ITEM 1. BUSINESS.
OVERVIEW
OrthAlliance, Inc., a Delaware corporation (together with its subsidiaries, the "Company"), was incorporated on October 21, 1996 and provides practice management and consulting services to orthodontic and pediatric dental practices throughout the United States. The Company (i) manages or provides consulting services with respect to certain business aspects of orthodontic and pediatric dental practices affiliated (the "Allied Practices") with the Company and (ii) provides capital for the development and growth of Allied Practices.
OrthAlliance's wholly-owned subsidiaries, incorporated in Delaware, include PedoAlliance, Inc. ("PedoAlliance") and OrthAlliance Finance, Inc. ("OA Finance") formed in December 1997, PedoAlliance Properties, Inc., a wholly-owned subsidiary of PedoAlliance, OrthAlliance Properties and OrthAlliance Services, Inc. were incorporated in California and were formed in April 1999, OrthAlliance Holdings, Inc., a Texas subsidiary, and OrthAlliance New Image, Inc. ("OA New Image") formed in January 2000. The subsidiaries were formed to provide practice management, patient financing, consulting and other services (collectively "Management Services") to allied orthodontic and pediatric dental practices (the "Allied Practices") or their patients. OA New Image was formed specifically in connection with the Company's acquisition of substantially all of the assets of New Image Orthodontic Group, Inc. "New Image," which was effective March 1, 2000. OrthAlliance, Inc. and its subsidiaries are collectively referred to as "OrthAlliance" or the "Company".
On August 26, 1997, the Company affiliated with 55 Allied Practices including 81 orthodontists and 1 pediatric dentist operating 147 offices in 16 states pursuant to long-term management service and consulting agreements, and commenced its initial operations. From August 26, 1997 to December 31, 2000, the Company increased the number of Allied Practices, including pediatric dental practices, to a net total of 175, with 225 orthodontists and pediatric dentists (collectively, "Allied Orthodontists or Allied Practitioners") operating 394 offices in 32 states. From May 1, 1998 through December 31, 2000, PedoAlliance entered into management and consulting agreements with 20 pediatric dental practices, with 29 allied pediatric dentists ("Allied Dentists") operating 24 offices in 8 states, all of which are included in the Company information set forth above. Unless the context indicates otherwise, certain references herein to Allied Orthodontists or Allied Practitioners also include Allied Dentists. OA Finance was formed in December 1997 to offer financing alternatives to the patients of the Allied Practices. During 2000, OA Finance funded 289 loans to patients for a total value of $.8 million and had $1.4 million of loans outstanding as of December 31, 2000.
The Company intends to continue to expand its network of Allied Practices and to target orthodontic and pediatric dental practices that management believes are leading practices in their markets based upon a variety of factors, including size, profitability, historical growth and reputation for high quality care among local consumers of orthodontic and pediatric dental services and within the orthodontic and pediatric dental services industry.
The Company provides fee-based management or consulting services to its Allied Practices thereby allowing Allied Orthodontists or Pediatric Dentists to concentrate on providing cost effective, quality patient care. The Company does not practice orthodontics or dentistry, but generally acquires certain operating assets of an orthodontic and pediatric dental practice, employs the practice staff and administrative employees (except orthodontists and dentists, and where applicable law requires, hygienists and dental assistants), and enters into service or consulting agreements with the Allied Practices whereby the Company also provides management or consulting services to the Allied Practices, including billing and collections, cash management, purchasing, inventory management, payroll processing, advertising and marketing, financial reporting and analysis, productivity reporting and analysis, training, associate orthodontist recruiting and capital for satellite office development and acquisitions. Where state law allows and upon request by an Allied Practice, the Company leases equipment or office space to the Allied Practices. Unless otherwise indicated by the context, references herein to practice management services, agreements or rights include consulting or similar
arrangements that the Company has or will enter into with certain Allied Practices in order to comply with applicable regulations in certain states regarding practice management.
For the year ended December 31, 2000, the Company generated an operating profit of $23.7 million on $142.0 million in net revenue.
THE ORTHODONTIC INDUSTRY
Orthodontics, the art and science of correcting the misalignment of teeth, has historically been one of the most profitable specialties in dentistry. Orthodontic research and education have aided the development of new materials and techniques of orthodontic treatment, including the use of computers to help solve complex cases. In 1998, orthodontists in the United States conducted examinations of nearly 2.7 million potential new patients and initiated treatment for approximately 1.8 million patients. The typical orthodontist initiated treatment for approximately 200 patients in 1998 and maintained approximately 450 active cases. Unless otherwise indicated, industry information is derived from the 1999 Journal of Clinical Orthodontists Orthodontic Practice Study (the "JCO Study") and relates to 1998. The information compiled in the JCO Study relates to orthodontists who have completed accredited graduate orthodontic training programs and does not include general dentists who also perform certain orthodontic services.
The primary target market for orthodontic treatment is children ages 8 to 18. In 1998, approximately 85% of all patients treated were children. The U.S. Census Bureau estimates that as of November 1, 1999, there were approximately 39.5 million children and adolescents between the ages of 10 and 19. Management believes that as many as 80% of these children and adolescents could benefit from orthodontic treatment. In addition to the traditional juvenile market, the adult market has been a growing market for orthodontic services. Based on statistics obtained from the JCO Study, management believes that the adult market for orthodontic services remains largely untapped, as the number of adults who need or want orthodontic treatment substantially exceeds the number of patients currently seeking treatment. In 1996, standard case fees averaged approximately $3,900 for children and $4,300 for adults.
There are approximately 9,000 practicing orthodontists in the United States, nearly all of whom have graduated from accredited graduate programs of orthodontics. The industry is highly fragmented, with approximately 90% of the practicing orthodontists acting as sole practitioners and the balance practicing in multiple-doctor practices (generally two orthodontists). The training and qualification of an orthodontist is extremely rigorous. Generally, a dentist must graduate in the top 10% of his or her class at an accredited graduate school of dentistry, pass national and state board examinations, and complete an accredited graduate orthodontic program to become an orthodontist. These programs typically are structured as two- or three-year programs. Each year about 200 new orthodontists graduate from accredited orthodontic programs.
THE PEDIATRIC DENTAL INDUSTRY
Pediatric dentistry is an age-defined specialty that provides both primary and comprehensive preventative and therapeutic oral health care for infants and children through adolescence, including those with special health care needs. Pediatric dentists provide primary and specialty care in offices as well as in hospital and other institutional sites and, when indicated, in conjunction with other dental and medical disciplines. There are approximately 3,600 professional active pediatric dentists in the United States. Pediatric dentists must complete a specialty degree program which is typically two to three years in length. Approximately 160 students are admitted each year to pediatric dental specialty training programs.
The U.S. Bureau of the Census projects that between 1998 and 2025 there will be an increase of 8.9 million children under the age of 15. Furthermore, the number of practicing pediatric dentists has decreased from approximately 3,900 in 1990 to approximately 3,600 in 2000. The number of spaces available in pediatric dental training programs has decreased from approximately 200 in 1990 to 160 in 2000. Accordingly, the Company believes that there will be an increased demand for the services of pediatric dentists.
OPERATING STRATEGY
The Company's operating strategy focuses on enabling the Allied Practices to compete more effectively and realize greater profitability than other practices, thereby providing an inducement for additional practices to affiliate with the Company. Key elements of the Company's operating strategy include:
Emphasizing Quality Patient Care. Management believes that the services and support it provides the Allied Orthodontists impact the level of patient care positively by increasing the Allied Orthodontists' time available to concentrate on patient care. The qualifications of providers of orthodontic and pediatric dental services vary from general dentists who have taken weekend courses to graduates of accredited three-year programs. Nearly all Allied Orthodontists affiliated with the Allied Practices are graduates of accredited orthodontic or pediatric dental programs. The Company established two clinical care advisory committees, one consisting of Allied Orthodontists and the other consisting of Allied Dentists, to formulate educational and training programs and to consult with each other on current treatments, techniques and issues.
Capitalizing on the Best Demonstrated Practices of Allied Orthodontists. The Company identifies practice-level strategies that have proven successful for individual Allied Practices and shares this information among other Allied Practices. The Company provides Allied Orthodontists with comparative operating and financial data to enable Allied Orthodontists to detect areas of their practices that could be improved. The Company provides its own analysis of such operating and financial data and recommends changes to improve performance. The Company consults with Allied Practices that have demonstrated success in a certain area and generally seeks to facilitate communication among Allied Practices through periodic conferences and meetings and through the internet.
Achieving Operating Efficiencies and Economies of Scale. The Company implements a variety of operating procedures and systems to improve the productivity and profitability of each Allied Practice and to achieve economies of scale including, without limitation, centralized payroll processing and national group purchasing contracts. Operating efficiencies and economies are instituted with the Allied Orthodontist's consent on a per Allied Practice need basis.
Increasing the Affordability of Professional Care through Flexible Payment Plans. The Company assists Allied Practices in developing and implementing payment plans designed to make orthodontic and pediatric dental services more affordable to prospective patients. Many of the Allied Practices historically receive a down payment of approximately 25% of the total treatment plan fee at the early stages of the procedure. Recognizing that orthodontic services are largely discretionary and that a significant down payment is often a deterrent to prospective patients, the Company believes that flexible payment plans or financing opportunities are an effective means of increasing patient volume. Payment plans are tailored to respond to the various market demands and opportunities. The Company makes general recommendations to all Allied Practices with respect to instituting flexible payment plans and develops and implements market-tailored plans at the request of individual Allied Practices. In addition, the Company provides access to working capital necessary for the Allied Practices to implement flexible payment plans which may result in the reduction or elimination of down payments.
Stimulating Demand in Local Markets through Marketing. In consultation with and upon approval of the Allied Practices, the Company develops and implements marketing plans to augment each Allied Practice's referral and other marketing systems. Certain Allied Practices have developed referral systems with local dentists. Upon the request of an Allied Practice and in appropriate markets, the Company attempts to assist such Allied Practice in reaching potential patients through print, local television and radio advertising.
GROWTH STRATEGY
The Company's growth strategy includes affiliation with existing practices in both new and existing markets, the development of satellite offices for existing Allied Practices and internal growth through improved operating efficiencies.
Internal Growth through Improved Operating Efficiencies. The Company offers a variety of operating procedures and systems to improve the productivity and profitability of the Allied Practices. The Company
implemented payroll processing, financial reporting and analysis, national group purchasing discounted contracts and assists with appropriate credit and collection policies which accommodate specific needs of each Allied Practice. Operating efficiencies and economies are instituted on a per Allied Practice need basis.
Development of Satellite Offices. If management determines market demand supports practice expansion, the Company assists Allied Orthodontists in developing satellite offices to be integrated into Allied Practices. The Company provides a certain amount of capital for practice expansion, market research, site selection, office design and marketing support for satellite office development.
