000 2001
---- ---- ---- ---- ----
(in thousands)
BALANCE SHEET DATA:
Cash and cash equivalents.................................. $ 2,908 $ 695 $ 59 $ 901 $ 3,979
Working capital (deficit).................................. 3,917 10,345 15,768 (62,259) (67,843)
Total assets............................................... 44,513 100,035 114,982 95,386 84,082
Long-term debt, less current portion....................... 3,659 44,937 53,996 429 16
Redeemable preferred stock................................. 1,550 - - - -
Total stockholders' equity................................. 31,113 36,397 37,163 18,039 3,192
(1) The Company recorded a non-cash dividend to accrete the Series A
Convertible Preferred Stock and Series C Convertible Preferred Stock to
their estimated fair value.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Introduction
The Company manages and operates integrated dental networks through
contractual affiliations with general, orthodontic and multi-specialty dental
practices in Texas, Florida, Tennessee and California. The Company does not
engage in the practice of dentistry but rather establishes integrated dental
networks by entering into management services agreements with affiliated dental
practices to provide on an exclusive basis management and administrative
services to affiliated dental practices. As of December 31, 2001, the Company
provided management services to 88 dental centers with approximately 190
affiliated dentists, orthodontists and other dental specialists.
Certain of the affiliated dental practices derive a significant portion of
their revenues from managed care contracts, preferred provider arrangements and
other negotiated price agreements. While the Company generally negotiates the
terms and conditions of managed care contracts, preferred provider arrangements
and other negotiated price agreements, the affiliated dental practices are the
contracting parties for all such relationships, and the Company is dependent on
its affiliated dental practices for the success of such relationships. The
Company generally bears the risk of loss resulting from any such arrangements
because it consolidates the financial results of its affiliated dental
practices. However, most of these contracts are cancelable by either party on
60 to 90 days written notice, thereby reducing the risk of long-term adverse
impact on the Company.
At December 31, 2001, the Company and its affiliated dental practices
maintained an aggregate of 41 capitated managed care contracts covering
approximately 172,000 members. Capitation fees, excluding supplemental fees and
co-payments by members, totaled $9.6 million, or approximately 9.8% of net
patient revenues in 2001. One managed care contract with a national insurance
company accounted for $7.2 million in revenues ($3.6 million in capitation
payments and $3.6 million in patient co-payments) in 2001, equal to 7.4% of
total net patient revenues. The Company periodically evaluates its capitated
managed care contracts by comparing the average reimbursement per procedure plus
the total capitation fees per contract to the usual and customary fees charged
by the affiliated dental practice. If the aggregate reimbursement percentage for
the capitated contract exceeds 55% of the usual and customary fees, the Company
believes that the incremental costs of providing covered services are being
recovered. Management believes that capitated managed care contracts, in the
aggregate, are profitable and the Company will continue to contract with
capitated managed care providers on a case-by-case basis.
Components of Revenues and Expenses
Net patient revenues represent amounts billed by the affiliated dental
practices to patients and third-party payors for dental services rendered. Such
amounts also include monthly capitation payments received from third-party
payors pursuant to managed care contracts. Net revenues are reported at
established rates reduced by contractual amounts based on agreements with
patients, third party payers and others obligated to pay for services rendered.
Under the terms of the typical management services agreement with an
affiliated dental practice,
15
the Company becomes the exclusive manager and administrator of all non-dental
services relating to the operation of the practice. While actual terms of the
various management agreements may vary from practice to practice, material
aspects of all the management service agreements, including the ability of the
Company to nominate the majority shareholder and the calculation of the
management fees, are consistent. The obligations of the Company include assuming
responsibility for the operating expenses incurred in connection with managing
the dental centers. These expenses include salaries, wages and related costs of
non-dental personnel, dental supplies and laboratory fees, rental and lease
expenses, advertising and marketing costs, management information systems, and
other operating expenses incurred at the dental centers. In addition to these
expenses, the Company incurs general and administrative expenses related to the
billing and collection of accounts receivable, financial management and control
of the dental operations, insurance, training and development, and other general
corporate expenditures.
Results of Operations
The following table sets forth the percentages of patient revenues represented
by certain items reflected in the Company's Statements of Operations. The
information that follows represents historical results of the Company and does
not include pre-acquisition results of the dental practices that the Company has
acquired. The Company did not acquire any dental practices in the period from
1999 through 2001 although it did acquire, in March 2000, the 20% minority
interest in its California subsidiary that it did not previously own.
