ITEM 3. LEGAL PROCEEDINGS
On December 10, 1996, Orthodontic Centers of America, Inc. ("OCA") filed a complaint in the United States District Court for the Eastern District of Louisiana against the Company, Dr. Vondrak, John G. Vondrak, P.C. and JGVAOI, alleging, among other things, misappropriation of trade secrets and certain breaches of a confidentiality agreement executed by Dr. Vondrak, on behalf of John G. Vondrak, P.C., in favor of OCA. While the Company is not a party to the confidentiality agreement, OCA alleged that the Company should be bound by its terms as a result of the relationship between Dr. Vondrak and the Company (specifically, OCA alleged that Dr. Vondrak and Apple are alter egos and, alternatively, that Dr. Vondrak was acting as the Company's agent when he executed the confidentiality agreement). OCA's complaint stated that OCA was seeking monetary damages in excess of $75,000. In August 1997, the court dismissed OCA's claims without prejudice on the grounds that the court lacked jurisdiction. There can be no assurance that OCA will not seek to overturn the court's decision or file a similar suit in another jurisdiction.
In August 1997, the Company filed a declaratory judgment action in the District Court of Harris County, Texas (164th Judicial District) seeking a finding by the court that neither the Company nor Dr. Vondrak has violated the terms of the confidentiality agreement, otherwise used confidential information supplied by OCA or unfairly competed against OCA. In October 1997, OCA filed an answer generally denying the Company's allegations, as well as asserting a counterclaim against the Company, JGVAOI, Apple Orthodontix of Texas, Inc., Apple Acquisition of Texas, Inc., Dr. Vondrak, John G. Vondrak, P.C., one of the Founding Affiliated Practices and the orthodontist associated with such practice. OCA's counterclaim alleges, among other things, unfair competition, misappropriation of trade secrets, tortious interference with prospective contractual arrangements and certain breaches of confidentiality agreements executed by each of Dr. Vondrak, on behalf of John G. Vondrak, P.C., and the affiliated orthodontist, on behalf of the Founding Affiliated Practice referred to above, in favor of OCA. While the Company is not a party to these confidentiality agreements, OCA alleged that the Company should be bound by their terms as a result of the relationships between Dr. Vondrak, the affiliated orthodontist and the Company (specifically, OCA alleged that Dr. Vondrak and the Company are alter egos and that the Company and abetted or conspired with Dr. Vondrak and the affiliated orthodontist in their wrongful conduct). OCA's complaint states that it is seeking monetary damages in excess of the minimum jurisdictional limits of the court, punitive damages, injunctive relief, prejudgment interest and attorneys' fees. The Company intends to vigorously defend the claims made by OCA, which the Company believes are without merit. This lawsuit is still pending, and the Company cannot predict whether it will succeed in obtaining the declarations sought from the court or, if it is not successful, what effect this may have on the Company.
In November 1997, the Company received notice that an acquaintance of Dr. Vondrak, Mr. Donald Rose, was threatening to sue the Company, JGVAOI, Dr. Vondrak and John G. Vondrak, P.C., alleging, among other things, certain breaches of an alleged oral agreement with Dr. Vondrak pursuant to which Dr. Vondrak was to award Mr. Rose 10% of any stock issued to Dr. Vondrak in the IPO in exchange for Mr. Rose's effort to obtain venture capital for the Company. On January 8, 1998, Dr. Vondrak filed a declaratory judgement action in the District Court of Harris County, Texas (269th Judicial District) seeking a finding by the court that Mr. Rose was not entitled to any of Dr. Vondrak's stock or any other remuneration. Mr. Rose has filed a special appearance challenging jurisdiction and a general denial. The Company is not a party to the declaratory judgement action filed by Dr. Vondrak. While the Company was not a party to the alleged oral agreement, Mr. Rose maintains that the Company should be bound by its terms as a result of the relationship between Dr. Vondrak and the Company. Although the Company believes that these allegations are without merit, there can be no assurance that a lawsuit will not be filed and, if filed, that the Company will obtain a successful outcome.
The Company is not currently a party to any other claims, suits or complaints relating to services and products provided by the Company or the existing Affiliated Practices, although there can be no assurance that such claims will not be asserted against the Company in the future. The Company is subject to certain pending claims as a result of successor liability in connection with its affiliations with existing Affiliated Practices; however, the Company believes that the ultimate resolution of those claims will not have a material adverse effect on the financial position or operating results of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Prior to the closing of the IPO, the stockholders of the Company approved a number of matters during the period covered by this Annual Report on Form 10-K. On April 24, 1997, the stockholders approved by unanimous written consent (i) the amendment and restatement of the Company's Certificate of Incorporation to, among other things, (A) increase the number of authorized shares of capital stock to 39,106,852 shares, consisting of 25,000,000 shares of Class A Common Stock, 4,106,852 shares of Class B Common Stock, par value $.001 per share (the "Class B Stock") and 10,000,000 shares of Preferred Stock, (B) change the par value of Common Stock to $.001 per share and (C) reclassify each outstanding share of Common Stock into 4,012.556913 shares of Class B Stock; and (ii) the adoption of the Company's 1996 Stock Option Plan. On May 18, 1997, the stockholders approved by unanimous written consent a certificate of amendment to the Company's Restated Certificate of Incorporation providing for the reclassification of each issued and outstanding share of Class B Stock into 0.815 shares of Class B Stock.
ITEM S-K 401(b). EXECUTIVE OFFICERS OF THE REGISTRANT
Pursuant to Instruction 3 to Item 401(b) of Regulation S-K and General Instruction G(3) to Form 10-K, the following information is included in Part I of this Form 10-K.
The following table sets forth the names, ages (as of March 15, 1998) and positions of the Company's executive officers and key employees:
NAME AGE POSITION ---- --- -------- John G. Vondrak, D.D.S..... 57 Chairman of the Board and Chief Executive Officer Robert J. Syverson......... 49 President and Chief Operating Officer
Michael W. Harlan.......... 37 Vice President and Chief Financial Officer
H. Steven Walton........... 40 Vice President of Business Development
W. Daniel Cook............. 43 Chief Administrative Officer and a Director
LeeAnn Peniche (1)......... 37 Vice President of Training and Marketing - -------------------- (1) Key Employee.
The executive officers of the Company are elected annually by the Board of Directors of the Company and serve at the discretion of the Board.
JOHN G. VONDRAK, D.D.S. is the founder of the Company and has been Chairman of the Board of Directors and Chief Executive Officer of the Company since October 1996 and has served as a director of the Company since July 1996. Dr. Vondrak has been the President and sole shareholder of JGVAOI, one of the Founding Affiliated Practices, for more than the past five years. Dr. Vondrak is a licensed dentist, a graduate of an American Dental Association accredited orthodontic program and maintained a private orthodontic practice for over 24 years. He is a member of the American Association of Orthodontists and the Southwest Society of Orthodontists and has served as President of the New Mexico Orthodontic Society (1979).
ROBERT J. SYVERSON has been President of the Company since November 1996 and Chief Operating Officer of the Company since October 1996. From July 1996 through October 1996, Mr. Syverson served as a consultant to the Company on operational and financial matters. From February 1979 through April 1996, Mr. Syverson held various executive positions in the finance operations and sales departments of "A" Company Orthodontics, a manufacturer and supplier of orthodontic materials. Positions included Vice President of Finance, Vice President of Operations, Vice President of International Sales and, most recently, Executive Vice President of Sales. "A" Company Orthodontics was an affiliate of Johnson & Johnson from April 1982 through June 1994. Prior thereto, Mr. Syverson held various positions with Coopers & Lybrand as a certified public accountant, where he was a manager from July 1977 through January 1979.