Affiliations with Existing Practices. The Company targets for affiliations a market that includes approximately half of the orthodontic and pediatric dental practices in the United States (approximately 4,500 orthodontic practices and 1,500 pediatric dental practices), which practices fit the Company model of quality and opportunity for revenue and earnings growth. The Company believes that affiliation will be an attractive option for existing practices, because the Company (i) provides access to capital to open and integrate new offices into existing Allied Practices, (ii) makes available best practice ideas from other Allied Practices, (iii) designs and offers business and clinical systems for Allied Practices, (iv) with the approval of the Allied Orthodontist, employs the necessary business and non-professional personnel for Allied Practices, (v) helps Allied Practices by recommending marketing and advertising strategies, and (vi) assists Allied Orthodontists with administrative and business related tasks. The Company has reduced the number of affiliations with existing practices in order to conserve capital resources. This is partially due to the Company's low stock price, which has made it difficult for the Company to raise capital and affiliate with practices. See, Item 5, Other Consequences of the Company's Historically Low Stock Price.
De Novo Practice Development. In addition to traditional affiliations, the Company believes that a complementary element to the Company's growth strategy includes the development of De Novo Practices. De Novo practice development represents an opportunity for the Company to build practices from the ground up in key strategic markets. By drawing on the experiences of its existing members, the Company can help to identify and implement the "best practices" for De Novo operations. The Company has, to date, established two De Novo Practices.
PAYMENT PLAN AND CASE FEES
In the Allied Practitioners offices, at the initial orthodontic treatment, generally the patient signs a contract outlining the terms of the treatment, including the anticipated length of treatment, total fees and payment terms. Each Allied Orthodontist determines the appropriate fee to charge for services to patients based upon market conditions in the area served by that Allied Orthodontist. Generally, the amount charged by the Allied Orthodontists is independent of the patient's source of payment. The number of required monthly payments is estimated at the beginning of the case and generally corresponds to the anticipated number of months of treatment. Generally, the Allied Practices require approximately 25% of the treatment contract to be paid upon installation of the braces, and the remaining 75% evenly over the remainder of the treatment term.
If the treatment period exceeds the period originally estimated by the Allied Orthodontist, the patient and the Allied Orthodontist will determine whether payment for additional treatment will be required. If the treatment is completed prior to the scheduled completion date, the patient is required to pay the remaining balance of the contract. If a patient terminates the treatment prior to the completion of the treatment period, the patient is required to pay the balance due for services rendered to date.
Other payment plans with lower monthly payments are available for patients who have insurance coverage for the treatment. Payments from patients with insurance may be lower, depending upon the amount of the fee paid on behalf of the patient by insurance policies. For patients with insurance coverage, the portion of the fee not covered by insurance is paid by the patient.
LOCATION
As of December 31, 2000, the Company provided management services to Allied Practices at the following locations:
AGREEMENTS WITH ALLIED PRACTICES AND ALLIED PRACTITIONERS
Each Allied Practice has entered or enters into the following three material agreements: (i) an acquisition agreement, which may be in the form of a purchase and sale agreement whereby the Company acquires certain of the assets, or stock of an entity holding certain assets, of the Allied Practice, or an agreement and plan of reorganization, whereby the Allied Practice transfers certain assets to the Company; (ii) either a service agreement or a consulting agreement (depending upon the applicable state regulatory requirements or a management service agreement for OA New Image practices), whereby the Company provides management or consulting services to the Allied Practice (collectively, "Management Agreements"); and (iii) an employment agreement between the Allied Practice and each related Allied Practitioner
who is an equity holder in the Allied Practice or who provides orthodontic or pediatric dental services through such practice for more than ten days each month.
Acquisition Agreements. Each acquisition agreement generally results in the sale by the Allied Practice of its equipment, licenses (to the extent assignable by law), inventory, accounts receivable, furniture and other personal property, or some combination thereof based on applicable state laws or regulations, in exchange for consideration based on the Allied Practice's adjusted patient revenue. The aggregate purchase price paid by the Company is generally payable in cash, shares of Class A Common Stock, or a promissory note as determined by each Allied Practice and the Company. The aggregate consideration, including acquisition costs, paid by the Company in connection with the affiliation of the 175 Allied Practices net of consolidation from August 26, 1997 to December 31, 2000 was approximately $217.0 million, comprised of approximately $90.3 million in cash, 8.2 million shares of Class A Common Stock and promissory notes of $29.2 million.
Service Agreements. Each service agreement generally requires or permits the Company to perform certain services for the Allied Practices, including provide and maintain specified furnishings and equipment; provide necessary employees (except practitioners and, where applicable law requires, hygienists and dental assistants); establish appropriate business systems; purchase and maintain inventory; perform payroll and accounting functions; provide billing and collection services with respect to patients, insurance companies, and third-party payors; arrange certain legal services not related to malpractice litigation; design and execute a marketing plan; advise with respect to new office locations; and manage and organize the Allied Practice's files and records, including patient records where permitted by applicable law. If the Allied Practice lacks sufficient funds to pay its current expenses, the Company is required to advance funds to the Allied Practice for the purpose of paying such expenses, subject to terms to be agreed upon. In exchange for performing the services described above, the Company receives a management fee based on one of the three fee structures described in Management's Discussion and Analysis of Financial Condition and Results of Operations. The Company has entered into agreements with certain Allied Practices to make the payment of such management fees after the first two years contingent on various factors, including practice profitability compared to acquisition consideration, timely reporting of information, participation in practice improvement programs and orthodontist hours worked. Prior patient revenue is not necessarily indicative of the level of revenue that these practices may be expected to generate in the future.
The term of each service agreement is for 20 or 25 years, subject to prior termination by either party in the event the other party becomes subject to voluntary or involuntary bankruptcy proceedings or materially breaches the agreement, subject to a cure period. In addition, the Allied Practices may terminate the service agreements upon the occurrence of a change of control of the Company (as defined therein, which does not include a transaction approved by the Company's Board of Directors). Upon the expiration or termination of the service agreement, the Allied Practice may, and in certain circumstances must, repurchase for cash (at book value) certain assets, including all equipment, and assume certain liabilities of the Company related to the Allied Practice.
Each service agreement is generally not assignable by either party thereto without the written consent of the other party; however, the Company may assign the service agreement without the Allied Practice's consent to any entity under common control with the Company. The Company and the Allied Practice indemnify each other for costs and expenses incurred by the other party that are caused directly or indirectly by, as the case may be, the Company's or the Allied Practice's intentional or negligent acts or omissions. In the case of the Allied Practice's obligation to indemnify the Company, such obligation also applies to intentional or negligent acts and omissions occurring prior to the date of the service agreement. As of December 31, 2000, the Company had entered into service agreements with 76 Allied Practices.
Consulting Agreements. Certain provisions of the consulting agreement are substantially similar to the service agreement, including provisions relating to the Company's obligation to loan funds to the Allied Practice in the event the Allied Practice is unable to pay its current expenses, termination of the consulting agreement, repurchase of assets and assumption of liabilities by the Allied Practice upon expiration or termination, assignment, and indemnification.
The services available to the Allied Practice under each consulting agreement generally include consulting with respect to equipment and office needs; preparing staffing models appropriate for an Allied Practice; advising and training with respect to business systems; purchasing and maintaining inventory; advising with respect to and providing or arranging accounting and bookkeeping services; advising with respect to developing a marketing plan; assessing the financial feasibility of establishing new offices; providing billing and collection services; and assisting the Allied Practice in organizing and developing filing and recording systems. In exchange for such services, the Company receives a consulting fee based on one of the three fee structures described in Management's Discussion and Analysis of Financial Condition and Results of Operations. As of December 31, 2000, the Company had entered into consulting agreements with 68 Allied Practices.
Pursuant to both the service agreements and consulting agreements, Allied Practitioners maintain professional control over and ownership of their practices, determine which personnel will be allied with the Allied Practices and set their own standards of practice. The Company does not engage in the practice of orthodontics or dentistry. Each Allied Practitioner is responsible for compliance of his or her Allied Practice with state and local regulations applicable to the practice of orthodontics and dentistry and with licensing or certification requirements. Each Allied Practice, in its sole discretion, determines the fees to be charged for services provided to patients based upon market conditions in the service area and other factors deemed appropriate by the Allied Practice. Each Allied Practice executes payor contracts and acquires and pays for its own malpractice insurance coverage.
Management Service Agreements. In March 2000, the Company and OA New Image assumed the obligations of New Image under the various Management Service Agreements ("MSA") between New Image and the orthodontic practices with whom it had entered into MSAs. The form of MSA provides for a variation of the service fee calculation compared to the traditional Company form defined in the service or consulting agreement. Under the MSAs, the service fee amount varies monthly depending on the Allied Practices financial performance and represents the residual amount after the payment of practice expenses and contractually determined practice distributions. The service fee is affected by two variables, (1) total Allied Practice gross revenue, less refunds, and (2) overhead. Service fees are calculated based on two separate standardized grids set forth in the MSA that determine (i) the percent of practice revenue that is distributed to the Allied Practice based on that Allied Practice's gross revenue, less refunds, ("Gross Revenue Grid") and (ii) any additional or offsetting percentage of gross revenue, less refunds, that is distributed to the Allied Practice based upon that Allied's Practice's overhead ("Overhead Grid"). Pursuant to the Gross Revenue Grid, in general, the Company's retained service fees increase if the Allied Practice's gross revenue increases and decrease if the Allied Practice's gross revenue decreases. Pursuant to the Overhead Grid, in general the Company's retained service fees decrease if the Allied Practice's overhead expenses increase and the retained service fees increase if the Allied Practice's overhead decreases. The maximum retained service fee percentage is 20.0%. The average service fee percentage for the OA New Image Allied Practices is approximately 16.1%. In addition, a few OA New Image MSAs provide for a fixed percentage service fee.
Employment Agreements. Each Allied Practitioner who is or becomes an equity holder in an Allied Practice or who provides orthodontic or dental services through an Allied Practice for more than 10 days a month is required to execute an employment agreement with the Allied Practice. Each employment agreement generally provides that the Allied Practitioner will perform professional services for the Allied Practice for a period of five years, subject to prior termination (i) for cause by the Allied Practice (which generally means death, incapacity, willful misconduct, conviction for a felony, or chronic alcoholism or drug addiction) and (ii) by the Allied Practitioner in the event of a material breach by the Allied Practice. The Allied Practitioner agrees that following termination or expiration of the employment agreement, he or she will not compete for a period of two years in the market in which the Allied Practice operates an office and will limit the methods of advertising in the area in which an Allied Practice is located.