Year Ended December 31,
-----------------------------------
1999 2000 2001
---------- ----------- ----------
Net patient revenues.................................................... 100.0% 100.0% 100.0%
Expenses:
Dentist salaries and other professional costs....................... 26.3% 26.8% 27.7%
Clinical salaries................................................... 20.8% 19.6% 20.4%
Dental supplies and laboratory fees................................. 9.4% 11.1% 12.0%
Rental and lease expense............................................ 6.0% 7.2% 6.6%
Advertising and marketing........................................... 3.6% 3.6% 3.4%
Depreciation and amortization....................................... 5.6% 6.4% 6.7%
Other operating expenses............................................ 6.0% 6.9% 8.2%
Bad debt expense.................................................... 4.1% 14.5% 5.1%
Restructuring costs and other charges............................... -- -- 2.4%
General and administrative.......................................... 10.6% 12.4% 11.5%
Asset impairment.................................................... -- 3.4% 3.0%
------- ------- -------
Total expenses.................................................. 92.4% 111.8% 106.8%
------- ------- -------
Operating income(loss)................................................ 7.6% -11.8% -6.8%
Litigation settlement................................................. 1.3% 1.4% 0.0%
Interest expense...................................................... 4.3% 7.3% 8.1%
------- ------- -------
Income (loss) before provision (benefit) for income taxes
and cumulative effect of change in accounting principle............. 2.0% -20.5% -14.9%
Provision (benefit) for income taxes.................................. 0.8% -2.4% 0.0%
------- ------- -------
Income (loss) before cumulative effect of change in
accounting principle................................................ 1.2% -18.0% -14.9%
Cumulative effect of change in accounting principle................... -- -- -0.3%
------- ------- -------
Net income (loss)..................................................... 1.2% -18.0% -15.2%
======= ======= =======
Twelve Months Ended December 31, 2001 Compared to Twelve Months Ended December
31, 2000
Net Patient Revenues - Net patient revenues decreased from $106.0 million for
the year ended December 31, 2000 to $97.9 million for the year ended December
31, 2001, a decrease of $8.1 million or 7.6%. Patient
16
revenues from dental centers opened for more than one year decreased
approximately $3.4 million, or 3.2%, offset slightly by de novo dental centers
opened in 2000. The decrease is attributable to the slowdown in general economic
activity during 2001 and the lower number of dentists in 2001 compared to the
prior year. The closing of 14 dental centers in the last year accounted for $5.0
million of the decrease in revenues.
Dentist Salaries and Other Professional Costs - Dentist salaries and other
professional costs consist primarily of compensation paid to dentists,
orthodontists, and hygienists employed by the affiliated dental practices. For
the year ended December 31, 2001, dentist salaries and other professional costs
were $27.1 million, a decrease of $1.3 million, or 4.6% lower than costs of
$28.4 million for the year ended December 31, 2000. The decrease is
attributable to the closing of 14 dental centers during 2000 and 2001 and the
reduction in the number of dentists during the year. Expressed as a percentage
of net patient revenues, dentist salaries and other professional costs increased
from 26.8% to 27.7% for the year ended December 31, 2000 and 2001, respectively.
Clinical Salaries - Clinical salaries decreased from $20.8 million for the
year ended December 31, 2000 to $20.0 million for the year ended December 31,
2001, a decrease of $0.8 million or 4.0%, resulting from the closing of 14
dental centers during 2000 and 2001. Expressed as a percentage of net patient
revenues, clinical salaries increased slightly from 19.6% for the year ended
December 31, 2000 to 20.4% for the year ended December 31, 2001.
Dental Supplies and Laboratory Fees - Dental supplies and laboratory fees
increased from $11.7 million for the year ended December 31, 2000, to $11.8
million for the year ended December 31, 2001, a slight increase of $0.1 million,
or 0.3%. Higher laboratory fees resulting from price increases and outsourcing
of certain lab functions accounted for the increase. Expressed as a percentage
of patient revenues, dental supplies and laboratory fees increased from 11.1%
for the year ended December 31, 2000 to 12.1% for the year ended December 31,
2001.
Rental and Lease Expense - Rental and lease expense decreased from $7.6
million for the year ended December 31, 2000 to $6.4 million for the year ended
December 31, 2001, a decrease of $1.2 million, or 15.4%. The decrease resulted
from the closing of 14 dental centers in the last year and the provision for
rents on closed centers that was recorded in 2000. Expressed as a percentage of
net patient revenues, rental and lease expense decreased from 7.2% for the year
ended December 31, 2000 to 6.6% for the year ended December 31, 2001.