MICHAEL W. HARLAN has been Vice President and Chief Financial Officer of the Company since March 1997. From December 1996 to February 1997, Mr. Harlan served as a consultant to the Company on financial and accounting matters. From April 1991 through December 1996, Mr. Harlan held various positions in the finance and acquisition departments of Sanifill, Inc., an international environmental services company that was acquired by USA Waste Services, Inc. in 1996. He served as the Treasurer of Sanifill, Inc. beginning in September 1993. While at Sanifill, Inc., Mr. Harlan participated in numerous acquisitions and was actively involved in raising public and private capital. From May 1982 through April 1991, Mr. Harlan held various positions in the tax and corporate financial consulting services division of Arthur Andersen LLP, where he had been a manager since July 1986. Mr. Harlan is a certified public accountant.
H. STEVEN WALTON has served as Vice President of Business Development since June 1997 and served as Vice President of Acquisitions from March 1997 to June 1997. From June 1994 to February 1997, Mr. Walton served as Vice President--Government Affairs and General Counsel of Sanifill, Inc., which was acquired by USA Waste Services, Inc. in 1996, and then as Vice President of Business Development of USA Waste Services, Inc. Before joining Sanifill, Mr. Walton was Senior Vice President and General Counsel of Catalyst Energy Corporation, an independent power company, and then Of Counsel to the law firm Blackwell, Sanders, Matheny, Weary & Lombardi, Kansas City, Missouri. While at Sanifill, USA Waste Services, Inc. and Catalyst Energy Corporation, Mr. Walton negotiated and closed numerous acquisitions.
W. DANIEL COOK has served as a director of the Company since October 1996 and as Chief Administrative Officer since February 1997. From December 1996 to January 1997, Mr. Cook served as a consultant to the Company on various legal matters. Prior thereto he was a partner at the law firm of Breard, Raines & Cook, P.L.L.C. (1996 to 1997) and was associated with the law firm of Page, Mannio, Peresich, Dickinson & McDermott, P.L.L.C. (1991 to 1995).
LEEANN PENICHE has been Vice President of Training and Marketing since June 1997. Prior to that time, she served as Director of Training of the Company beginning in March 1997. From September 1996 to February 1997, Ms. Peniche served as a consultant to the Company on various practice development matters. In July 1989, Ms. Peniche founded Peniche & Associates, Inc., a consulting firm specializing in the development and implementation of practice development techniques for orthodontic practices throughout North America, where she has served as its President from inception to the date of the IPO. From January 1985 until September 1991, Ms. Peniche was on the faculty of Paradigm Practice Management Company, where she specialized in training orthodontists and their staff in practice development activities. Ms. Peniche is a frequent lecturer with the American Association of Orthodontics, the Pacific Coast Orthodontic Society and numerous other private orthodontic societies. Ms. Peniche is a Registered Dental Assistant, specializing in orthodontics.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
(a) The Company's authorized common stock consists of 25,000,000 shares of Common Stock, par value $.001 per share, and 4,106,852 shares of Class B Stock.
The Company's Common Stock has been publicly traded on the American Stock Exchange under the symbol AOI since the Company's IPO offering on May 22, 1997. The following table sets forth the quarterly high and low sales prices for the indicated quarter of fiscal 1997:
QUARTER ENDED HIGH LOW ------------- ---- --- June 30, 1997 $ 12 15/16 $ 7 3/8 (partial quarter commencing May 22, 1997)
September 30, 1997 16 1/4 9
December 31, 1997 16 1/16 10
The Company's Class B Stock is not publicly traded.
There were approximately 106 shareholders of record (including brokerage firms and other nominees) of the Company's Common Stock as of March 24, 1998. The number of record holders does not bear any relationship to the number of beneficial owners of Common Stock.
The Company has never paid any cash dividends and does not anticipate paying cash dividends on its Common Stock or Class B Stock in the foreseeable future. The Company currently intends to retain earnings to support operations and finance expansion. In addition, the Company's existing credit facility prohibits the payment of dividends.
RECENT SALES OF UNREGISTERED SECURITIES
The following information relates to securities of the Company issued or sold during 1997 which were not registered under the Securities Act:
In April 1997, each outstanding share of Common Stock was reclassified into 4,012.5569 shares of Class B Stock (the "Stock Split"), which was subsequently readjusted in May 1997 with the net effect of a 3,270-for-one split. The Stock Split and adjustment were exempt from the registration requirements of the Securities Act as they did not involve a "sale," as defined in Section 2(3) of the Securities Act.
Simultaneously with the completion of its IPO, the Company issued 3,682,554 shares of Common Stock in connection with the acquisitions of the Founding Affiliated Practices. These issuances were exempt from the registration requirements of the Securities Act by virtue of Section 4(2) thereof as transactions not involving any public offering.
Each share of Class B Stock will automatically convert to Common Stock on a share-for-share basis (i) in the event of a disposition of such share of Class B Stock by the holder thereof (excluding dispositions to such holder's affiliates), (ii) in the event any person not affiliated with the Company acquires beneficial ownership of 15% or more of the outstanding shares of capital stock of the Company, (iii) in the event any person not affiliated with the Company offers to acquire beneficial ownership of 15% or more of the outstanding shares of capital stock of the Company, (iv) in the event the holder of such share elects to so convert at any time after the second anniversary of the date of the IPO, (v) on the fifth anniversary of the date of the IPO or (vi) in the event the holders of a majority of the outstanding shares of Common Stock approve such conversion. In addition, the Company may elect to convert any outstanding shares of Class B Stock into shares of Common Stock in the event 80% or more of the outstanding shares of Class B Stock as of the date of the IPO have previously been converted into shares of Common Stock.
(b) Use of Proceeds.
The Company's Registration Statement on Form S-1 (Registration No. 333-22785), as amended, with respect to the offering of shares in the IPO was declared effective by the Securities and Exchange Commission (the "Commission") on May 14, 1997. The IPO commenced on May 22, 1997, and has since terminated, resulting in (i) the sale by the Company of 2,350,000 shares of Common Stock on May 22, 1997 and (ii) the sale by the Company of 352,500 shares of Common Stock pursuant to the exercise of the underwriters' over-allotment option on May 27, 1997. The shares sold constituted all the shares of Common Stock covered by the Registration Statement. The managing underwriters for the IPO were Bear, Stearns & Co. Inc. and Equitable Securities Corporation. The aggregate price to the public for the shares sold in the IPO was $18.9 million. The Company incurred total expenses of $6.8 million with respect to the IPO, including $1.3 million in underwriting discounts and commissions paid by the Company and $5.5 million in other expenses. The amount of other expenses is a reasonable estimate of such amount. None of such payments was a direct or indirect payment to directors or officers of the Company or their associates, to persons owning 10% or more of any class of equity securities of the Company or to affiliates of the Company, other than $3.0 million to repay certain transaction costs advanced by TriCap Funding I, L.L.C and approximately $500,000 in consulting fees paid to TriCap Partners, an affiliate of TriCap Funding I, L.L.C., which was co-owned by Mr. William W. Sherrill, a director of the Company.