GOVERNMENT REGULATION
General. The field of dentistry, including orthodontics, is highly regulated, and there can be no assurance that the regulatory environment in which the Company operates will not change significantly in the future. In
general, regulation of healthcare companies is increasing. Every state imposes licensing requirements on individual practitioners and on facilities operated by and services rendered by practitioners. In addition, federal and state laws regulate health maintenance organizations and other managed care organizations for which practitioners may be providers. The Company, Allied Practices and Allied Practitioners may become subject to compliance with additional regulations.
The operations of the Allied Practices must meet federal, state and local regulatory standards in the areas of safety and health. Historically, compliance with those standards has not had any material adverse effect on the operations of the Allied Practices. Based on its familiarity with the historical operations of the Allied Practices and the activities of the Allied Practitioners, management believes that the Allied Practices are in compliance in all material respects with all applicable federal, state and local laws and regulations relating to safety and health.
State Legislation. The laws of several states prohibit practitioners from splitting fees with non-practitioners. Furthermore, many states prohibit non-professional entities from practicing dentistry, including orthodontics, employing practitioners, or in some circumstances, employing hygienists and dental assistants. The laws of some states prohibit advertising professional services under a trade or corporate name and require that all advertising be in the name of the practitioner. A number of states also regulate the content of advertisement of professional services and the use of promotional gift items. A number of states limit the ability of a non-licensed dentist or non-orthodontist to own equipment or offices used in a practice. Some of these states allow leasing of equipment and office space to an orthodontic or dental practice, under a bona-fide lease, if the equipment and office remain in the complete care and custody of the practitioner. Management believes, based on its familiarity with the historical operations of the Allied Practices, that the activities of the Allied Practitioners and applicable regulations, that the Company's current and planned activities do not constitute the prohibited practices contemplated by these statutes and regulations. There can be no assurance, however, that future interpretations of such laws, or the enactment of more stringent laws, will not require structural and organizational modifications of the Company's existing contractual relationships with its Allied Practitioners or the operation of the Allied Practices. In addition, statutes in some states could restrict expansion of Company operations in those jurisdictions. The Company enters into either a service agreement or consulting agreement depending upon applicable state regulations.
Regulatory Compliance. The Company monitors developments in laws and regulations relating to the practice of orthodontics and dentistry. The Company may be required to modify its agreements, operations and marketing strategies from time to time in response to changes in the regulatory environment. The Company structures all of its agreements, operations and marketing in accordance with applicable law, although there can be no assurance that its arrangements will not be successfully challenged or that required changes may not materially affect the Company's business, financial condition and results of operations.
COMPETITION
The business of providing orthodontic and pediatric dental services is highly competitive in each market in which the Allied Practices operate. Allied Practices compete with practitioners who maintain single offices or operate a single satellite office, as well as with practitioners who maintain group practices or operate in multiple offices. Allied Practices also compete with general dentists and pediatric dentists who provide certain orthodontic and pediatric dental services, some of whom have more established practices. The provision of orthodontic and pediatric dental services by such dentists and pediatric dentists has increased in recent years.
The Company faces substantial competition from other entities as the Company seeks to affiliate with additional practices. The Company is aware of several practice management companies that are focused in the area of orthodontics and dental specialties. Additional entities may enter this market and compete with the Company. Certain of these competitors have greater financial or other resources than the Company.
EMPLOYEES
As of December 31, 2000, the Company employed approximately 1,604 persons, including 1,200 full-time employees. None of the Company's employees is represented by a collective bargaining agreement. The Company considers its relationship with its employees to be good.
INTELLECTUAL PROPERTY
The Company has obtained trademark registrations from the U.S. Patent and Trademark Office for its service marks "OrthAlliance" and "PedoAlliance." Management intends to continue to utilize the service marks, as allowed by applicable law, in the Company's marketing and advertising campaigns and in connection with the Company's services.
INSURANCE
The Company maintains general liability insurance for itself and on behalf of the Allied Practices and, where permitted by applicable law and insurers, the Company is named as an additional insured under the policies of the Allied Practices. There can be no assurance that any claims against the Company or any of the Allied Practices will not be successful, or if successful, will not exceed the limits of available insurance coverage or that such coverage will continue to be available at acceptable rates. The Allied Practitioners purchase and maintain their own malpractice liability insurance coverage.
ITEM 2.
ITEM 2. PROPERTIES.
The Company leases approximately 12,465 square feet of office space in Torrance, California for its headquarters. In addition, the Company leases office space for certain Allied Practices. The Company's annual lease or rent payments were approximately $11.8 million for the year ended December 31, 2000. See note 14 to the Company's financial statements.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
From time to time, the Company is involved in various legal proceedings, claims and litigation matters arising in the ordinary course of business, including labor and personnel related issues. In the opinion of management, the outcome of such routine matters will not have a material adverse effect on the Company's business, financial condition or results of operations.
From time to time, the Company has been, and can expect to be, involved in litigation with certain of its Allied Practices. Such litigation has involved claims that the Company failed to provide certain services under the Management Agreements with the Allied Practices and that certain provisions of the Management Agreements may be unenforceable, among other claims. The Company vigorously defends against such claims and believes that such claims are without merit. As of December 31, 2000, the Company did not have any pending legal proceedings that separately, or in the aggregate, if adversely determined, would have a material adverse effect on the Company. See also Item 5, Other Consequences of the Company's Historically Low Stock Price.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of the Company's stockholders during the fourth quarter of the fiscal year covered by this report.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS.
The Company's Class A Common Stock is traded on The NASDAQ Stock Market's National Market System under the symbol "ORAL." There is no established public trading market for the Company's Class B Common Stock. No transfers are permitted of Class B Common Stock, except to the Class B stockholder's spouse, parents, siblings, lineal descendants, trusts for the benefit of any such individual or as determined by laws of descent or wills. The high and low prices of the Company's Class A Common Stock as reported on The NASDAQ Stock Market during each quarter from January 1, 1999 are shown below:
At March 23, 2001, the last reported sale price of the Class A Common Stock was $2.00 per share and there were approximately 97 record holders of Class A Common Stock and 49 record holders of Class B Common Stock.
CONTINUED LISTING ON THE NASDAQ NATIONAL MARKET
The Company's Common Stock is currently quoted on the NASDAQ National Market under the symbol "ORAL". For continued inclusion on the NASDAQ National Market, a company must meet certain tests, including compliance with the NASDAQ National Market Rule 4450(b)(4) concerning minimum bid price which requires among other things, a minimum bid price of $1.00 and tangible net assets of at least $4 million. As of December 31, 2000, the Company was not in compliance with that requirement. The continued listing of the Company's Common Stock was recently reviewed by the NASDAQ Staff and on February 28, 2001 the Company was notified by the National Market that the Company's stock was not in compliance with Rule 4450(b)(4) and that the stock may be subject to removal from the National Market.
The Company has requested a hearing before the NASDAQ Listing Qualifications Panel which has been scheduled for April 6, 2001. There can be no assurance that the Company will satisfy the NASDAQ National Market conditions or that the Company will be able to maintain the continued listing requirements in the future. If the Company's Common Stock is delisted from the NASDAQ National Market, and if trading of the Company's Common Stock is to continue, such trading could be conducted on the NASDAQ Small Cap Market, in the over-the-counter market on the so called "pink sheets" or, if available, on the NASD's Electronic Bulletin Board. In such event, investors could find it more difficult to dispose of, or to obtain accurate quotations as to the value of, the Company's Common Stock. The trading price per share of the Company's Common Stock could be reduced as a result.
OTHER CONSEQUENCES OF THE COMPANY'S HISTORICALLY LOW STOCK PRICE
In addition to the consequences of a possible de-listing from the NASDAQ National Market discussed above, the Company's historically low stock price has also had adverse consequences on its relations with certain of its Allied Practitioners and its ability to affiliate with new orthodontic and pediatric dental practices. Many of the Company's Allied Practitioners received shares of the Company's common stock in consideration for their affiliation with the Company. The significant decline in the price of the Company's stock has
adversely affected these Allied Practitioners and, the Company believes, has harmed the Company's relationship with certain of its Allied Practitioners. The Company believes that this has led some Allied Practices to send notices to the Company or institute's litigation against the Company alleging that the Company has failed to provide certain services to the Allied Practice. See also Item 3, Legal Proceedings.
On February 22, 2001, the Company announced the formation of a Special Committee of the Board of Directors to explore strategic alternatives to increase shareholder value. The Special Committee was formed as a result of the Company's belief that the Company's stock remains undervalued despite meeting certain financial objectives. The Committee's goal is to identify alternatives to increase shareholder value.
Except for the payment in August 1997 of $13.8 million cash consideration paid to the initial 55 Allied Practices which was recorded as a cash dividend, the Company has never declared and paid any dividends on either its Class A Common Stock or its Class B Common Stock. The Company expects that future earnings, if any, will be retained for the growth and development of the Company's business and, accordingly, the Company does not anticipate that any dividends will be declared or paid on the Class A Common Stock or Class B Common Stock for the foreseeable future. The declaration, payment and amount of future dividends, if any, will depend upon the future earnings, results of operations, financial position and capital requirements of the Company, among other factors, and are limited by the Company's credit agreement.
Unregistered Securities
On August 26, 1997, simultaneously with the closing of the Company's initial public offering of its Class A Common Stock pursuant to a Registration Statement on Form S-1, the 55 initial Allied Practices received 5,882,985 shares of unregistered Class A Common Stock as partial consideration for certain assets or stock of such Allied Practices pursuant to the exemption set forth in Section 4(2) of the 1933 Act regarding non-public offerings.
On August 26, 1997, pursuant to that certain Agreement and Plan of Merger between the Company, US Orthodontic Care, Inc. ("USOC") and Premier Orthodontic Group, Inc. ("POG"), the Company issued 1,750,000 shares of unregistered Class A Common Stock and 250,000 shares of unregistered Class B Common Stock as merger consideration to the shareholders of USOC and POG in reliance on the exemption set forth in Section 4(2) of the 1933 Act regarding non-public offerings.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The selected consolidated statements of income data for the years ended December 31, 2000, 1999 and 1998 and the selected balance sheet data as of December 31, 2000 and 1999 are derived from the Company's audited consolidated financial statements included elsewhere in this Form 10-K. The Company's historical results are not necessarily indicative of the results that may be achieved for any other period. The following data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements included in this Form 10-K.
- --------------- (1) Excludes internal same-store growth.
(2) Represents period subsequent to IPO, 8/26/97 to 12/31/97.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion and analysis should be read in conjunction with the accompanying Consolidated Financial Statements and Notes thereto for the years ended December 31, 2000, 1999 and 1998.