Advertising and Marketing - Advertising and marketing expenses decreased from
$3.8 million for the year ended December 31, 2000, to $3.3 million in 2001, a
decrease of $0.5 million, or 14.7%. Lower expenditures on television
advertising, yellow pages advertisements and reduced promotional costs accounted
for the decrease. Expressed as a percentage of net patient revenues,
advertising and marketing expenses decreased from 3.6% for the year ended
December 31, 2000 to 3.4% for the year ended December 31, 2001.
Depreciation and Amortization - Depreciation and amortization decreased from
$6.8 million for the year ended December 31, 2000 to $6.6 million for the year
ended December 31, 2001, a decrease of $0.2 million, or 3.0%. The decrease is
attributable to the write off of certain intangible expenses and property and
equipment in late 2000. Expressed as a percentage of net patient revenues,
however, depreciation and amortization increased from 6.4% in the prior year to
6.7% for the year ended December 31, 2001.
Other Operating Expenses - Other operating expenses increased from $7.3
million for the year ended December 31, 2000, to $8.0 million for the year ended
December 31, 2001, an increase of $0.7 million or 9.2%. The increase is
attributable primarily to higher insurance costs, management recruiting expenses
and third-party financing costs. Expressed as a percentage of net patient
revenues, other operating expenses increased from 6.9% for the year ended
December 31, 2000 to 8.2% for year ended December 31, 2001.
Bad Debt Expense - Bad debt expense of $4.9 million for the year ended
December 31, 2001 decreased by $10.4 million, or 67.7%, from $15.3 million for
the year ended December 31, 2000. In 2000, the Company changed its estimates
for the collectibility of certain categories of accounts receivable resulting in
additional charges of $7.9 million on billed accounts receivable and $2.1
million of unbilled accounts receivable from orthodontic patients. Excluding
these charges, bad debt expense, expressed as a percentage of net patient
revenues increased slightly, from 5.0% for the year ended December 31, 2000 to
5.1% for the year
17
ended December 31, 2001.
Restructuring Costs and Other Charges - For the year ended December 31, 2001
the Company recorded restructuring costs and other charges of $2.3 million
including severance costs, remaining lease obligations on closed offices and
legal and professional fees related to the implementation of the plan to improve
operating results and restructure the Company's credit facilities. (See Note 4
of Notes to Consolidated Financial Statements)
General & Administrative - General and administrative expenses decreased from
$13.1 million for the year ended December 31, 2000, to $11.3 million for the
year ended December 31, 2001, a decrease of $1.8 million, or 14.0%. The
decrease is attributable to reductions in corporate and regional overhead costs
and the reorganization of field management during 2001. Expressed as a
percentage of net patient revenues, general and administrative expense decreased
from 12.4% to 11.5% for the years ended December 31, 2000 and 2001,
respectively.
Asset Impairment - For the year ended December 31, 2001 the Company recorded a
$2.9 million asset impairment, resulting primarily from the closing of two
dental centers in Texas and Tennessee, a charge to reflect the impairment in
value of fixed assets for two under-performing dental centers and the write-off
of intangible assets associated with certain acquisitions. As a result, the
Company reduced intangible assets by approximately $2.4 million and leasehold
improvements by approximately $0.5 million. For the year ended December 31,
2000, the Company recorded a $3.6 million asset impairment, resulting primarily
from the closing of six dental offices in Florida, Texas and California, a
charge to reflect the impairment in the value of fixed assets for eleven under-
performing dental centers, and the write-off of related intangible assets and
long-term receivables associated with certain acquisitions. As a result, the
Company reduced intangible assets by approximately $1.2 million, leasehold
improvements and equipment by approximately $1.7 million, and other assets by
approximately $0.7 million
Litigation settlement - For the year ended December 31, 2000, the Company
recorded a $1.5 million charge resulting from an adverse arbitration award in an
arbitration proceeding in Los Angeles, California (See Note 5 of Notes to
Consolidated Financial Statements).
Interest Expense - Interest expense increased from $7.8 million for the year
ended December 31, 2000 to $8.0 million for the year ended December 31, 2001, an
increase of $0.2 million or 2.7%. The increase resulted from the accrual of a
full year of default interest related to the various defaults under the
Company's credit agreements, offset by lower interest rates during 2001.
Benefit for Income Taxes -For the year ended December 31, 2000, the Company
recorded a benefit for income taxes of $2.6 million against a loss before income
taxes of $21.7 million. The benefit for income taxes in fiscal 2000 was reduced
by a valuation allowance of approximately $5.2 million that was recorded against
the Company's entire deferred tax asset. For the year ended December 31, 2001,
the Company did not record a benefit for income taxes against a pre-tax loss of
$14.6 million as the benefit was reduced by a valuation allowance of
approximately $8.9 million. The Company's valuation allowance for both periods
was recorded as there is no assurance the Company will be able to realize the
tax asset in future periods.