The net proceeds to the Company from the IPO were $12.1 million. The Company used such net proceeds as follows: (i) $6.6 million for a special dividend to the Founding Affiliated Practices and (ii) $5.5 million for affiliations with additional orthodontic practices. None of such payments was a direct or indirect payment to directors or officers of the Company or their associates, to persons owning 10% or more of any class of equity securities of the Company or to affiliates of the Company, other than approximately $525,000 paid to Dr. John G. Vondrak, Chairman of the Board and Chief Executive Officer of the Company, for the affiliation of Dr. Vondrak's orthodontic practice with the Company and the reimbursement of certain organizational expenses of the Company incurred by such practice.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information set forth below for the year ended December 31, 1997 and for the period from inception of operations (July 15, 1996) through December 31, 1996 is derived from the audited consolidated financial statements of the Company included elsewhere in this Report. The Company believes that comparison of results for 1997 periods to those for 1996 periods is not meaningful because the Company was effectively not in operation in 1996.
- ------------ (1) Reflects management service fees for the Founding Affiliated Practices since June 1, 1997. Management service fees related to affiliations subsequent to the IPO are included from the date of such affiliation.
(2) Corporate office expenses are included for all periods presented.
(3) Reflects non-recurring charges related to shares issued to management and advisors of the Company in October and December 1996, at $7.00 per share.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is management's discussion and analysis of certain significant factors that have affected certain aspects of the Company's financial position and results of operations during the periods included in the accompanying consolidated financial statements. This discussion should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto presented elsewhere in this Report.
OVERVIEW
The Company conducted no significant operations before its IPO in May 1997 when the Company acquired the tangible and intangible assets and liabilities of, and entered into Service Agreements with, the 31 Founding Affiliated Practices. Since that time, through December 31, 1997, the Company has affiliated with an additional 20 practices and 35 orthodontists operating in 39 offices. The Company expects that its future growth will come from (i) implementing a comprehensive practice operating approach designed to drive internal growth of the Affiliated Practices, (ii) entering into Service Agreements with new Affiliated Practices and (iii) developing new orthodontic centers, including satellite offices (branch locations of existing Affiliated Practices), with existing and future Affiliated Practices.
Through its Service Agreements, the Company provides a full complement of practice management services to Affiliated Practices in return for management service fees. The management service fees earned by the Company are in accordance with three general types of Service Agreements -- the Standard Contract, the Alternative Contract and the Flat Fee Contract. The Standard Contract calls for a calculation of the monthly service fee based on the total patient revenues earned by the Affiliated Practice, which is defined by the agreement to represent 24% of the total contract value in the initial month of a patient's treatment, with the remainder of the contract balance earned evenly over the balance of the contract term. From total patient revenues, the practices retain a percentage of the Affiliated Practices' cash collections.
The Alternative Contract is used in certain jurisdictions where use of the Standard Contract is not permitted. It is a cost-plus fee arrangement, whereby the service fee includes the reimbursement of defined expenses incurred by the Company in the course of providing services to the Affiliated Practice plus a percentage of revenues. The Flat Fee Contract is based on a flat fee that is subject to adjustment on an annual basis. It is used when local jurisdictions do not allow use of the Standard Contract or the Alternative Contract. The Company believes the fees generated by each of these formulas reflect the fair market value of the services provided and are comparable to the fees earned by other practice management service companies in the respective jurisdictions where these arrangements exist. See "Items 1 and 2. Business and Properties -- Service Agreements."
The expenses incurred by the Company in fulfilling its obligations under the Service Agreements are generally of the same nature as the operating costs and expenses that would have otherwise been incurred by the Affiliated Practices, including salaries, wages and benefits of practice personnel (excluding orthodontists and, in some cases, orthodontic assistants and other professional personnel), orthodontic supplies and office supplies used in administering their clinic practices, the office (general and administrative) expenses of the practices and depreciation and amortization of assets acquired from the existing Affiliated Practices. In addition to the operating costs and expenses discussed above, the Company incurs personnel and administrative expenses in connection with establishing and maintaining a corporate office, which provides management, administrative, marketing and business development services.
The Company's results of operations may fluctuate significantly from quarter to quarter or year to year. Results may fluctuate due to a number of factors, including the timing of future affiliations and new office openings, seasonal fluctuations in the demand for orthodontic services and competitive factors. Accordingly, quarterly comparisons of the Company's revenues and operating results should not be relied on as an indication of future performance, and the results of any quarterly period may not be indicative of results to be expected for a full year.
The securities markets have, from time to time, experienced significant price and volume fluctuations that may be unrelated to the operating performance of particular companies. These fluctuations often substantially affect the market price of a company's common stock. The market prices for securities of physician practice management companies have been, and can in the future be expected to be, particularly volatile. The market price of the Common
Stock may be subject to volatility from quarter to quarter depending on announcements regarding the Affiliated Practices and the Company's ability to open new offices, affiliations by the Company or its competitors, government relations, developments or disputes concerning proprietary rights, changes in health care policy in the United States and Canada, the issuance of stock market analyst reports and recommendations, and economic and other external factors beyond the control of the Company, as well as operating results of the Company and fluctuations in the Company's financial results.
In accordance with Staff Accounting Bulletin ("SAB") No. 48, "Transfers of Nonmonetary Assets by Promoters or Shareholders," published by the Commission, the acquisition of the assets and assumption of certain liabilities for all the Founding Affiliated Practices has been accounted for by the Company at the transferors' historical cost basis, with the shares of Common Stock issued in those transactions being valued at the historical cost of the nonmonetary assets acquired net of liabilities assumed. The cash consideration paid at closing on May 29, 1997 is reflected as a dividend by the Company to the owners of the Founding Affiliated Practices in the quarter ended June 30, 1997. SAB No. 48 is not applicable to affiliations made by the Company subsequent to the IPO. The Company's subsequent acquisitions of certain of the assets and liabilities of Affiliated Practices has resulted and will continue to result in substantial noncash amortization charges for intangible assets in the Company's statements of operations.
RESULTS OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 1997 AND THE PERIOD FROM INCEPTION (JULY 15, 1996) THROUGH DECEMBER 31, 1996
MANAGEMENT SERVICE FEE REVENUES
The Company generated management service fee revenues of $19.2 million for the year ended December 31, 1997. The Company conducted no significant operations during 1996 through the date of the IPO. Following completion of the IPO and the affiliations with the Founding Affiliated Practices on May 29, 1997, the Company began operations effective June 1, 1997. Therefore, management service fee revenues reflect only seven months of operations during the year ended December 31, 1997 and there were no management service fee revenues during the year ended December 31, 1996.
COSTS AND EXPENSES
The Company incurred costs and expenses of $18.0 million (93.6% of service fee revenues) for the year ended December 31, 1997. The Company's costs and expenses consisted primarily of salaries and benefits, orthodontic supplies, rent, advertising and marketing, general and administrative and depreciation and amortization. Costs and expenses of $24.3 million for 1996 represented corporate office expenses for the period from inception (July 15, 1996) through December 31, 1996. Of the $24.3 million of costs and expenses for the period ended December 31, 1996, $23.4 million related to the valuing of stock issued to founders, management and advisors of the Company in October and December 1996 at the initial public offering price of $7.00 per share. This valuation resulted in special compensation expense of $13.8 million and special consulting expense of $9.6 million, with a corresponding increase in additional paid-in capital of $23.4 million. There was no net effect on stockholders' equity. The Company also incurred various legal, accounting, travel, personnel and marketing costs during the period from inception (July 15, 1996) through December 31, 1996 in connection with the IPO and the affiliations with the Founding Affiliated Practices.