GENERAL
The Company began providing practice management and consulting services to Allied Practices in the United States on August 26, 1997. The initial 55 Allied Practices included 82 Allied Orthodontists operating 147 offices in 16 states. By the end of 1997, the Company had affiliated with 11 new practices, including 17 additional orthodontists operating out of 31 new locations. In 1998, the Company affiliated with 30 new practices, including 38 additional orthodontists and pediatric dentists operating out of 67 locations. In 1999, the Company affiliated with 36 new practices, including 40 additional orthodontists and pediatric dentists operating out of 73 locations. In 2000, the Company affiliated with 43 new practices, including 48 additional orthodontists and pediatric dentists operating out of 76 locations. Of the 43 new Allied Practices, 31 were affiliated on March 1, 2000 when the Company, through OrthAlliance New Image, Inc., a wholly owned subsidiary, acquired substantially all the assets of New Image Orthodontic Group, Inc., a provider of business operations, financial and marketing and administrative services to orthodontic practices across the United States.
The Company derives net revenues by providing services pursuant to long-term Management Agreements with Allied Practices. The Company provides management or consulting services to each Allied Practice and assumes substantially all operating expenses except for compensation to the Allied Practitioners and other employees that the Company cannot employ according to applicable state laws. In exchange for assuming these expenses and providing services, the Company records revenues in amounts equal to the assumed expenses plus a service fee or consulting fee, as described below. In general, the Management Agreements provide for the recognition of fees to the Company based on a negotiated percentage of the "Adjusted Patient Revenue" of Allied Practices. The timing of the payment of such service fees is based upon cash collected. Adjusted Patient Revenue is net patient revenue, as determined under accounting principles generally accepted in the United States, including certain accrual adjustments, including those related to patient
prepayments, and adjustments for contractual allowances and other discounts, plus an adjustment for uncollectible accounts.
Patient revenue is recognized as services are performed. For orthodontic services, approximately 20% of the orthodontic contract revenues are recognized at the time of initial treatment and generally approximates 25% of the total treatment plan revenues collected by the Allied Practice. The balance of the contract revenue is realized evenly over the remaining treatment period. The 20% estimated revenue at the initial treatment date is based on the estimated costs incurred by the Company at that time as compared to the total costs of providing the contracted services and is consistent with industry standards. The percentage includes the estimated costs of diagnosis and treatment plan development, initial treatment by OrthAlliance employees at the Allied Practices, orthodontic supplies, and associated administrative services.
The service fee is earned and paid monthly to the Company by each Allied Practice using one of three different fee structures set forth in the Management Agreements:
(i) a designated percentage ranging from 13.5% to 20% of Adjusted Patient Revenue. The average designated percentage is 17% for the Allied Practices subject to this fee structure. In some cases, the Allied Practice must guarantee a minimum level of management fees to be paid by the Allied Practice for a portion of the agreement ranging from one to 25 years.
(ii) a designated percentage of Adjusted Patient Revenue, ranging from 14% to 17%, subject to an annual adjustment based upon improvements in the Allied Practice's operating margin in the most recent calendar year as compared with the immediately preceding calendar year. No annual adjustment will be made which would result in reducing the designated percentage below the percentage applicable during the first year of the Management Agreement. Operating margin is defined as the percentage determined by dividing operating profit by Adjusted Patient Revenue. Operating profit is equal to Adjusted Patient Revenue less operating expenses, excluding the management fee and such expenses associated with the Allied Practices which the Company is prohibited from incurring, primarily consisting of orthodontist compensation. The average designated percentage is 16.2% for the Allied Practices subject to this fee structure.
(iii) a fixed dollar fee with annual fixed dollar increases for each year of the term of the Management Agreement.
The Company has entered into agreements with certain Allied Practices to make the payment of service fees after the first two years contingent on various factors, including practice profitability compared to acquisition consideration, timely reporting of information, participation in practice improvement programs and orthodontist hours worked.
In March 2000, the Company and OA New Image assumed the obligations of New Image under the various Management Service Agreements ("MSA") between New Image and the orthodontic practices with whom it had entered into MSAs. The form of MSA provides for a variation of the service fee calculation compared to the traditional Company form defined in the service or consulting agreement. Under the MSAs, the service fee amount varies monthly depending on the Allied Practices financial performance and represents the residual amount after the payment of practice expenses and contractually determined practice distributions. The service fee is affected by two variables, (1) total Allied Practice gross revenue, less refunds, and (2) overhead. Service fees are calculated based on two separate standardized grids set forth in the MSA that determine (i) the percent of practice revenue that is distributed to the Allied Practice based on that Allied Practice's gross revenue, less refunds, ("Gross Revenue Grid") and (ii) any additional or offsetting percentage of gross revenue, less refunds, that is distributed to the Allied Practice based upon that Allied's Practice's overhead ("Overhead Grid"). Pursuant to the Gross Revenue Grid, in general, the Company's retained service fees increase if the Allied Practice's gross revenue increases and decrease if the Allied Practice's gross revenue decreases. Pursuant to the Overhead Grid, in general the Company's retained service fees decrease if the Allied Practice's overhead expenses increase and the retained service fees increase if the Allied Practice's overhead decreases. The maximum retained service fee percentage is 20.0%. The average
service fee percentage for the OA New Image Allied Practices is approximately 16.1%. In addition, a few OA New Image MSAs provide for a fixed percentage service fee.
Expenses reported by the Company include certain of the expenses to operate the orthodontic or pediatric dental offices and all of the expenses of any corporate offices, facilities or functions. Therefore, salaries and benefits include the wages, benefits, taxes or other employment costs for all employees of the Company, including practice office staff, business office staff and management personnel. Rent includes facility expenses for both practice offices and corporate offices. General and administrative expenses include professional services, such as legal and accounting, utilities, advertising, marketing, insurance, telephone, license fees, office supplies and shipping expenses. Advertising and marketing costs, which are included in general and administration costs, includes practice activities to attract new patients and corporate activities to attract new orthodontists or pediatric dentists to join the Company. Practice supplies include only those expenses required by the Allied Practitioners to provide treatment to patients.
From time to time the Company may receive notices of alleged defaults of certain Management Agreements. To date, the Company believes that such claims of alleged default are without merit and vigorously defends the Company's position. However, there is no assurance that such present or future disputes will be resolved favorably for the Company.
RESULTS OF OPERATIONS
The consolidated income statement of the Company for the years ended December 31, 2000, 1999 and 1998, include net income of $9.5 million on revenues of $142.0 million, net income of $9.6 million on revenues of $95.7 million, and net income of $7.5 million on revenues of $74.4 million, respectively. For the years 2000, 1999, and 1998, the Company had income before taxes of $17.0 million, $16.9 million, and $13.7 million, respectively. Direct expenses for the fourth quarter of 2000 included approximately $800,000 in expenses incurred in the separation of its former Chief Executive Officer and certain charges.
The following table sets forth certain selected condensed consolidated income statement data for the periods indicated in thousands of dollars and as a percentage of total net revenues:
YEAR ENDED DECEMBER 31, 2000 COMPARED TO YEAR ENDED DECEMBER 31, 1999
Net Income and Operating Income
Net income for the year ended December 31, 2000 of $9.5 million remained at approximately the same level as net income in 1999. Operating income for the year ended December 31, 2000 increased 25.4% to
$23.7 million from $18.9 million in 1999. The increase in operating income for the year ended December 31, 2000 is attributable to an overall increase in net revenues related primarily to the acquisition of New Image and other Allied Practices and internal same store growth. Despite achieving higher operating income, net income remained flat due to the severance of the Company's former President and Chief Executive Officer, higher than expected interest rates, higher taxes, and other increased expenses.
Net Revenues
Net revenues for the year ended December 31, 2000 increased 48.4% to $142.0 million from $95.7 million in 1999. The increase in net revenues is due primarily to an increase in affiliations of Allied Practices, the acquisition of New Image, as well as internal store to store growth for the year approximating 8% compared to 9% in 1999. New Image contributed approximately $20.7 million of the total year 2000 revenues. Net revenues as reported by the Company include the Company's contractual service or consulting fee based in part on adjusted patient revenues, as well as reimbursed expenses of the Allied Practices.
Operating Expenses
Total operating expenses increased 54.0% to $118.3 million, or 83.3% of net revenues, for the year ended December 31, 2000 from $76.8 million, or 80.2% of net revenues, from the prior year.
Direct expenses including salaries and benefits, orthodontic and dental supplies and rent increased 47.7% to $68.1 million, or 48.0% of net revenues, for the year ended December 31, 2000 from $46.1 million, or 48.2% of net revenues, from the prior year. Direct expenses have increased in absolute dollars as a result of the acquisition of New Image and other Allied Practices, the expansion and growth of existing Allied Practices, as well as expenses relating to the resignation of the Company's former President and Chief Executive Officer. The amount of severance paid to the Company's former President and Chief Executive Officer totaled approximately $600,000. The decrease in direct expenses as a percentage of 1999 net revenues is primarily attributable to economies of scale related to salaries and benefits and other direct expenses.
Salaries and benefits increased 49.4% to $42.5 million, or 29.9% of net revenues, for the year ended December 31, 2000 from $28.4 million, or 29.7% of net revenues from the prior year. Salaries and benefits have increased in absolute dollars as a result of the acquisition of New Image and Allied Practices, the expansion and growth of existing Allied Practices, as well as expenses relating to the resignation of the Company's former President and Chief Executive Officer.
General and administrative expenses, consisting primarily of administrative operating costs, non-rent facility costs, professional fees and overhead costs, increased 62.7% to $43.4 million, or 30.6% of net revenues, for the year ended December 31, 2000 from $26.6 million, or 27.9% of net revenues, from the prior year. General and administrative expenses have shown an increase in absolute dollars and as a percentage of revenue relating primarily to the acquisition of New Image and other Allied Practices, expansion and growth of previously existing Allied Practices, and higher laboratory cost.
Depreciation and Amortization
Depreciation and amortization expense increased approximately 69.1% to $6.7 million, or 4.7% of net revenues, for the year ended December 31, 2000 from $4.0 million, or 4.1% of net revenues from the prior year. This increase was attributable to the increase in intangible assets associated with the acquisition of New Image and other Allied Practices in 2000. Intangible assets increased from $83.6 million in 1999 to $124.2 million in 2000. Depreciation and amortization expense primarily relates to the depreciation of capital assets and the amortization of excess cost over the fair value of net assets acquired (goodwill) and certain other intangibles. The Company's policy has been to amortize goodwill over the expected period to be benefited, not to exceed the term of the Management Agreements.