Cumulative Effect of Change in Accounting Principle - During September 1998,
the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities", which requires that companies
recognize all derivative instruments as either assets or liabilities on the
balance sheet and measure those instruments at fair value. SFAS No. 137,
"Accounting for Derivative Instruments and Hedging Activities - Deferral of the
Effective Date of FASB Statement No. 133," deferred the implementation of SFAS
133 until the fiscal year ending December 31, 2001. The Company implemented
SFAS 133 effective January 1, 2001. In July 2000, the Company entered into a
swap agreement with a bank. The term of the swap contract expired July 10,
2001. The cumulative effect of the accounting change as of January 1, 2001, was
a charge of $0.3 million, or $0.04 per common share, that was reflected in the
first quarter of 2001.
Twelve Months Ended December 31, 2000 Compared to Twelve Months Ended December
31, 1999
Net Patient Revenues - Net patient revenues of affiliated dental practices
increased from $102.7 million for the year ended December 31, 1999, to $106.0
million for the year ended December 31, 2000, an
18
increase of $3.3 million or 3.2%. Approximately $5.4 million of the increase was
attributable to the opening of de novo dental centers in Texas, Florida and
Tennessee. Patient revenues for dental centers open for more than one year
increased approximately $1.2 million, or 1.2%, offset by decreased revenues of
approximately $3.3 million from dental centers closed in the last year.
Dentist Salaries and Other Professional Costs - Dentist salaries and other
professional costs consist primarily of compensation paid to dentists,
orthodontists, and hygienists employed by the affiliated dental practices. For
the year ended December 31, 2000, dentist salaries and other professional costs
were $28.4 million, an increase of $1.4 million or 5.2% from the comparable
period of 1999. The increase was due primarily to the staffing of de novo
dental centers and increased dentist compensation resulting from higher net
patient revenues. Expressed as a percentage of net patient revenue, dentist
salaries and other professional costs increased from 26.3% for 1999 to 26.8% for
2000.
Clinical Salaries - Clinical salaries decreased from $21.4 million for the
year ended December 31, 1999, to $20.8 million for the year ended December 31,
2000, a decrease of $0.6 million or 2.9%. The decrease was due primarily to
reduced staffing in the dental centers. Expressed as a percentage of net patient
revenues, clinical salaries decreased from 20.8% to 19.6% for the years ended
December 31, 1999 and 2000, respectively.
Dental Supplies and Laboratory Fees - Dental supplies and laboratory fees
increased from $9.6 million for the year ended December 31, 1999 to $11.7
million for the year ended December 31, 2000, an increase of $2.1 million or
21.7%. The increase is attributable to additional dental supplies required for
the opening of de novo dental centers and increased laboratory costs. Expressed
as a percentage of net patient revenues, dental supplies and laboratory fees
increased from 9.4% in 1999 to 11.1% in 2000.
Rental and Lease Expense - Rental and lease expense increased from $6.2
million for the year ended December 31, 1999 to $7.6 million for the year ended
December 31, 2000, an increase of $1.4 million or 22.7%. Lease expense in 2000
included the accrual of $0.7 million in lease expense on closed dental centers
and on properties that are under lease but that will not be built-out due to the
Company's plan to reduce capital expenditures. Excluding this charge, rent and
lease expense, expressed as a percentage of net patient revenues, increased from
6.0% in 1999 to 6.5% for the comparable 2000 period. This increase is
attributable primarily to the addition of de novo dental centers.
Advertising and Marketing - Advertising and marketing expense increased from
$3.6 million for the year ended December 31, 1999, to $3.8 million for the year
ended December 31, 2000, an increase of $0.2 million, or 5.4%. Expressed as a
percentage of net patient revenues, advertising and marketing expense of 3.6%
for the year ended December 31, 2000 was unchanged from the prior year.
Depreciation and Amortization - Depreciation and amortization increased from
$5.8 million for the year ended December 31, 1999 to $6.8 million for the year
ended December 31, 2000, an increase of $1.0 million, or 17.3%. The increase
resulted from the addition of leasehold improvements and dental equipment
associated with de novo centers and management information system updates.
Expressed as a percentage of net patient revenues, depreciation and amortization
increased from 5.6% to 6.4% for the years ended December 31, 1999 and 2000,
respectively.
Other Operating Expenses - Other operating expenses increased from $6.2
million for the year ended December 31, 1999, to $7.3 million for the year ended
December 31, 2000, an increase of $1.2 million or 19.3%. Other operating
expenses include certain costs related to the operation of the Company's dental
centers such as maintenance, utilities and communications expenses. The increase
is attributable primarily to additional operating expenses associated with the
opening of de novo dental centers. Expressed as a percentage of net patient
revenues, other operating expenses increased from 6.0% for the year ended
December 31, 1999 to 6.9% in 2000.