OPERATING INCOME
The Company generated operating income of $1.2 million for the year ended December 31, 1997. This operating income amount comprised 6.4% of service fee revenues for the period. The Company generated an operating loss of $24.3 million for the year ended December 31, 1996, which was primarily attributable to the compensation and consulting charges described above. As stated above, these results reflect the impact of the Company's Service Agreements only for the period from June 1, 1997 through December 31, 1997 (i.e., the period subsequent to the IPO) for the Founding Affiliated Practices and from the date of affiliation through December 31, 1997 for all subsequent affiliations. General and administrative expenses were incurred during the entire period from inception (July 15, 1996) through May 29, 1997 in connection with the IPO and the affiliation with the Founding Affiliated Practices.
INTEREST EXPENSE
Interest expense of $273,506 for the year ended December 31, 1997 reflected the cost of borrowings under the Company's revolving credit facility entered into on July 28, 1997, certain indebtedness of the Founding Affiliated Practices that was assumed by the Company and certain capital lease obligations for computer and office equipment. There was no interest expense incurred during the year ended December 31, 1996.
INTEREST INCOME
Interest income of $190,669 for the year ended December 31, 1997 reflected interest earned on the Company's net proceeds from the IPO and on notes receivable from certain of the Founding Affiliated Practices. There was no interest income generated during the year ended December 31, 1996.
INCOME TAX PROVISION
The Company incurred an income tax provision of $439,282 for the year ended December 31, 1997, representing an effective tax rate of 38%. The Company incurred no income taxes for the period ended December 31, 1996. The benefit of the net operating loss generated during 1996 was fully reserved.
NET INCOME (LOSS)
As a result of the foregoing factors, the Company generated net income of $716,725 for the year ended December 31, 1997, or earnings per share of $0.09. This net income amount comprised 3.7% of service fee revenues for the period. The net loss of $24.3 million for 1996 represented a loss per share of $7.24.
YEAR 2000 IMPACT ON INFORMATION TECHNOLOGY INFRASTRUCTURE
During 1997, the Company completed a comprehensive evaluation of its information technology infrastructure to analyze the impact of the technical problems anticipated for the year 2000. Following its evaluation, the Company determined that substantially all its information technology infrastructure would be unaffected by such problems and that the financial impact of the year 2000 on the Company's information technology infrastructure would be negligible.
LIQUIDITY AND CAPITAL RESOURCES
FINANCING ACTIVITIES
The Company has financed its capital requirements to date with borrowings from banks and issuances of equity securities. To date, it has been able to obtain satisfactory financing for its operations and believes that it will be able to obtain such financing as it requires in the future. On July 28, 1997, the Company entered into a three-year, $15.0 million revolving credit facility with Chase Bank of Texas, N.A. (the "Chase Facility"). Availability under the Chase Facility is tied to the Company's cash flow and liquidity. Advances under the Chase Facility bear interest, at the Company's option, at prime rate or LIBOR, in each case plus a margin calculated based on the Company's ratio of indebtedness to cash flow. At December 31, 1997, the Company had no borrowings drawn under this facility.
In May 1997, the Company issued and sold 2,702,500 shares of Common Stock in its IPO. The IPO provided the Company with net proceeds of $12.1 million. The Company used the net proceeds from the IPO to fund cash paid for affiliations with the Founding Affiliated Practices of $6.6 million with the remainder funding affiliations with additional practices. In November 1997, the Company issued and sold 1,490,014 shares of Common Stock in a public offering (the " Offering"). The Offering provided the Company with net proceeds of $15.3 million. The Company has used the proceeds of the Offering to repay $12.2 million under the Chase
Facility, to affiliate with additional orthodontists, to develop new offices, for capital expenditures and for general corporate purposes.
Total long-term debt increased from zero at December 31, 1996, to $247,624 at December 31, 1997. The increase is attributable to borrowings for affiliations with new orthodontic practices, the purchase of property and equipment and general working capital needs, net of repayment of borrowings under the Chase Facility out of the proceeds of the Offering. The Company's weighted average cost of indebtedness was 8.7% per annum for the year ended December 31, 1997.
WORKING CAPITAL MANAGEMENT
The Company's strategy in managing its working capital is to maintain sufficient availability under its bank credit facility to finance short-term capital needs in excess of internally generated funds and minimize excess cash on its balance sheet.
The cash and cash equivalents balance of $2.1 million at December 31, 1997 consisted primarily of net proceeds remaining from the Offering.
The restricted cash balance of $2.1 million at December 31, 1997 consisted of borrowings under the Company's revolving credit facility which were placed into escrow pending the resolution of certain post-closing contingencies related to a new affiliation completed during the third quarter of 1997. A favorable resolution of these post-closing contingencies would result in payment of the $2.1 million to the sellers in January 1999. The Company has the right to post a letter of credit in order to have the $2.1 million released from escrow to the Company prior to January 1999.
CAPITAL EXPENDITURES
The Company made capital expenditures for the Affiliated Practices during 1997 of approximately $3.6 million to fund, among other things, the development of new offices. The average cost of developing a new office (which may vary by geographic market) is estimated to be approximately $250,000 to $400,000, including initial working capital requirements. The Service Agreements provide for advances by the Company to the Affiliated Practices for working capital requirements (including any deficits in cash flows of Affiliated Practices resulting from, among other factors, development of satellite offices) and other purposes. Such loans bear interest at prime plus 1% and are repayable over varying periods of time not to exceed five years. Total notes receivable from Affiliated Practices were $1.6 million at December 31, 1997. It is anticipated that capital expenditures in 1998 will be funded from the Company's cash flow from operations, the net proceeds from the Offering and borrowings under the Chase Facility.
The Company's expansion strategy requires substantial capital resources. Capital is needed not only for the affiliation with future Affiliated Practices, but also for the effective integration, operation and expansion of the existing and future Affiliated Practices. In addition, the Affiliated Practices may from time to time require capital for renovation and expansion and for the addition of equipment and technology. The extent to which the Company is able or willing to use shares of Common Stock to enter into future affiliations or provide future financing will depend on the market value of the Common Stock from time to time and, in the case of affiliations, the willingness of owners of potential Affiliated Practices to accept Common Stock as full or partial payment of consideration for their affiliations. Using shares of Common Stock for these purposes may result in significant dilution to then-existing stockholders. The Company will require additional capital from outside financing sources in order to continue its expansion program. There can be no assurance that the Company will be able to obtain additional funds when needed on satisfactory terms or at all. Any limitation on the Company's ability to obtain additional financing could have a material adverse effect on the Company's business, financial condition and results of operations.
BUSINESS DEVELOPMENT
The Company's business development program also requires significant amounts of capital. The amount of cash to be used in attracting the affiliation of new Affiliated Practices, particularly the amount to be used in any given
period, depends on a number of factors, many of which are beyond the Company's control. The Company anticipates the use of a combination of cash, notes and shares of its Common Stock to fund the cost of additional affiliations. In order to fund such additional affiliations, the Company will use cash flow from operations, net proceeds from the Offering and borrowings under the Chase Facility and will seek to raise capital through additional bank borrowings and public or private debt or equity issuances. The availability of these capital sources will depend on prevailing market conditions, interest rates and the then existing financial condition of the Company. During the year ended December 31, 1997, the Company spent $8.7 million of cash (including $321,000 in deferred payments and $1.5 million in related out-of-pocket costs) and issued 1.9 million shares of Common Stock in connection with affiliations with new Affiliated Practices.