Interest Expense
For the years ended December 31, 2000 and 1999, interest expense was approximately $7.4 million and $2.5 million, respectively and represents interest charges on the Company's borrowings on its revolving line of credit and notes payable. The increase was primarily due to increased borrowings under the revolving line of credit in support of the acquisition of New Image and other Allied Practices affiliated during the period. Company borrowings under the line of credit increased from $47.5 million at December 31, 1999 to $62.0 million as of December 31, 2000 (See "Liquidity and Capital Resources").
Provision for Income Taxes
Provision for income taxes for 2000 and 1999 approximates $7.5 million and $7.3 million, respectively. A reconciliation of the provision for income taxes for the years ending December 31, 2000, 1999 and 1998 to the amount computed at the Federal statutory rate is included in Note 15 of Notes to Consolidated Financial Statements. The Company's effective income tax rates for the years ended December 31, 2000 and 1999 were higher than the statutory tax rate primarily due to the amortization of certain intangible assets which were not deductible for income tax purposes. The effective tax rate was 44% for the year ended December 31, 2000 compared to 43% for the comparable period in 1999.
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
Net Income and Operating Income
Net income for the year ended December 31, 1999 increased 27.2% to $9.6 million from $7.5 million from 1998. Operating income for the year ended December 31, 1999 increased 36.5% to $18.9 million from $13.9 million from 1998. The increase in net income and operating income for the year ended December 31, 1999 is attributable to an overall increase in net revenues related to Allied Practice acquisitions, internal same store growth and a reduction of expenses as a percentage of net revenues.
Net Revenues
Net revenues increased 28.7% from 1998 to 1999, from $74.4 million to $95.7 million. The increase in net revenues is primarily due to an increase in affiliations of Allied Practices together with an increase of approximately 9% attributed to internal growth of comparable existing practices. Net revenues as reported by the Company include the Company's contractual service or consulting fee based in part on adjusted patient revenues, as well as reimbursed expenses of the Allied Practices.
Operating Expenses
Total operating expenses increased 26.9% to $76.8 million, or 80.2% of net revenues, for the year ended December 31, 1999 from $60.5 million, or 81.4% of net revenues, from the prior year.
Direct expenses including salaries and benefits, orthodontic and dental supplies and rent increased 25.8% to $46.1 million, or 48.2% of net revenues, for the year ended December 31, 1999 from $36.6 million, or 49.3% of net revenues from the prior year. Direct expenses have increased in absolute dollars as a result of the affiliation of additional Allied Practices during the period as well as the expansion and growth of previously existing Allied Practices. The decrease in direct expenses as a percentage of 1999 net revenues is primarily attributable to economies of scale related to salaries and benefits and other direct expenses.
Salaries and benefits increased 24.2% to $28.4 million, or 29.7% of net revenues, for the year ended December 31, 1999 from $22.9 million, or 30.8% of net revenues from the prior year. The decrease in salaries and benefits as a percentage of revenues is a result of a significant number of current year practice affiliations whereby their employees remained employees of the Allied Practice's professional corporations. Accordingly, for these practices, salary and benefit expenses are not reported by the Company. The Company expects that in future periods salaries and benefits will increase in absolute dollars, but may vary as a percentage of net revenues.
General and administrative expenses, consisting primarily of administrative operating costs, non-rent facility costs, professional fees and overhead costs, increased 24.4% to $26.7 million, or 27.9% of net revenues, for the year ended December 31, 1999 from $21.5 million, or 28.8% of net revenues, from the prior year. General and administrative expenses have shown an increase in absolute dollars primarily related to the acquisition of additional Allied Practices during the period as well as the expansion and growth of previously existing Allied Practices offset by reductions in marketing, advertising and other costs.
Depreciation and Amortization
Depreciation and amortization expense increased approximately $1.6 million in 1999 from 3.3% to 4.1% of net revenues from the prior year. This increase was attributable to the increase in intangible assets associated with the affiliation of Allied Practices in 1999. Intangible assets increased from $50.9 million to $83.6 million from 1998 to 1999. Depreciation and amortization expense primarily relates to the depreciation of capital assets and the amortization of excess cost over the fair value of net assets acquired (goodwill) and certain other intangibles. The Company's policy is to amortize goodwill over the expected period to be benefited, not to exceed the term of the Management Agreements. For the years ended December 31, 1999 and 1998, depreciation and amortization expense approximates $4.0 million and $2.4 million, respectively.
Interest Expense
For the years ended December 31, 1999 and 1998, interest expense was approximately $2.5 million and $0.6 million, respectively and represents interest charges on the Company's borrowings on its revolving line of credit. The increase was primarily due to increased borrowings under the revolving line of credit in support of Allied Practices affiliated during the period. Company borrowings under the line of credit increased from $15.5 million at December 31, 1998 to $47.5 million as of December 31, 1999 (See "Liquidity and Capital Resources").
Provision for Income Taxes
Provision for income taxes for 1999 and 1998 approximates $7.3 million and $6.1 million, respectively. A reconciliation of the provision for income taxes for the years ending December 31, 1999, 1998 and 1997 to the amount computed at the Federal statutory rate is included in Note 15 of Notes to Consolidated Financial Statements. The Company's effective income tax rates for the years ended December 31, 1999 and 1998 were higher than the statutory tax rate primarily due to the amortization of certain intangible assets which were not deductible for income tax purposes. The effective tax rate was 43% for the year ended December 31, 1999 compared to 45% for the comparable period in 1998.
QUARTERLY OPERATING RESULTS
The Company's unaudited quarterly operating information (amounts in thousands, except per share amounts) for 2000, 1999 and 1998 is shown in the following table.
SEASONALITY
Most patients who seek orthodontic treatment are children and young adults, although the number of adults seeking treatment has been increasing in recent years particularly with the introduction of new products such as Invisalign. Based upon information provided by the Allied Practices, and based upon the results of operations in 2000, 1999 and 1998, the Company generally experiences an increase in new patient volume during the summer months when children are not in school. The Company also expects the lowest volume of patient starts during the Thanksgiving and Christmas holiday season when children are on vacation and when many of the Allied Practices are closed. As a consequence, the Company expects higher patient revenue in the third quarter and lower patient revenue in the fourth quarter. Accordingly, the Company generally expects a stronger third quarter.
LIQUIDITY AND CAPITAL RESOURCES
The Company has funded its operations to date primarily through cash from operations, the Company's line of credit and other available capital sources. This capital is used for affiliations with new Allied Practices, development of Allied Practice enhancements, development of Allied Practice satellite offices, capital asset additions, and general working capital. The Company's working capital decreased 46% to $11.5 million at December 31, 2000 from $21.5 million at December 31, 1999. Stockholders' equity increased 9.2% to $74 million at December 31, 2000 from $67.8 million on December 31, 1999.
The Company's operating activities generated cash of 12.7 million during the year ended December 31, 2000, primarily attributed to net income during the period, increased patient prepayments and other factors which were offset by increases in patient and other receivables, compared to $15.2 million during the year ended December 31, 1999. Net cash used in financing activities approximated $1.2 million in the year ended December 31, 2000. Cash used in financing activities consisted of debt repayment and the repurchase of the Company's Class A Common Stock. For the year ended December 31, 2000, the Company borrowed approximately $83 million and repaid $81.5 million. Repurchase of the Company's Class A Common Stock totaled approximately $3.8 million. For the year ended December 31, 1999, $28.1 million was provided by financing activities and resulted primarily from borrowings under the revolving credit facility. Cash used in investing activities of $17.8 million in the year ended December 31, 2000 consisted of payments in connection with the acquisition of New Image and other Allied Practices affiliated and capital expenditures, primarily for office and computer equipment used in Company operations. Cash used in investing activities was $35.3 million in the year ended December 31, 1999 and consisted of payments in connection with the affiliation of Allied Practices and capital expenditures, primarily for office and computer equipment used in Company operations. The Company does not currently have any material commitments with respect to any capital expenditures.
On December 30, 1997, the Company entered into a credit agreement with First Union National Bank to provide a $25 million revolving line of credit. The interest on borrowings accrues at either the bank's prime
rate or LIBOR, plus a margin. Amounts borrowed are secured by security interests in substantially all of the Company's assets, which include accounts receivable, Management Agreements and the capital stock of the Company's wholly-owned subsidiaries. The Company expanded the credit facility ("the Revolving Credit Facility") on March 26, 1999 from $25 million to $55 million and from $55 million to $75 million on April 14, 2000. Outstanding amounts under the April 14, 2000 agreement are repayable in full on April 13, 2003. As of December 31, 2000 and 1999, the outstanding balance under this credit facility was $62 million and $47.5 million, respectively. There can be no assurance that the Company will be able to renew or replace its Revolving Credit Facility or obtain alternate financing on reasonable terms, if at all. As of December 31, 2000, the Company was in compliance with the terms and covenants of the Revolving Credit Facility.
In 1997, after the completion of the IPO and the affiliation of the founding 55 Allied Practices, the Company acquired certain operating assets of, or the stock in entities that held certain operating assets of, 11 additional orthodontic practices. The total consideration paid for these Allied Practices was $12.4 million, of which $2.1 million was paid in cash and the balance through the issuance of 863,775 shares of Class A Common Stock, pursuant to a Registration Statement on Form S-4 (No. 333-29435).
For the year ended December 31, 1998, the Company acquired certain operating assets of, or the stock in entities that held certain operating assets of, 36 additional Allied Practices. The total consideration paid for these Allied Practices was $46.8 million, of which $24.5 million was paid in cash, $2.5 million issued in short-term notes payable and the balance through the issuance of 1,640,492 shares of Class A Common Stock, pursuant to a Registration Statement on Form S-4 (No. 333-29435).
For the year ended December 31, 1999, the Company acquired certain operating assets of, or the stock in entities that held certain operating assets of, 36 additional Allied Practices. The total consideration paid for these Allied Practices was $39.5 million, of which $33.0 million was paid in cash, $5.7 million in long term notes payable and the balance through the issuance of 93,584 shares of Class A Common Stock, pursuant to a Registration Statement on Form S-4 (No. 333-53415).
For the year ended December 31, 2000, the Company acquired certain operating assets of, or the stock in entities that held certain operating assets of 43 additional Allied Practices. Of the 43 Allied Practices, 31 practices were acquired on March 1, 2000, by acquiring substantially all of the assets of New Image Orthodontic Group, Inc. ("New Image"), a privately held Georgia corporation based in Atlanta, Georgia, for a total consideration (including acquisition costs) of approximately $32.1 million. The acquisition price included a cash payment of $5.6 million; an estimated $0.3 million in acquisition costs; promissory notes issued of approximately $12.9 million, with interest rates ranging from 6% to 10%, repayable over a one to five year period; the assumption of approximately $13.4 million of existing debt due to New Image's former orthodontic practices, repayable over the next five years at interest rates approximating 9%; and the issuance of approximately 273,000 stock options. See note 3 to the Company's financial statements.