Bad Debt Expense - Bad debt expense increased from $4.2 million for the year
ended December 31, 1999 to $15.3 million for the year ended December 31, 2000,
including charges of $10.0 million to record additional allowance for doubtful
accounts receivable. The Company has changed its estimates for the
collectibility of certain categories of accounts receivable resulting in
additional charges of $7.9 million on billed accounts receivable and $2.1
million of unbilled accounts receivable from orthodontic patients. Lower
19
collection rates on patients with insurance, slower payments from insurance
companies, and higher than expected attrition of orthodontic patients accounted
for the change in estimates.
General & Administrative Expense - General and administrative expenses
increased from $10.9 million for the year ended December 31, 1999, to $13.1
million for the year ended December 31, 2000, an increase of $2.2 million, or
20.3%. Excluding charges of $1.4 million, general and administrative expenses
were $11.7 million for the year ended December 31, 2000, 11.0% higher than
general and administrative expenses for the year ended December 31, 1999. The
charges included investment costs related to the investigations of strategic
alternatives, provisions for litigation and severance costs. Furthermore,
excluding these charges, general and administrative expenses, expressed as a
percentage of net patient revenues, were 11.1% for the year ended December 31,
2000 compared to 10.6% for the prior year.
Asset Impairment - In the third quarter of 2000, the Company recorded a charge
of $1.9 million related to the closing of six dental centers in Florida,
California and Texas. The closed offices included two dental centers on the
east coast of Florida, two centers in the Los Angeles area, and two centers in
Texas. In December 2000, the Company recognized an additional charge of $1.7
million to reflect the impairment in the value of fixed assets for eleven under-
performing dental offices.
Litigation settlement - For the year ended December 31, 2000, the Company
recorded a $1.5 million charge resulting from an adverse arbitration award in an
arbitration proceeding in Los Angeles, California (See Note 5 of Notes to
Consolidated Financial Statements). In the year ended December 31, 1999,
litigation expense of $1.4 million resulted from the settlement of a lawsuit
filed by the former owner of certain dental practices acquired by the Company in
1996.
Interest Expense - Interest expense increased from $4.4 million for the year
ended December 31, 1999 to $7.8 million for the year ended December 31, 2000, an
increase of $3.4 million, or 77.4%. The increase resulted from higher
borrowings and an increase in variable interest rates during 2000. Also, in the
fourth quarter of 2000, the Company accrued additional interest expense of $0.5
million resulting from default interest charged by its lenders as a result of
the defaults on the Company's senior and senior subordinated credit facilities.
Provision (benefit) for Income Taxes - For the year ended December 31, 1999,
the Company recorded a provision for income taxes of $0.8 million, resulting
from income before income taxes of $2.0 million. For the year ended December
31, 2000, the Company recorded a benefit for income taxes of $2.6 million
resulting from a loss before income taxes of $21.7 million. The benefit for
income taxes in fiscal 2000 was reduced by a valuation allowance of
approximately $5.2 million that was recorded against the Company's entire
deferred tax asset because there is no assurance that the Company will be able
to recognize the tax asset in the future. Accordingly, the benefit for income
taxes recorded in the 2000 was limited to 11.9% of the loss before income taxes
compared to an effective tax rate of 41.1% recorded in the prior year.
Liquidity and Capital Resources
Historically the Company has relied on cash flow from operations and
borrowings on its senior credit facility to finance its operations, and on a
combination of bank borrowings, the issuance of Company common stock and
subordinated seller notes, and the assumption of certain debt and lease
obligations to finance its acquisitions.
At December 31, 2001 the Company had a net working capital deficit of $67.8
million, resulting primarily from the classification as a current liability of
$45.2 million of outstanding borrowings under the Company's senior bank credit
facility, $15.0 million in senior subordinated note and convertible note
agreements (see below) and $2.9 million in other subordinated notes. Current
assets consisted of cash and cash equivalents of $4.0 million, billed and
unbilled accounts receivable of $7.7 million and $1.4 million of prepaid
expenses and other current assets. Current liabilities totaled $80.9 million,
consisting of $17.0 million in accounts payable and accrued liabilities, $63.8
million in current maturities of long-term debt and $0.1 million of deferred
compensation payable to a stockholder.