AFFORDABLE PAYMENT PLANS
A part of the Company's business strategy is to encourage Affiliated Practices to offer more affordable payment plans to patients. The Company does not expect the affordable payment plans, or any potential increase in bad debt expense resulting from these plans, to have any significant negative impact on the working capital or liquidity of the Affiliated Practices. Existing Affiliated Practices using such payment plans have experienced an initial decrease in working capital; however, the Company believes that the decrease in working capital generally will be offset by an increase in the number of patients receiving orthodontic treatment because of the combined effect of advertising, offering more affordable payment plans and the use of the Company's practice-building program. Moreover, the Company believes the existing Affiliated Practices have the financial wherewithal to sustain any negative impact that may result from these payment plans. Therefore, the Company does not anticipate that the offering by the Affiliated Practices of more affordable payment plans will impair the Company's ability to collect service fees from the Affiliated Practices.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of Apple Orthodontix, Inc.:
We have audited the accompanying consolidated balance sheets of Apple Orthodontix, Inc., a Delaware corporation, and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, changes in stockholders' equity (deficit) and cash flows for the year ended December 31, 1997 and the period from inception, July 15, 1996, through December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Apple Orthodontix, Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the year ended December 31, 1997 and the period from inception, July 15, 1996, through December 31, 1996, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Houston, Texas February 25, 1998
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
PERIOD FROM INCEPTION (JULY 15, 1996) YEAR ENDED THROUGH DECEMBER 31, DECEMBER 31, 1997 1996 ------------ ------------
Management service fee revenues ....................... $ 19,185,550 $ -- Costs and expenses: Salaries and benefits ....... 8,411,032 627,476 Orthodontic supplies ........ 2,351,786 -- Rent ........................ 2,155,876 19,676 Advertising and marketing ... 483,973 -- General and administrative .. 3,616,596 232,232 Depreciation and amortization 943,437 4,510 Special compensation expense related to issuance of stock ......... -- 13,812,681 Special consulting expense related to issuance of stock ......... -- 9,612,803 ------------ ------------ Total costs and expenses ............... 17,962,700 24,309,378 ------------ ------------ Operating income (loss) .. 1,222,850 (24,309,378)
Interest expense ............... 273,506 -- Interest income ................ (190,669) -- Other expense (income), net ... (15,994) -- ------------ ------------ Income (loss) before income tax provision ... 1,156,007 (24,309,378) Income tax provision ........... 439,282 -- ------------ ------------ Net income (loss) ........ $ 716,725 $(24,309,378) ============ ============ Earnings (loss) per common and common equivalent share: Basic ................... $ 0.09 $ (7.24) ============ ============ Diluted ................. $ 0.09 $ (7.24) ============ ============ Number of shares used in calculating earnings (loss) per common and common equivalent share Basic ................... 8,131,905 3,358,513 ============ ============ Diluted ................. 8,344,398 3,358,513 ============ ============
The accompanying notes are an integral part of these consolidated financial statements.
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)
The accompanying notes are an integral part of these consolidated financial statements.
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS AND ORGANIZATION
Apple Orthodontix, Inc. ("Apple" or the "Company") was founded in July 1996 to provide practice management services to orthodontic practices in the United States and Canada. On May 29, 1997, Apple acquired substantially all of the tangible and intangible assets and assumed certain of the liabilities of 31 orthodontic practices (collectively, the "Founding Affiliated Practices") in exchange for 3.7 million shares of its class A common stock, par value $.001 per share (the "Common Stock"), and $6.6 million (the "Acquisitions"). Simultaneous with the Acquisitions, Apple closed its initial public offering (the "IPO") of 2.7 million shares of Common Stock. The net proceeds of the Common Stock issued in the IPO (after deducting the underwriting discounts and commissions) were $17.6 million. Total related offering costs were $5.5 million.
Apple effectively began operations with the Founding Affiliated Practices on June 1, 1997. Apple has subsequently acquired the assets and assumed the liabilities of additional practices (the "New Orthodontist Affiliations"). The New Orthodontist Affiliations together with the Founding Affiliated Practices are collectively referred to as the "Affiliated Practices."
The acquisitions of the Founding Affiliated Practices have been accounted for in accordance with the Securities and Exchange Commission's Staff Accounting Bulletin ("SAB") No. 48. In accordance with SAB No. 48, the acquisition of the assets and assumption of certain liabilities for all of the Founding Affiliated Practices has been accounted for by the Company at the transferors' historical cost basis, with the shares of Common Stock issued in those transactions being valued at the historical cost of the nonmonetary assets acquired net of liabilities assumed. The cash consideration paid at closing on May 29, 1997, is reflected as a dividend by the Company to the owners of the Founding Affiliated Practices in the quarter ended June 30, 1997. SAB No. 48 is not applicable to affiliations made by the Company subsequent to the IPO.
The acquisitions of assets and liabilities of the New Orthodontist Affiliations are accounted for by allocating the fair market value of the consideration paid by Apple to the assets acquired, net of liabilities assumed, including intangible assets. As a result of this allocation process, the Company records a significant portion of the consideration as a service fee intangible. The service fee intangible has resulted and will continue to result in substantial noncash amortization charges for intangible assets in the Company's consolidated statements of operations.
2. SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated.
CASH AND CASH EQUIVALENTS
For purposes of the consolidated statements of cash flows, the Company considers all time deposits and certificates of deposit with original maturities of three months or less to be cash equivalents.
RECEIVABLE FROM ORTHODONTIC PRACTICES, NET
The Company grants credit to its customers (i.e. the Affiliated Practices), which are located in various geographic regions throughout the United States and Canada. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. The Company maintains an allowance for doubtful accounts at a level which management believes is sufficient to cover potential credit losses.
PROPERTY AND EQUIPMENT, NET
Property and equipment is stated at cost. Equipment under capital leases is stated at the net present value of the future minimum lease payments at the inception of the related leases. Depreciation of property and equipment is calculated using the straight-line method over the estimated useful lives of the assets. Routine maintenance and repairs are charged to expense as incurred, while costs of betterment and renewals are capitalized.
INTANGIBLE ASSETS, NET
Intangible assets consist primarily of service fee intangibles which are amortized over the life of the service agreement (ranging from 20 to 40 years) with the respective Affiliated Practice. Service fee intangibles represent the excess of the
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
costs of affiliation over the fair value of the net assets acquired. The costs of affiliation include the consideration paid to the owners of the Affiliated Practices, the incremental out-of-pocket costs incurred in connection with the affiliation and the direct costs related to the Apple employees who identify, evaluate, negotiate and close the affiliation. Such costs are recorded as other noncurrent assets until consummation of the affiliation. If an affiliation is not consummated, all such costs are expensed in the period in which the affiliation is abandoned. The Company's management periodically evaluates the realizability of the intangible assets on a practice by practice basis considering such factors as profitability and net cash flow. Should this evaluation result in an assessment that the value of the intangible asset is overstated, an adjustment will be made in the period that the adjustment is identified. If it is determined that the estimated remaining service period requires revision, that revision will be made on a prospective basis.
REVENUE RECOGNITION
The management service fee revenues (the "Service Fees") payable to the Company by the Founding Affiliated Practices under their Service Agreements with the Company (the "Service Agreements") vary based on the fair market value, as determined in arm's-length negotiations, for the nature and amount of services provided. Except with respect to Service Agreements providing for the payment of flat fees, the Service Fees earned by the Company are in accordance with the Company's two general types of Service Agreements. The Standard Contract calls for a calculation of the monthly Service Fee based on the total revenues earned by the Founding Affiliated Practices, which is defined by the agreement to represent 24% of the total contract value in the initial month of a patient's treatment with the remainder of the contract balance earned evenly over the balance of the contract term. From total revenues, the practices retain a percentage of the Founding Affiliated Practices' cash collections. There are adjustments to the service fee designed to both provide incentives for the orthodontists to provide efficient patient treatment and to increase the number of patients treated, as well as to ensure that the orthodontists retain a minimum amount for payment of their compensation from their respective practices on a monthly basis. The Alternative Contract is used in California. It is a cost plus fee arrangement, whereby the service fee includes the reimbursement of defined expenses incurred by Apple in the course of providing services to the Founding Affiliated Practice plus a percentage based on revenues.