Capital resources needed to continue acquisition and development efforts will be funded through a combination of cash flows provided by ongoing operations, the Revolving Credit Facility, the possible issuance of equity and debt securities, as described in the Company's Form S-4 registration statement which became effective on August 6, 1999, and other sources. Management believes that these sources of capital will be sufficient to meet the Company's capital requirements for the next twelve months. The Company may choose to issue debt or equity to meet its future long-term capital needs, as management deems appropriate. There can be no assurance that the Company will be able to raise such additional working capital on acceptable terms, if at all. (See Item 5, Market for Registrant's Common Stock and Related Stockholder Matters.) In the event the Company is unable to raise additional working capital, further measures would be necessary including, without limitation, the delay, or scale back of its operations, Allied Practice affiliations and development efforts, marketing programs and other actions. Certain of such measures may require third party consents or approvals, including the Company's bankers, and there can be no such assurance that such consents or approvals can be obtained. The Company has reduced the number of new affiliations with existing practices, in order to conserve capital resources.
The Management Agreements provide for short-term advances by the Company to the Allied Practices for working capital requirements and other purposes on terms to be mutually agreed upon. These items are
advanced and repaid in a revolving manner. Generally, advances are repaid when Allied Practices deposit patient revenue into their depository accounts. Advances occur when the Allied Practice operating expenses paid exceed patient revenue earned. From time to time the Company may enter into short-term loan agreements with Allied Practices for office expansion or satellite office programs. Loans are provided generally at an interest rate of prime plus 1 1/2% with monthly payments through maturity.
ACQUISITION OF NEW IMAGE ORTHODONTIC GROUP, INC.
On March 1, 2000 the Company, through OA New Image, a wholly owned subsidiary, closed a purchase and sale agreement with New Image. The Company acquired substantially all the assets of New Image.
New Image was founded in February 1997 and provides business operations, financial and marketing and administrative services to orthodontic practices across the United States in accordance with long term service agreements. The transaction was accounted for as a purchase and includes practice management agreements with 36 orthodontic practitioners operating in 50 locations with over $33 million in annualized revenues.
Collectively, the consideration totaled approximately $32.1 million. Of this amount, $5.6 million was paid in cash, an estimated $0.3 million in acquisition costs, approximately $13.4 million of debt was assumed and $12.9 million in promissory notes were issued to the sellers, with interest rates ranging from 6% to 10%, and approximately 273,000 stock options with an aggregate fair value of approximately $0.6 million.
During 2000, the Company integrated New Image into its business operations. Management continues to believe that the Company will benefit from the economies of scale and synergies resulting from the acquisition.
Internal Revenue Service Examination
The Internal Revenue Service (the "Service") has completed its examination of the Company's federal income tax return for the year ended December 31, 1998. The Company has agreed with the Service's proposed adjustment of approximately $583,000 of additional tax payments for the years ended 1998 and 1999 which was paid in March 2001. The adjustment related to timing differences between book and tax with regard to certain capitalized practice acquisition costs. The Company adequately provided reserves in prior years and the additional tax payments did not result in additional income tax expense in fiscal 2000.
STOCK REPURCHASE PLAN
On December 1, 2000, the Company announced the extension of its Common Stock Repurchase Program to repurchase up to $6.8 million of its Class A Common Stock. The Company had initially announced the program on October 22, 1998. The Company is authorized to purchase shares on the NASDAQ National Market at prevailing prices through December 31, 2001. During 2000, the Company had repurchased 0.9 million shares amounting to $3.8 million under this program. Share repurchases are financed by a combination of operating cash flow and borrowings under the Revolving Credit Facility. The timing and the amount of shares to be purchased will be determined based on the evaluation of working capital needs and stock market conditions. Subsequent to December 31, 2000 the Company has acquired 4,300 shares of its Common Stock at a cost of approximately $13,000. As of March 26, 2001, the Company's total purchase of Class A Common Stock totaled approximately $6.7 million.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities", as amended by SFAS 137 and SFAS 138. SFAS 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. It requires that entities recognize all derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair value. Management anticipates that the adoption of SFAS 133 will not have a material effect on the Company's results of operations or financial position.
The SEC issued Staff Accounting Bulletin Number 101, Revenue Recognition in Financial Statements, on December 3, 1999 ("SAB 101"). This pronouncement clarifies existing revenue recognition principles and states that revenue is generally realized or realizable and earned when all of the following criteria are met: i) persuasive evidence of an arrangement exists, ii) delivery has occurred or services rendered, iii) the seller's price to the buyer is fixed or determinable and iv) collectibility is reasonably assured. Management believes the Company is in compliance with SAB 101.
INFLATION
The Company does not believe that inflation has had a material effect on the results of operations during the past three years. There can be no assurance that the Company's business will not be affected by inflation in the future.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company does not have any derivative financial instruments as of December 31, 2000. Further, the Company is not exposed to interest rate risk as the Company's revolving line of credit agreement has a variable interest rate. Therefore, the fair value of these instruments is not affected by change in market interest rates. The Company believes that the market risk arising from holdings of its financial instruments is not material.
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The Company's Consolidated Financial Statements, together with the Independent Public Accountant's Report thereon of Arthur Andersen LLP, dated March 7, 2001 begin on page of this report.
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 following sets forth information with respect to individuals who served as executive officers and directors as of December 31, 2000.
EXECUTIVE OFFICERS
W. Dennis Summers (age 52) -- Interim President and Chief Executive Officer -- Mr. Summers has been employed by the Company since November 2000. In addition to his current position, W. Dennis Summers has been a director of the Company since completion of the Company's initial public offering ("Offering") in August 1997. Effective after the 1999 Annual Meeting of Stockholders, Mr. Summers has been serving as Chairman of the Board. Mr. Summers has been a principal in the Atlanta, Georgia office of McGuireWoods, L.L.P. ("McGuireWoods"), a national law firm, since August 1999, when he moved from his previous firm, Roberts, Isaf & Summers. There, Mr. Summers served as a principal of the law firm since 1984. Mr. Summers specializes in corporate and business matters. Mr. Summers is currently on leave of absence from McGuireWoods.
James C. Wilson (age 51) -- Senior Vice President, Chief Financial Officer -- Jim Wilson has been with OrthAlliance since July 1999. Mr. Wilson came from Interplay Entertainment Corp., a leading developer, publisher and distributor of interactive entertainment software. He was CFO of Interplay Entertainment and previously held similar positions at Cloud 9 Interactive and Applause Enterprises. Earlier in his career, Mr. Wilson was a senior finance officer with Sega of America, the California Angels baseball team and Mattel Electronics, and he was an audit manager with Arthur Young & Company, a major public accounting firm.
Paul H. Hayase (age 46) -- Senior Vice President, Human Resources, General Counsel and Secretary -- Mr. Hayase has been with OrthAlliance since its inception in October 1996. Prior to joining OrthAlliance, Mr. Hayase served as VP of Human Resources, General Counsel, and Secretary for Systemed, Inc., a pharmacy benefit management company. From 1983 to 1985 he served as Senior Vice President -- Human Resources and General Counsel for Knapp Communications Corporations, publisher of Architectural Digest, Bon Appetit and HOME Magazines. Mr. Hayase also served as Senior Counsel for Ralphs Grocery Company from 1993 to 1995.
Stephen M. Toon (age 53)-- Senior Vice President, Chief Development Officer -- Mr. Toon has served as Senior Vice President and Chief Development Officer of OrthAlliance since August 1998. From 1995 until 1998, Mr. Toon served as Chief Development Officer of Team Health Group, a division of MedPartners. From 1991 until 1995, Mr. Toon served as Senior Vice President of Operations with Coastal Health Care. Prior to joining Coastal, Mr. Toon served as President of the Southern Division with MEDSEARCH International, a position to which he was named in 1986.
BOARD MEMBERS
Stephen G. Tracey, D.D.S., M.S. (age 42) has practiced orthodontics in the Upland, California area since 1986. Dr. Tracey graduated from Loma Linda University in 1986 with a M.S. degree in orthodontics and in 1983 with a D.D.S. degree. He is an Assistant Professor of Orthodontics at Loma Linda University School of Dentistry and a past Director of the California Association of Orthodontists.
Larry D. Dormois, D.D.S., M.S. (age 49) has practiced pediatric dentistry in Memphis since 1987. Before that he was director of the Graduate Pediatric Dental Residency Program and interim Chairman of the Department of Pediatric Dentistry at the University of Tennessee College of Dentistry. He graduated from the University of Tennessee College of Dentistry in 1975 with a DDS degree and the Pediatric Dental Graduate Program in 1981 with a Master of Sciences in Pediatric Dentistry. He has been a member of the executive committee for LeBonheur Children's Medical Center since 1990.
Craig L. McKnight (age 50) has been a director of the Company since completion of the initial public offering of Class A Common Stock (the "Offering") in August 1997. Since June, 1999, Mr. McKnight has served as Executive Vice President and Chief Financial Officer of Hillcrest Healthcare System, a not-for-profit healthcare system with inpatient facilities and clinics, including teaching hospitals. Previously, Mr. McKnight served from March 1995 to May, 1999, as Executive Vice President of Magellan Health Services ("Magellan"), a specialty managed care company, which was previously known as Charter Medical Corporation. Mr. McKnight practiced public accounting with Coopers & Lybrand, LLP from 1985 through 1995. From June 1994 to March 1995, Mr. McKnight was responsible for the Health Care Practice of Coopers & Lybrand, L.L.P. in California and Philadelphia, Pennsylvania.
Douglas D. Durbin, D.M.D., M.S.D. (age 46) has been a director of the Company since the completion of the Offering in August 1997. Dr. Durbin has served as President of The Kentucky Center for Orthodontics, P.S.C. and its predecessors since 1983. Dr. Durbin is a member of the American Association of Orthodontics, the American Dental Association and the Kentucky Association of Orthodontists, a Diplomate of the American Board of Orthodontics and has served as President, Treasurer, and Secretary of the Bluegrass Dental Society. Dr. Durbin graduated from the University of Kentucky College of Dentistry with a D.M.D. degree in 1978 and received his M.S.D. and Certificate in Orthodontics from the University of Kentucky College of Dentistry in 1983.
Randall K. Bennett, D.D.S., M.S. (age 45) has served as a Director of the Company since its inception in October 1996. Dr. Bennett has practiced orthodontics in Salt Lake City, Utah since 1989 and he practiced in Beverly Hills, California from 1988 to 1989. Dr. Bennett graduated from Loma Linda University in 1988 with a M.S. degree in orthodontics and from the University of Alberta in 1981 with a D.D.S. degree.