For the year ended December 31, 2001, cash provided by operating activities
was approximately $4.4 million compared $3.5 million in 2000. In 2001, cash
used in investing activities amounted to $0.9 for capital
20
expenditures to maintain the existing dental centers. For the year ended
December 31, 2000, cash used in investing activities was $8.3 million,
consisting of $5.0 million to acquire the remaining 20% minority interest in the
Company's California subsidiary and $3.3 million for capital expenditures. For
the year ended December 31, 2001, cash used in financing activities amounted to
$0.4 million in repayment of debt. For the year ended December 31, 2000, cash
provided by financing activities totaled $5.7 million representing $16.9 million
in proceeds from long-term debt offset partially by $9.1 million in repayments
of long-term debt and capital lease obligations, payment of $1.3 million in debt
issuance costs and $0.8 million reduction in bank overdrafts.
During 2001, the Company's principal sources of liquidity consisted primarily
of cash, cash equivalents and accounts receivable. The Company incurred losses
of $19.1 million in 2000 and $14.8 million in 2001, and, as a result, has not
been in compliance with certain financial covenants of the Credit Agreement, the
Subordinated Note Agreement and the Convertible Note Agreement since June 30,
2000 (collectively the "Debt Agreements").
The Credit Agreement provides for borrowings up to $55.0 million and matures
November 2002. Advances under the Credit Agreement required quarterly interest
payments only through March 2001 at which time principal became payable
quarterly based on a five-year amortization with final payment at maturity.
Borrowings under the Credit Agreement may at no time exceed a specified
borrowing base, which is calculated as a multiple of the Company's earnings
before interest, income taxes, depreciation and amortization ("EBITDA"), as
adjusted. The Credit Agreement bears interest at variable rates, which are based
upon either the bank's base rate or LIBOR, plus, in either case, a margin which
varies according to the ratio of the Company's funded debt to the EBITDA, each
as defined in the Credit Agreement. A commitment fee is payable quarterly at
rates ranging from 0.125 percent to 0.5 percent of the unused amounts for such
quarter. The Credit Agreement contains affirmative and negative covenants that
require the Company to maintain certain financial ratios, limit the amount of
additional indebtedness, limit the creation or existence of liens, set certain
restrictions on acquisitions, mergers and sales of assets and restrict the
payment of dividends. At December 31, 2001, $45.2 million was outstanding under
the Credit Agreement. In November 2001, the Credit Agreement became a term
note, therefore additional borrowings under the agreement are not available.
The Subordinated Note Agreement and Convertible Note Agreement provided
borrowings of $13.7 and $1.3 million, respectively. Proceeds from these notes
were used to reduce borrowings under the bank credit facility, to acquire a 20%
minority interest in the Company's California subsidiary and to reduce other
accrued liabilities and accounts payable. Loans under the Subordinated Note
Agreement bear interest at the 90-day LIBOR rate plus five and one-half percent,
payable quarterly, and are due in eight quarterly installments beginning in the
sixty-third month following the closing date. Loans under the Convertible Note
Agreement bear interest at the same rate as loans under the Subordinated Note
Agreement and are due on demand beginning seven years after the closing date
with a final maturity date of January 30, 2009. The convertible note is
convertible at any time into 442,880 shares of Company common stock at the
request of the holders at a fixed conversion price of $3.1125 per share. The
Subordinated Note Agreement and Convertible Note Agreement contain affirmative
and negative covenants that require that Company to maintain certain financial
ratios, limit the amount of additional indebtedness, limit the creation or
existence of liens, set certain restrictions on acquisitions, mergers and sales
of assets and restrict the payment of dividends.
As a result of losses incurred in the 2000 and 2001, the Company has not been
in compliance with the financial covenants of the Debt Agreements since June 30,
2000. At December 31, 2001, approximately $45.2 million in senior debt and $15.0
million in subordinated debt were outstanding under the Debt Agreements in
addition to approximately $3.5 million in other outstanding subordinated debt.
Since the Company is in default under these agreements, all amounts outstanding
are subject to acceleration and have been classified as current liabilities.
The Company has continued to pay interest (other than default interest) on the
amounts outstanding under the Credit Agreement, but has not made scheduled
principal payments of $11.3 million under the Credit Agreement, nor made
interest or principal payments of $5.8 million owed to subordinated creditors
since July 2000. During the last half of 2001, the Company negotiated with its
creditors and an unrelated third party concerning a potential equity investment
and the restructuring of the bank credit facility, the subordinated notes and
other Company debt. However, due to the deterioration in operating results in
the fourth
21
quarter 2001, the discussions concerning the potential equity investment were
terminated in January 2002 and the Company has continued negotiations with the
senior and subordinated lenders concerning a forbearance agreement or a
restructuring of the Company's debt. However, these negotiations have not
resulted in a forbearance agreement or restructuring of the debt as of April 15,
2002. There can be no assurance that the Company's lenders will consent to the
restructuring necessary to allow the Company to continue to operate. If the
Company and its lenders cannot reach an agreement, it may be necessary for the
Company to seek protection under Chapter 11 of the Bankruptcy Code. These
factors, among others, indicate that the Company may be unable to continue as a
going concern.