GENERAL AND ADMINISTRATIVE COSTS
General and administrative costs include office expenses, professional fees, clerical and other administrative overhead.
INCOME TAXES
The Company recognizes deferred tax assets and liabilities for expected future tax consequences of events that have been recognized in the financial statements or tax returns. Deferred tax assets and liabilities are determined based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities using enacted tax rates and laws in effect in the years in which the differences are expected to reverse.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's financial instruments consist primarily of cash and cash equivalents, trade receivables, trade payables and debt instruments. The book values of each of these items are considered to be representative of their respective fair values.
NEW ACCOUNTING STANDARDS
In February 1997, the Financial Accounting Standards Board issued SFAS No. 128, "Earnings Per Share." This statement establishes new standards for computing and presenting earnings per share requiring the presentation of "basic" and "diluted" earnings per share as compared to "primary" and "fully diluted" earnings per share. The Company adopted SFAS No. 128 for the year ended December 31, 1997and restated its prior period earnings per share data.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires the use of estimates and assumptions by management in determining the reported amounts of liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates.
3. NEW ORTHODONTIST AFFILIATIONS
During the period from commencement of operations (June 1, 1997) through December 31, 1997, the Company completed New Orthodontist Affiliations with 21 practices representing 27 orthodontists and 37 office locations. In addition, eight orthodontists joined existing Affiliated Practices. The New Orthodontist Affiliations generated patient revenue of $23.2 million (unaudited)for their most recently completed fiscal year. Prior patient revenue is not necessarily indicative.
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
of the level of patient revenue that these practices may be expected to generate in the future and is not necessarily indicative of the future Service Fees that the Company will receive in conjunction with these affiliations.
Total consideration related to the New Orthodontist Affiliations is summarized as follows:
Cash $ 6,815,963 Deferred payments 321,054 Debt assumed 650,000 Common stock 14,114,552 ============ Total consideration $21,901,569 ============
In addition to the above consideration, the Company incurred out-of-pocket costs of $1.5 million related to entering into service agreements with the New Orthodontist Affiliations. The Company also placed $2.1 million into an escrow account pending the resolution of certain post-closing contingencies related to one of the New Orthodontist Affiliations closed during the third quarter of 1997. This $2.1 million is reflected as restricted cash on the accompanying consolidated balance sheet. A favorable resolution of these post-closing contingencies would result in payment of the $2.1 million to the sellers in January 1999. The Company has the right to post a letter of credit in order to have the $2.1 million released from escrow to the Company prior to January 1999. Upon the resolution of these contingencies beyond a reasonable doubt, the Company will record a liability for the consideration and allocate the consideration to the assets to be acquired, primarily intangibles.
The cost of each of the above New Orthodontist Affiliations has been allocated on the basis of the estimated fair market value of the assets acquired and liabilities assumed, resulting in gross service fee intangibles of $39.5 million. These allocations may be adjusted to the extent that management becomes aware of additional information within one reporting year of the affiliation date which results in a material change in the amount of any contingency or changes in the estimated fair market value of assets acquired and liabilities assumed.
4. PROPERTY AND EQUIPMENT
A summary of property and equipment is as follows:
USEFUL DECEMBER 31, LIVES IN ----------------------- YEARS 1997 1996 ----------- ---------- ---------- Equipment 5 $1,440,889 $ -- Furniture and fixtures 7 1,371,330 -- Computer software 5 1,310,521 -- Leasehold improvements 5 1,073,448 -- Construction in progress -- 831,250 -- Computer hardware 3 487,460 --
---------- ---------- 6,514,898 -- Less: accumulated depreciation (489,468) -- ========== ========== $6,025,430 $ -- ========== ==========
5. INTANGIBLE ASSETS
A summary of intangible assets is as follows:
DECEMBER 31, --------------------------- 1997 1996 ------------- ------------ Service fee intangible $ 39,482,835 $ -- Other 122,015 49,197 ------------- ------------ 39,604,850 49,197 Less: accumulated amortization (458,479) (4,510) ============= ============ $ 39,146,371 $ 44,687 ============= ============
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
6. LONG-TERM DEBT
A summary of long-term debt is as follows:
DECEMBER 31, --------------------------- 1997 1996 ------------- ------------
Unsecured revolving credit facility $ -- $ -- Notes payable, maturing in varying amounts through October 2002, with interest ranging from 7.5% to 9.25% 1,076,020 --
Capitalized lease obligations, due in monthly installments through April 2001, with interest ranging from 9.5% to 24.66% 194,314 -- ------------- ------------ 1,270,334 --
Less: current maturities 1,022,710 -- ------------- ------------ Long-term debt, net of current maturities $ 247,624 $ -- ============= ============
On July 28, 1997, the Company entered into a three-year, $15 million unsecured revolving credit facility with Chase Manhattan Bank. Advances under this facility bear interest, at the Company's option, at prime rate or LIBOR, in each case plus a margin which is calculated based upon the Company's ratio of indebtedness to cashflow. The Company is required to maintain certain financial covenants regarding net worth, coverage ratios and additional indebtedness.
The notes payable primarily relate to debts of the Affiliated Practices that were assumed by the Company.
Total assets recorded under capital leases and the accumulated depreciation thereon were $263,781 and $76,958 as of December 31, 1997, respectively. There were no capital leases at December 31, 1996.
Aggregate maturities of the notes payable and the future minimum payments under capital leases are as follow:
Year Ended December 31, ----------------------- 1998 $1,022,710 1999 142,252 2000 54,303 2001 34,383 2002 16,686 Thereafter -- ============ $ 1,270,334 ============
7. STOCKHOLDERS' EQUITY
COMMON STOCK
Holders of the Company's Class A common stock (the "Class A Stock") are entitled to one vote per share. Holders of the Company's Class B common stock (the "Class B Stock") are entitled to three-tenths (3/10ths) of a vote per share. The Class B Stock is convertible into Class A Stock in certain circumstances, including the disposition of shares of Class B Stock by the holder thereof (excluding dispositions to such holder's affiliates). During the year ended December 31, 1997, 170,310 shares of Class B Stock were converted into Class A Stock. Included in the 9,980,192 shares of Class A Stock at December 31, 1997 were 1,027,354 nonvoting exchangeable shares issued in connection with Canadian affiliations during 1997 which are exchangeable into shares of Class A Stock.
DIVIDENDS
With the exception of a special dividend paid to the Founding Affiliated Practices in connection with the Acquisitions (see Note 1), the Company has never paid cash dividends on its common stock and has no present intention to pay cash dividends. In addition, the Company's unsecured revolving credit facility prohibits the payment of cash dividends on its common stock. It is the Company's intention to retain earnings to finance the expansion of its business.
WARRANTS
In May 1997, the Company granted stock purchase warrants that entitled certain venture capital investors to purchase 180,000 shares of the Company's common stock at a price of $7.00 per share through May 2002. All of the warrant shares were vested at issuance. The warrants were recorded at their estimated value of $777,106 by applying the Black-Scholes option pricing model at the date of grant.