G. Harry Durity (age 54) has served as a Director of the Company since December 1998. Since August 1994, Mr. Durity has served as Corporate Vice President/Worldwide Business Development for Automatic Data Processing, Inc., a payroll service company. From 1992 to August 1994, Mr. Durity was Senior Vice
President/Corporate Development for Revlon Consumer Products Company, a personal care products company, and prior thereto was Vice President/Corporate Development for RJR Nabisco, Inc., a consumer products company.
Raymond G.W. Kubisch, D.D.S., M.S.D. (age 56) has served as a Director of the Company since June 1999. Dr. Kubisch has practiced orthodontics in the Seattle, Washington area since 1976. Dr. Kubisch graduated from Indiana University in 1968 with a Bachelor of Science in Marketing, and in 1974 graduated with a D.D.S. degree from Indiana University as Valedictorian. In 1976, Dr. Kubisch received his M.S.D. and Certificate in Orthodontics from the University of Washington. From 1986 to 1993, Dr. Kubisch was an Assistant Clinical Professor for the University of Washington.
Robert W. Miller (age 60) has served as a director of the Company since January 2001. Mr. Miller graduated from the University of Georgia in 1964 with a Bachelor of Arts in History, and in 1967 graduated with a law degree from Yale Law School. From 1967 - 1997, Mr. Miller served as partner in a number of law firms including Alston, Miller, & Gaines, Bondurant, Miller, Hishon & Stephenson, and King & Spalding. In addition, Mr. Miller serves on a variety of boards including Chairman of the Board at Magellan Health Services and Paracelsus Healthcare Corporation.
With the exception of Mr. Summers, none of the directors are, or have been, employed by any parent, subsidiary or other affiliate of the Company; provided, however, that Dr. Bennett entered into a part-time employment arrangement with the Company effective February 20, 1998. There are no family relationships between any directors or executive officers.
COMPENSATION OF DIRECTORS
Commencing with the November 2000 Board of Directors meeting, the following non-employee directors of the Company (the "Outside Directors") received compensation at the rate of $12,500 per meeting for their services as directors, Dr. Larry Dormois, Dr. Douglas Durbin, Dr. Stephen Tracey, Dr. Raymond Kubisch, Dr. Randall K. Bennett and Dr. Harry G. Durity. W. Dennis Summers received $15,000 prior to his assuming the responsibilities of interim President and Chief Executive Officer. In addition, pursuant to the 1997 Non-Employee Director Stock Plan, the Company made the following grants of options during 2000 to directors: Craig McKnight, Dr. Douglas Durbin, Dr. Harry G. Durity, Dr. Randall Bennett and Dr. Raymond Kubisch each received options to acquire 15,000 shares of Class A Common Stock, Dr. Larry Dormois and Dr. Stephen Tracey each received 10,000 options to acquire shares of Class A Common Stock. W. Dennis Summers received options to acquire 25,000 shares prior to assuming his responsibilities as interim President and Chief Executive Officer. Finally, directors are entitled to be reimbursed for expenses incurred in connection with their services as directors.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
SUMMARY COMPENSATION TABLE
The following table sets forth certain information concerning the compensation paid to the Company's Chief Executive Officer and each of the Named Executive Officers whose salary and bonus compensation for the year ended December 31, 2000 exceeded $100,000.
- --------------- (1) Represents annual salary, except where noted.
(2) Represents annual bonus earned for the periods indicated.
(3) Represents severance salary paid upon resignation.
(4) Represents commission payments for practice affiliations paid during 2000 and 1999.
(5) 25,000 of the 200,000 options were acquired under the OrthAlliance 1997 Director Stock Option Plan ("Director Plan").
(6) Represents options acquired under the Director Plan.
(7) Represents salary paid for the months of November and December 2000.
OPTION GRANTS IN LAST FISCAL YEAR
The following table sets forth information regarding stock option grants for the year ended December 31, 2000 to the Chief Executive Officer and each of the Named Executive Officers:
- --------------- (1) There can be no assurance provided to any executive officer or any other holder of the Company's securities that the actual stock price appreciation over the term will be at the assumed 5% and 10% levels or at any other defined level. Unless the market price of the Class A Common Stock appreciates over the option term, no value will be realized from the option grants made to the Chief Executive Officer or the Named Executive Officers.
The following table sets forth certain information with respect to the value of unexercised in-the-money options held by the Named Executive Officers of the Company at December 31, 2000. No options were exercised by the Named Executive Officers of the Company during 2000.
- --------------- (1) Based on a closing price of $2.6875 per share of Class A Common Stock on December 31, 2000.
NONCOMPETITION AND EMPLOYMENT CONTRACTS
The Company entered into employment agreements, each dated May 13, 1997, with Messrs. Westover and Hayase providing for annual base salaries of $250,000 and $165,000, respectively, with each person being eligible for a cash bonus of up to 30% of his base salary (the "Employment Agreements"). Additionally, the Employment Agreements provided for the grant of options for the purchase of Class A Common Stock to each of Messrs. Westover and Hayase for 300,000 and 75,000 shares, respectively, which such options (i) vested 20% on August 21, 1997 and (ii) will vest 20% per year on the first through the fourth anniversary dates thereof. These options expire ten years from the date of grant and are exercisable at $12.00 per share. In the event of employment termination, these options terminate 90 days from the date of such termination of employment.
Mr. Westover's employment agreement was terminated in December 2000. Mr. Hayase's Employment Agreement is for an initial term of five years with an automatic renewal for successive 1 year terms unless prior notice of termination is provided. The Company may terminate Mr. Hayase's Employment Agreement (i) for cause, (ii) without cause upon 30 days prior notice, or (iii) upon death or disability of Mr. Hayase. Mr. Hayase may terminate the Employment Agreement within 120 days after a constructive termination (as defined therein). If Mr. Hayase is terminated by the Company without cause or Mr. Hayase terminates the Employment Agreement within 120 days following a constructive termination, the Company is required to pay Mr. Hayase a lump sum severance equal to 2 times the applicable annual base salary. Mr. Hayase's Employment Agreement provides that if Mr. Hayase is terminated within a twelve-month period following a change in control of the Company (as defined therein), the Company will pay him three times the sum of (i) his annual base compensation, plus (ii) the maximum possible cash bonus for such year. In addition, upon a change in control, the Company will pay Mr. Hayase any accrued salary, benefits or reimbursements and his options will fully vest and become immediately exercisable for the longer of (i) 90 days from the change in control or (ii) the time period specified in the stock plan. Mr. Hayase's Employment Agreement prohibits Mr. Hayase from competing with the Company for a period of 2 years following termination of employment.
The Company entered into a letter agreement with Mr. Wilson on June 16, 1999 providing for an annual base salary of $174,996, and a cash bonus of up to 40% of his annualized base salary. Subject to the approval of the Board of Directors and the achievement of certain financial goals of the Company established by the Board of Directors and Management. Additionally, the Company granted Mr. Wilson an option to purchase 75,000 shares of Class A Common Stock, with a vesting schedule consistent with the vesting schedule described above for the Employment Agreements.
The Company entered into a letter agreement with Mr. Toon on May 22, 1998 providing for an initial base salary of $185,000 with a guaranteed management bonus in the amount of $92,500, and such bonus was paid in February of 1999. Thereafter, Mr. Toon is eligible to receive a bonus of up to 40% of his base salary, subject to the approval of the Board of Directors and the achievement of certain financial goals of the Company established by the Board of Directors and management. Additionally, the Company granted Mr. Toon an option to purchase 75,000 shares of Class A Common Stock, 20% of which vested on the date of grant, and 20% of which vests on each anniversary of the grant date. The letter agreement term is for a two year period and was extended for an additional two year term by amendment on May 22, 2000.
On November 29, 2000, the Company and Sam Westover ("Westover"), entered into a Severance Agreement and General Release dated November 29, 2000 (the "Westover Settlement Agreement") pursuant to which Westover agreed to resign as CEO and President of the Company. As part of the settlement, the Company and Westover agreed to a lump sum pay out of approximately $597,000 payable upon resignation. The Westover Severance Agreement also provided that Westover released the Company from any claims relating to his employment with the Company. Furthermore, to ensure an orderly transition, the Company and Westover agreed to a 1 year consulting agreement. The consulting agreement with Westover requires payment of approximately $12,000 per month beginning January 2001 and ending December 2001.
On December 15, 2000, the Company entered into letter agreements with each of Messrs. Hayase, Toon and Wilson. In the event each employee remains as a full time employee through September 15, 2001, Messrs. Hayase, Toon and Wilson will receive a one time bonus payment of $100,000, $75,000, and $75,000,
respectively. In the event that the Company terminates Messrs. Hayase, Toon, or Wilson's employment before September 15, 2001, other than for cause, then such named executive shall receive payment in full.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The current members of the Compensation Committee are Dr. Dormois, Messrs. Durity and McKnight. Dr. Dormois, Messrs. Durity, and McKnight are not and have not been officers or employees of the Company or any of its subsidiaries. A predecessor of the Company, U.S. Orthodontic Care, Inc. ("USOC"), entered into a consulting agreement with Newfound Capital Associates ("Newfound") and Newfound's president, Mr. Wilfong. The Company succeeded to the rights and obligations of USOC with respect to this agreement upon the merger of USOC with and into the Company and Mr. Wilfong entered into a separate consulting agreement with the Company whereby Mr. Wilfong agreed to provide financial and general business services to the Company in return for consulting fees of $300,000. In addition to the consulting fees, the Company granted Mr. Wilfong a warrant to purchase 150,000 shares of Class A Common Stock at an exercise price of $12.00 per share. A warrant granted to Mr. Wilfong to purchase 168,750 shares of USOC's common stock was converted in such merger to a warrant to purchase 168,750 shares of Class A Common Stock at $11.16 a share. Both warrants are exercisable for five (5) years from August 21, 1997.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
COMMON STOCK OWNERSHIP BY MANAGEMENT AND PRINCIPAL STOCKHOLDERS
The following table sets forth the beneficial ownership of shares of Class A Common Stock and Class B Common Stock as of March 13, 2001 for (i) directors of the Company, (ii) the Chief Executive Officer and each of the three most highly compensated executive officers of the Company (collectively the "Named Executive Officers"), (iii) the directors and executive officers of the Company as a group and (iv) each person who is a stockholder of the Company holding more than a five percent (5%) interest in the Company.
- --------------- * Less than 1%.