During 2001, the Company implemented a plan to allow it to continue to operate
without the need for additional borrowings. Components of this plan included:
(i) reorganization of field management to improve efficiency and reduce regional
overhead costs; (ii) reduction in corporate general and administrative costs
through job eliminations and reduction in other overhead expenses; (iii) closing
of unprofitable and under-performing dental centers; (iv) realignment of
accounts receivable management to focus on improved collection of insurance and
patient receivables; (v) restructuring of compensation for management to
emphasize performance-based incentives; and, (vi) cancellation of further de
novo development and reducing capital expenditures to maintenance levels.
While the plan resulted in lower operating costs during the last half of the
year, patient revenues were adversely affected by slower general economic
activity in the second half of 2001, the negative impact on retail sales caused
by the tragic events of September 11, and higher than anticipated attrition of
dentists during the year. This resulted in lower than anticipated patient
revenues, particularly in the fourth quarter 2001, that resulted in operating
losses and severely reduced cash flows.
For 2002, management plans to focus on: (i) increased hiring of new dentists
and improving dentist retention; (ii) continuing to monitor and close
unprofitable and under performing dental centers; (iii) refurbishing and
modernizing existing dental centers within capital expenditure constraints of
$1.5 million; (iv) upgrading dental office management personnel; and (v)
improving patient services in order to increase patient retention rates.
However, there can be no assurance that the these efforts to improve operating
results and cash flows will be sufficient to allow the Company to meet its
obligations in a timely manner or that the Company's creditors will agree with
the its plan. Therefore, there is substantial doubt about the Company's ability
to continue in existence.
Critical Accounting Policies
Management's discussion and analysis of financial condition and results of
operations are based upon the consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires
management to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. On an ongoing basis, management evaluates these
estimates, including those related to net patient revenues, accounts receivable,
intangible assets and contingent liabilities. The Company believes that of its
significant accounting policies (see Note 2 to the consolidated financial
statements), the following may involve a higher degree of judgment and
complexity.
Net patient revenues represent the estimated realizable amounts to be received
from patients, third-party payors and others for services rendered by affiliated
dentists. They are reported at established rates reduced by contracted amounts
based on agreements with patients, third party payers and others obligated to
pay for service rendered. Patient revenues from general dentistry are
recognized as the services are performed. Patient revenues from orthodontic
services are recognized in accordance with the proportional performance method.
Under this method, revenue is recognized as services are performed under the
terms of contractual agreements with each patient. Approximately 25% of the
services are performed in the first month with the remaining services recognized
ratably over the remainder of the contract. Billings under each contract, which
average approximately 26 months, are made equally throughout the term of the
contract, with final payment at the completion of the treatment.
Net patient revenues include amounts received from capitated managed care
contracts that the Company negotiates on behalf of its affiliated dental
practices. Under capitated contracts the affiliated dental
22
practice receives a predetermined amount per patient per month in exchange for
providing certain necessary covered services to members of the plan. Usually,
the capitated plans also provide for supplemental payments and/or co-payments by
members for certain higher cost procedures. These contracts typically result in
lower average fees for services than the usual and customary fees charged by the
Company's affiliated dental practices and may, in certain instances, expose the
Company to losses on contracts where the total revenues received are less than
the costs of providing such dental care. The Company generally bears the risk of
such loss because it consolidates the financial results of its affiliated dental
practices. However, most of these contracts are cancelable by either party on 30
to 90 days written notice thereby reducing the risk of long-term adverse impact
on the Company. Fees from capitated contracts totaled $7.4 million, $9.1 million
and $9.6 million in 1999, 2000 and 2001, respectively, including supplemental
payments and excluding co-payments by members. No single contract amounted to a
significant portion of the Company's revenues, as each of the Company's regional
operations contracts separately with managed care providers. The Company
periodically evaluates its capitated managed care contracts by comparing the
average reimbursement per procedure plus the total capitation fees per contract
to the usual and customary fees charged by the affiliated dental practice. As of
December 31, 2001, the Company did not have a loss in the aggregate related to
managed care contracts.
Accounts receivable consist primarily of receivables from patients, insurers,
government programs and contracts between the affiliated dental practices and
third-party payors for dental services provided by dentists. The Company does
not believe that change in the reimbursement arrangements for its affiliated
dental practice contracts with third-party payors would have a material impact
on revenues. An allowance for doubtful accounts is recorded by the Company based
on historical experience and collection rates.