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
STOCK OPTION PLAN
The Company maintains an incentive compensation plan (the "Incentive Plan") which provides the ability to grant non-qualified options, restricted stock, deferred stock, incentive stock options, stock appreciation rights and other long-term incentive awards. Stock options are typically granted under the Incentive Plan at an exercise price which equals the fair market value of the stock on the date of the grant. The number of shares available for issuance under the Incentive Plan at any time is limited to the greater of 1.0 million shares of common stock or 12% of the number of shares of common stock outstanding on the last day of the preceding calendar quarter.
The Company issued options to purchase 922,550 shares and 0 shares during the years ended December 31, 1997 and 1996, respectively. No options were exercised during either of the two years ended December 31, 1997 or 1996. At December 31, 1997, options were outstanding at prices ranging from $3.00 to $15.25 per share, of which 225,925 were exercisable. All of the Company's options were issued at fair market value.
As allowed by SFAS No. 123, "Accounting for Stock-Based Compensation," the Company accounts for awards under its 1997 Stock Option Plan under Accounting Principles Board Opinion No. 25, under which no compensation cost has been recognized for stock options issued with exercise prices greater than or equal to the fair market value at the date of grant. Had compensation cost for these plans been determined consistent with SFAS No. 123, the Company's net loss and loss per share would have been reduced to the following pro forma amounts:
YEAR ENDED DECEMBER 31, --------------------------- 1997 1996 ------------- ------------ Net income (loss) As reported $ 716,725 $(24,309,378) ============= ============ Pro forma $ 591,637 $(24,309,378) ============= ============ Income (loss) per share As reported $ 0.09 $ (7.24) ============= ============ Pro forma $ 0.07 $ (7.24) ============= ============
During the year ended December 31, 1997, the Company issued options to purchase 28,000 shares to individuals other than employees and directors of the Company as consideration for the closing of New Orthodontist Affiliations. The fair value of these options was determined using the Black-Scholes option pricing model at the date of grant and capitalized as a cost of affiliation.
PROFIT SHARING PLAN
In 1997, the Company established a defined contribution 401(k) profit sharing plan for employees meeting certain employment requirements. Eligible employees may contribute amounts up to the lesser of 15% of their annual compensation or the maximum amount permitted under IRS regulations to their 401(k) account. The Company does not match any portion of employee contributions.
8. INCOME TAXES
The Company and its subsidiaries file a consolidated federal income tax return. Affiliated Practices file "short-period" federal returns through their respective acquisition dates and thereafter are included in the Company's consolidated return. The new practices established by the affiliating orthodontists file separate federal returns and are solely responsible for their tax liabilities on an ongoing basis.
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The amounts of consolidated federal and state income tax expense are as follows:
YEAR ENDED DECEMBER 31, --------------------------- 1997 1996 ------------- ------------ Current: Federal $ 298,361 $ -- State 52,652 -- ------------- ------------ 351,013 -- ------------- ------------ Deferred: Federal 79,782 -- State 8,487 -- ------------- ------------ 88,269 -- ============= ============ $ 439,282 $ -- ============= ============
A reconciliation of total income tax expense to the amounts calculated by applying the federal statutory tax rate is as follows:
YEAR ENDED DECEMBER 31, --------------------------- 1997 1996 ------------- ------------ Tax at statutory rate $ 393,382 $(300,524) Add (deduct): State income taxes 45,774 (26,516) Nondeductible expenses 27,166 -- Valuation allowance (27,040) 327,040 ============= ============ Income tax expense $ 439,282 $ -- ============= ============
The components of deferred income tax liabilities and assets are as follows:
YEAR ENDED DECEMBER 31, --------------------------- 1997 1996 ------------- ------------ Deferred income tax liabilities: Property and equipment $ (38,000) $ -- Intangibles (14,718,642) -- ------------- ------------ Total deferred income tax liabilities (14,756,642) -- ------------- ------------
Deferred income tax assets: Estimated tax basis resulting from affiliation with founding practices 300,000 -- Bad debt reserves 26,220 -- Accrued expenses 186,039 -- Net operating loss -- 327,040 Less: valuation allowance (300,000) (327,040) ------------- ------------ Total deferred income tax assets 212,259 -- ============= ============ Net deferred income tax liabilities $(14,544,383) $ -- ============= ============
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
9. EARNINGS PER SHARE
Earnings per common and common equivalent share have been computed based on the weighted average number of shares outstanding. The following table reconciles the number of common shares outstanding with the number of common shares used in computing earnings per share:
YEAR ENDED DECEMBER 31, ---------------------------- 1997 1996 ------------- ------------- Common shares outstanding 13,156,966 3,347,084 Effect of using weighted average common shares outstanding during the period (5,025,061) 11,429 ------------- ------------- Shares used in calculating basic earnings per share 8,131,905 3,358,513 Effect of shares issuable under stock option plans and warrant agreements based on the treasury stock method 212,493 -- ============= ============= Shares used in calculating diluted earnings per share 8,344,398 3,358,513 ============= =============
10. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental disclosures of cash flow information are as follows:
YEAR ENDED DECEMBER 31, -------------------------- 1997 1996 ------------ ----------- Interest paid during the period, net of capitalized interest $279,313 $ --
Income taxes paid during the period -- $ --
The Company acquired assets in capital lease transactions for $263,781 and $0 in 1997 and 1996, respectively.
11. COMMITMENTS AND CONTINGENCIES
The Company has entered into various non-cancelable operating lease agreements, primarily for facilities and equipment utilized for operations. Rental expense under operating leases was $1,801,944 and $19,676 in 1997 and 1996, respectively. Minimum future annual lease payments under these agreements are as follows:
Year Ended December 31, ----------------------- 1998 $2,086,462 1999 1,731,841 2000 1,480,489 2001 1,185,844 2002 743,002 Thereafter 1,215,345 ============ $8,442,983 ============
The Company has secured employment agreements with various officers and certain key employees of the Company. The agreements generally provide for the employee's annual base salary and bonus participation. The agreements also generally provide for one year non-competition agreements and severance payments of between one and three year's salary in the event the employee is terminated without cause.
The Company carries a broad range of insurance coverage, including general liability, comprehensive property damage, workers' compensation, employers' liability, directors' and officers' liability and other coverage customary in the industry. The Company and the existing Affiliated Practices maintain professional liability insurance coverage on a claims-made basis. Such insurance provides coverage for claims asserted when the policy is in effect, regardless of when the events that caused the claim occurred.
12. RELATED PARTY TRANSACTIONS
In 1996, the Company entered into an agreement with TriCap Funding I, L.L.C. ("TriCap"), which is co-owned by a director of the Company, whereby TriCap agreed to provide $3 million to finance costs related to the IPO. The $3 million, to the extent expended, was repaid out of proceeds from the IPO, including interest at a rate of prime plus 25 basis points. The Company also entered into an agreement with TriCap during 1996 that provided for the payment to TriCap of a $500,000 financial advisory fee and the issuance to TriCap of warrants to purchase 180,000 shares of common stock with an exercise price of $7.00 per share, each upon the consummation of the IPO.
The practice of a founding stockholder of the Company (the "Founding Stockholder") paid for certain costs and expenses
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
on behalf of the Company prior to the consummation of the IPO. The amount payable to the Founding Stockholder's practice at December 31, 1996 was $30,444 and was included in accounts payable and accrued expenses in the accompanying balance sheet. This amount was repaid with the proceeds from the IPO.
13. CONCENTRATIONS OF SERVICE FEE REVENUE
For the year ended December 31, 1997, 14% of the Company's revenues were derived from one Affiliated Practice, which was the only Affiliated Practice that provided 10% or more of revenues. For the year ended December 31, 1997, 25% of the Company's revenues were derived from Affiliated Practices in Canada.