The Company's acquisitions involve the purchase of tangible and intangible
assets and the assumption of certain liabilities of the affiliated dental
practices. As part of the purchase allocation, the Company allocates the
purchase price to the tangible assets acquired and liabilities assumed, based on
estimated fair market values. In connection with each acquisition, the Company
enters into a long-term management services agreement with each affiliated
dental practice, which cannot be terminated by either party without cause. The
cost of the management services agreement is amortized on a straight line basis
over its term, or such shorter period as may be indicated by the facts and
circumstances, as described below. Amortization periods of the management
services agreements acquired through December 31, 2001 are 25 years.
In connection with the allocation of the purchase price to identifiable
intangible assets, the Company analyzes the nature of the group with which a
management services agreement is entered into, including the number of dentists
in each group, number of dental centers and ability to recruit additional
dentists, the affiliated dental practice's relative market position, the length
of time each affiliated dental practice has been in existence, and the term and
enforceability of the management services agreement. Because the Company does
not practice dentistry, maintain patient relationships, hire dentists, enter
into employment and non-compete agreements with the dentist, or directly
contract with payors, the intangible asset created in the purchase allocation
process is associated primarily with the management services agreement with the
affiliated dental practice.
The Company reviews intangible assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of the asset may not
be recoverable. If this review indicates that the carrying amount of the asset
may not be recoverable, as determined based on the undiscounted cash flows of
the related operations over the remaining amortization period, the carrying
value of the asset is reduced to estimated fair value. Among the factors that
the Company will continually evaluate are unfavorable changes in each affiliated
dental practice's relative market share and local market competitive
environment, current period and forecasted operating results and cash flows of
the affiliated dental practice and its impact on the management fee earned by
the Company, and legal factors governing the practice of dentistry.
The Company carries insurance with coverages and coverage limits that it
believes to be customary in the dental industry. Although there can be no
assurance that such insurance will be sufficient to protect the Company against
all contingencies, management believes that its insurance protection is
reasonable in view of the nature and scope of the Company's operations.
The Company is from time to time subject to claims and suits arising in the
ordinary course of operations. In the opinion of management, the ultimate
resolution of such pending legal proceedings will
23
not have a material adverse effect on the Company's financial position, results
of operations or liquidity.
Inflation
Inflation has not had a significant impact on the results of operations of the
Company during the last three years.
Recent Accounting Pronouncements
On July 20, 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 141, Business Combinations and SFAS
No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 supercedes APB
Opinion No. 16, Business Combinations, to prohibit use of the pooling-of-
interest (pooling) method of accounting for business combinations initiated
after the issuance date of the final Statement. SFAS No. 142 supercedes APB
Opinion No. 17, Intangible Assets, by stating that goodwill will no longer be
amortized, but will be tested for impairment in a manner different from how
other assets are tested for impairment. SFAS No. 142 establishes a new method of
testing goodwill for impairment by requiring that goodwill be separately tested
for impairment using a fair value approach rather than an undiscounted cash flow
approach.
The provisions of SFAS No. 141 and SFAS No. 142 will be effective for fiscal
years beginning after December 15, 2001. SFAS No. 142 must be adopted at the
beginning of a fiscal year. The Company is currently evaluating the impact of
the adoption of these Statements.
On August 16, 2001, the Financial Accounting Standards Board issued SFAS 143,
"Accounting for Asset Retirement Obligation". SFAS 143 addresses financial
accounting and reporting for obligations associated with the retirement of
tangible long-lived assets and the associated asset retirement costs. These
provisions of SFAS 143 are effective for financial statements issued for fiscal
years beginning after June 15, 2002. Earlier application is encouraged.
On October 3, 2001, the Financial Accounting Standards Board issued SFAS 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS 144
addresses financial accounting and reporting for the impairment or disposal of
long-lived assets. This Statement supercedes SFAS 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and
the accounting and reporting 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", both of which address the disposal of a segment of a business.
The provisions of SFAS 144 are effective for financial statements issued for
fiscal years beginning after December 15, 2001 and interim periods within those
fiscal years, with early application encouraged. The Company is currently
evaluating the impact of the adoption of this Statement but does not believe it
will have a material impact on the Company's net income, cash flows, or
financial condition.
Item 7A. Quantitative And Qualitative Disclosures About Market Risk
The Company's financial instruments with market risk exposure are revolving
credit borrowings under its Debt Agreements that total $60.2 million at December
31, 2001. Based on this balance, a change of one percent in the interest rate
would cause a change in interest expense of approximately $602,000, or