14. COMBINED PATIENT DATA
Combined operating data for the Affiliated Practices for the period from initial affiliation through December 31, 1997 is as follows:
PATIENT CASH REVENUES COLLECTIONS ------------ ------------ Practices participating under the Standard Contract $14,891,945 $13,617,373 Practices participating under the Alternative Contract 4,095,918 3,982,313 Practices participating under flat fee agreements 6,054,841 6,054,841 ============ ============ $25,042,704 $23,654,527 ============ ============
Combined patient receivables, net of the Affiliated Practices as of December 31, 1997 is as follows:
Patient receivables $ 3,471,028 Unbilled patient receivables 3,443,896 Patient prepayments (2,410,327) -------------- Patient receivables, net of prepayments $ 4,504,597 ==============
15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER ---------- ----------- ----------- ---------- Management service fee revenues $ -- $1,685,957 $7,479,653 $10,019,940 Operating income (loss) (475,322) (609,521) 873,995 1,433,698 Net income (loss) (475,322) (192,962) 512,763 872,246 Basic earnings (loss) per share (0.14) (0.03) 0.05 0.07 Diluted earnings (loss) per share (0.14) (0.03) 0.05 0.07 Management service fee revenues $ -- $ -- $ -- $ -- Operating income (loss) -- -- (172,395) (24,136,983) Net income (loss) -- -- (172,395) (24,136,983) Basic earnings (loss) per share -- -- (0.05) (7.19) Diluted earnings (loss) per share -- -- (0.05) (7.19)
16. SUBSEQUENT EVENTS
Since December 31, 1997, nine additional orthodontists have affiliated with the Company. Five of these orthodontists had established practices, and four agreed to join Affiliated Practices. The additional orthodontists in established practices operate four locations and generated historical patient revenue of $1.9 million for their most recently completed fiscal year. Prior patient revenue is not necessarily indicative of the level of patient revenue that these practices may be expected to generate in the future and is not necessarily indicative of the future Service Fees that the Company will receive in conjunction with these affiliations. Total consideration to these new orthodontists consisted of 149,799 shares of common stock and $819,490 of cash, assumed debt and deferred purchase price.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is set forth under the captions "Election of Directors" and "Section 16(a) Reporting Delinquencies" will be set forth in the Company's definitive Proxy Statement (the "1998 Proxy Statement") for its 1998 annual meeting of shareholders, which sections are incorporated herein by reference.
Pursuant to Item 401(b) of Regulation S-K, the information required by this item with respect to executive officers of the Company is set forth in Part I of this Report.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item will be set forth in the section entitled "Executive Compensation" in the 1998 Proxy Statement, which section is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item will be set forth in the section entitled "Principal Stockholders" in the 1998 Proxy Statement, which section is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
The information required by this item will be set forth in the section entitled "Certain Transactions" in the 1998 Proxy Statement, which section is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) FINANCIAL STATEMENTS
Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 1997 and 1996
Consolidated Statements of Operations for the Year Ended December 31, 1997 and the period from inception (July 15, 1996) through December 31, 1996
Consolidated Statements of Changes in Stockholders' Equity (Deficit) for the Year Ended December 31, 1997 and the period from inception (July 15, 1996) through December 31, 1996
Consolidated Statements of Cash Flows for the Year Ended December 31, 1997 and the period from inception (July 15, 1996) through December 31, 1996
Notes to Consolidated Financial Statements
(a)(2) FINANCIAL STATEMENT SCHEDULES
All schedules and other statements for which provision is made in the applicable regulations of the Commission have been omitted because they are not required under the relevant instructions or are inapplicable.
(a)(3) EXHIBITS
EXHIBIT NUMBER DESCRIPTION ------ -----------
*3.1 -- Restated Certificate of Incorporation (Incorporated herein by reference to Exhibit 3.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
*3.2 -- Bylaws (Incorporated herein by reference to Exhibit 3.2 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
*4.1 -- Form of certificate evidencing ownership of Common Stock of Apple Orthodontix, Inc. (Incorporated herein by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
*4.2 -- Form of Registration Rights Agreement (Incorporated herein by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
*4.3 -- Registration Rights Agreement among Apple Orthodontix, Inc., John G. Vondrak, D.D.S. and TriCap Funding I, L.L.C. (Incorporated herein by reference to Exhibit 4.3 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
*4.4 -- Registration Rights Agreement between TriCap Partners, L.L.C. and Apple Orthodontix, Inc. (Incorporated herein by reference to Exhibit 4.4 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
*10.1 -- Revolving Credit Facility with Chase Bank of Texas, N.A.(formerly named "Texas Commerce Bank, N.A.")(Incorporated herein by reference to Exhibit 10.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-38817)).
+*10.2 -- Apple Orthodontix, Inc. 1997 Stock Compensation Plan (Incorporated herein by reference to Exhibit 10.2 of the Company's Registration Statement on Form S-1 (Registration No. 333-38817)).
*10.3 -- Form of Option Agreement for the Apple Orthodontix, Inc. 1997 Stock Compensation Plan (Incorporated herein by reference to Exhibit 10.3 of the Company's Registration Statement on Form S-1 (Registration No. 333-38817)).
+*10.4 -- Employment Agreement between Apple Orthodontix, Inc. and John G. Vondrak, D.D.S. (Incorporated herein by reference to Exhibit 10.2 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
+*10.5 -- Employment Agreement between Apple Orthodontix, Inc. and Robert J. Syverson (Incorporated herein by reference to Exhibit 10.3 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
+*10.6 -- Employment Agreement between Apple Orthodontix, Inc. and Michael W. Harlan (Incorporated herein by reference to Exhibit 10.4 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
+*10.7 -- Employment Agreement between Apple Orthodontix, Inc. and W. Daniel Cook (Incorporated herein by reference to Exhibit 10.5 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
+*10.8 -- Employment Agreement of H. Steven Walton (Incorporated herein by reference to Exhibit 10.7 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
+*10.9 -- Amendment to Employment Agreement of H. Steven Walton (Incorporated herein by reference to Exhibit 10.9 of the Company's Registration Statement on Form S-1 (Registration No. 333-38817)).
+*10.10 -- Second Amendment to Employment Agreement of H. Steven Walton (Incorporated herein by reference to Exhibit 99.2 of the Company's Current Report on Form 8-K dated February 24, 1998).
*10.11 -- Form of Service Agreement for Founding Affiliated Practices (Incorporated herein by reference to Exhibit 10.8 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
*10.12 -- Form of Alternative Service Agreement for Founding Affiliated Practices (Incorporated herein by reference to Exhibit 10.6 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
*10.13 -- Form of Flat Fee Service Agreement for Founding Affiliated Practices (Incorporated herein by reference to Exhibit 10.11 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)).
+*10.14 -- First Amendment to Employment Agreement of Robert J. Syverson (Incorporated herein by reference to Exhibit 99.1 of the Company's Current Report on Form 8-K dated February 24, 1998).
21.1 -- Subsidiaries of the Registrant.
23.1 -- Consent of Arthur Andersen LLP.
27.1 -- Financial Data Schedule. - ---------------- *Incorporated herein by reference as indicated
+Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to the requirements of Item 14(c) of Form 10-K.
(b) REPORTS ON FORM 8-K
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: March 27, 1998.
APPLE ORTHODONTIX, INC.
/s/ John G. Vondrak, D.D.S. ----------------------------- By: John G. Vondrak, D.D.S. Chairman of the Board and Chief Executive Officer
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.