(1) Based on an aggregate of 12,076,601 shares of Class A Common Stock and 172,526 shares of Class B Common Stock issued and outstanding as of March 13, 2001. Includes shares of Class A Common Stock that may be acquired upon the exercise of stock options and warrants exercisable within 60 days. Each share of Class B Common Stock automatically converts into 8 shares of Class A Common Stock upon the attainment of certain average closing price calculations for the Class A Common Stock in 5 increments of 20% each. If not converted on or before August 21, 2003, each share of Class B Common Stock automatically converts into 1 share of Class A Common Stock. Each person named above has sole voting and dispositive power with respect to all shares listed opposite such person's name, except as otherwise noted. The address of all persons listed, except Goldman Sachs Asset Management, Wasatch Advisors, Inc. and Dr. Pickron, is 21535 Hawthorne Boulevard, Suite 200, Torrance, California 90503.
(2) The business address of Goldman Sachs Asset Management ("GSAM") is 1 New York Plaza, New York, New York 10004. Share ownership for GSAM, a separate operating division of Goldman, Sachs & Co. is as of December 31, 2000 and was obtained from a Schedule 13G/A, dated February 14, 2001, filed with the Securities and Exchange Commission February 13, 2001. GSAM has sole voting power with respect to 1,208,800 shares and sole dispositive power with respect to 1,541,000 shares.
(3) The business address of Wasatch Advisors, Inc. ("Wasatch") is 150 Social Hall Avenue, Salt Lake City, UT 84111. Share ownership Wasatch is as of December 31, 2000 and was obtained from a Schedule 13G/A, dated February 14, 2001, filed with the Securities and Exchange Commission February 15, 2001.
(4) Includes 30,000 shares of Class A Common Stock purchasable upon exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the OrthAlliance 1997 Director Stock Option Plan, as amended ("Director Plan") and 100,000 shares of Class A Common Stock purchasable under exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the OrthAlliance, Inc. Amended and Restated 1997 Employee Stock Option Plan ("Employee Plan").
(5) Includes 340,000 shares of Class A Common Stock purchasable upon exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the Employee Plan. Mr. Westover resigned effective December 27, 2000.
(6) Consists of 50,000 shares of Class A Common Stock purchasable upon exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the Employee Plan.
(7) Includes 210,000 shares of Class A Common Stock purchasable upon exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the Employee Plan.
(8) Includes 82,371 shares of Class A Common Stock purchasable upon exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the Employee Plan.
(9) Includes 50,000 shares of Class A Common Stock purchasable upon exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the Director Plan.
(10) Includes 30,000 shares of Class A Common Stock purchasable upon exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the Director Plan. This amount also includes 1,600 shares of Class A Common Stock that are indirectly owned.
(11) Consists of 20,000 shares of Class A Common Stock purchasable upon exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the Director Plan.
(12) Consists of 15,000 shares of Class A Common Stock purchasable upon exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the Director Plan.
(13) Consists of 14,359 shares of Class A Common Stock purchasable upon exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the OrthAlliance, Inc. 1999 Orthodontist Stock Option Plan.
(14) Consists of 30,000 shares of Class A Common Stock purchasable upon exercise of stock options that are currently exercisable or exercisable within 60 days pursuant to the Director Plan.
(15) The business address of Dr. Pickron is 3294 Medlock Bridge Road, Building A, Norcross, Georgia 30092. Class A Common Stock share ownership of Dr. Pickron is as of December 31, 1998 and was obtained from a Schedule 13G/A, dated December 31, 1999, filed with the Securities and Exchange Commission June 20, 2000. Class B Common Stock share ownership of Dr. Pickron is as of December 31, 1998 and was obtained from a Schedule 13G/A, dated December 31, 1999, filed with the Securities and Exchange Commission June 20, 2000.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS.
Dr. Randall Bennett, a director and shareholder, serves as Chairman of the OrthAlliance Clinical Advisory Committee as an independent contractor at the rate of $2,000 per month. In addition, Dr. Bennett assists in the development and improvement of OrthAlliance's orthodontic programs, procedures and training materials as a part-time employee of OrthAlliance Properties, Inc. for a salary of $2,000 per month. On
April 7, 1998, the Company loaned $49,885 to Randall K. Bennett, D.D.S., M.S., P.C. of which Dr. Bennett, a director of the Company, is the 100% owner to purchase office equipment. Interest in the loan accrues at the prime rate plus 10% and the term of the loan is thirty-six months. At March 31, 2001, principal in the amount of $1,500 was outstanding.
W. Dennis Summers, Esq., Interim President and Chief Executive Officer and Chairman of the Board of Directors, is a partner of the law firm McGuire Woods, L.L.P. ("McGuire Woods"). OrthAlliance has retained McGuire Woods to assist with certain transactions, including, but not limited to, the Purchase and Sale Agreement dated February 29, 2000 by and among OrthAlliance, New Image Orthodontic Group, Inc. and OrthAlliance New Image, Inc. During 2000, approximately $51,000 was paid to this firm.
Effective March 1, 2000, OrthAlliance acquired substantially all of the assets of New Image. The consideration paid to New Image included approximately $5.6 million in cash, an estimated $0.3 million in acquisition costs, the issuance of approximately $12.9 million in promissory notes to New Image and the assumption of approximately $13.4 million in indebtedness from New Image. At the time of the sale, New Image was controlled by certain entities which OrthAlliance believes are affiliated with Goldman Sachs Asset Management. Goldman Sachs Asset Management has reported beneficially owning 12.8% of OrthAlliance's Class A Common Stock. See "Common Stock Ownership by Management and Principal Stockholders." The purchase price in the New Image acquisition was determined in arms'-length negotiations between officers and directors of OrthAlliance, on one hand, and officers and directors of New Image, on the other hand. OrthAlliance believes the purchase price is within the range of purchase prices generally paid by OrthAlliance and similar companies for similar assets and rights related to orthodontic practices.
REPORT ON EXECUTIVE COMPENSATION
The Compensation Committee is responsible for ensuring that a proper system of short and long-term compensation is in place to provide performance-oriented incentives to management. Its report on compensation is as follows:
The Compensation Committee (the "Committee") of the Board of Directors is responsible for administering the Company's executive compensation program. None of the members of the Committee are officers or employees of the Company.
EXECUTIVE COMPENSATION PROGRAM
The Committee believes that a portion of the compensation paid to executive officers should relate to both the short-term and long-term profitability of the Company. Therefore, the executive officers' compensation program is composed of base salary, bonus and long-term incentive compensation.
Base Salary and Bonus. Base salaries for Messrs. Westover and Hayase are paid pursuant to the Employment Agreements and the base salary for Messrs. Toon and Wilson is paid pursuant to Letter Agreements. Base salary for Mr. Summers is paid pursuant to an oral agreement.
Each of Messrs. Hayase, Wilson and Toon is eligible for an annual cash bonus of up to forty percent (40%) of his annualized base salary. Until his resignation from the Company on December 27, 2000, Mr. Westover was eligible for an annual cash bonus of up to forty percent (40%) of his annualized base salary. The individual bonus percentages for 2000 were established by the Committee based upon each officer's level of responsibility within the Company and his contributions toward improving operating performance and profitability. The bonus percentages will be reviewed annually by the Committee and may be adjusted in accordance with these factors or others that the Committee determines to be relevant at the time.
The Committee believes that the bonus portion of the executive compensation program is effective in motivating the executive officers of the Company to improve the current profitability of the Company. The Committee also believes that an adequate base salary is necessary to retain effective executive officers and to discourage management decisions which might improve short-term profitability but may not always be in the long-term best interest of the Company.
Long-Term Incentives. The Committee believes that, in addition to the annual cash bonus arrangements, it is appropriate for the Company to provide long-term incentive awards to motivate the executive officers to improve long-term profitability of the Company and create value for the stockholders.
COMPENSATION OF THE CHIEF EXECUTIVE OFFICER
Compensation arrangements for Mr. Summers as President and Chief Executive Officer consisting of base salary and stock options were based on consideration of various factors, including his prior experience with the Company as Chairman and a Director, his compensation at his law firm from which he is on leave of absence and his willingness to serve on an interim basis until a replacement is identified.
Mr. Westover served as President and Chief Executive Officer of the Company until his resignation as such on November 29, 2000. Compensation arrangements for Mr. Westover were determined based on his Employment Agreement with respect to base salary and long-term compensation and based on consideration of the factors described above with respect to the bonus amounts. The Committee noted the growth of the Company, attainment of financial objectives and the increase in Mr. Westover's responsibilities related thereto.
SECTION 162(m) OF THE INTERNAL REVENUE CODE
Section 162(m) of the Internal Revenue Code, added as part of the Omnibus Budget Reconciliation Act of 1993, imposes a limitation on deductions that can be taken by a publicly held corporation for compensation paid to certain of its executives. Under Section 162(m), a deduction is denied for compensation paid in a tax year beginning on or after January 1, 1994, to a corporation's chief executive officer or any of its other four
most highly compensated officers to the extent that such compensation exceeds $1 million. Certain performance-based compensation, however, is specifically exempt from the deduction limit.
The Committee's current policy with respect to the Section 162(m) limitations is to preserve the federal income tax deductibility of executive compensation payments when it is appropriate and in the best interests of the Company and its stockholders. For the foreseeable future, the Committee does not expect Section 162(m) to have any practical effect on the Company's compensation program. However, the Committee reserves the right to approve the payment of nondeductible compensation in the future if it deems such payment to be appropriate.
COMPENSATION COMMITTEE
Craig L. McKnight Larry Dormois G. Harry Durity
THE FOREGOING REPORT SHOULD NOT BE DEEMED INCORPORATED BY REFERENCE BY ANY GENERAL STATEMENT INCORPORATING BY REFERENCE THIS FORM 10-K INTO ANY FILING UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR UNDER THE EXCHANGE ACT (TOGETHER, THE "ACTS"), EXCEPT TO THE EXTENT THAT THE COMPANY SPECIFICALLY INCORPORATES THIS INFORMATION BY REFERENCE, AND SHALL NOT OTHERWISE BE DEEMED FILED UNDER SUCH ACTS.
STOCK PRICE PERFORMANCE GRAPH
The following line graph compares the yearly percentage change in cumulative stockholder return on the Common Stock with (a) the performance of a broad equity market indicator, and (b) the performance of a published industry index. The graph compares the percentage change in the return on the Common Stock since August 21, 1997 with the cumulative total return on the Nasdaq Stock Market Index and Nasdaq Health Services Stock Index. The stock price performance graph assumes an investment of $100 in the Company on August 21, 1997 and an investment of $100 in the two (2) indexes on August 21, 1997 and further assumes the reinvestment of all dividends. Stock price performance, presented monthly for the period from August 21, 1997 through December 31, 2000 is not necessarily indicative of future results.
COMPARISON OF 40 MONTH CUMULATIVE TOTAL RETURN* AMONG ORTHALLIANCE, INC., THE NASDAQ STOCK MARKET (U.S.) INDEX AND THE NASDAQ HEALTH SERVICES INDEX
* $100 INVESTED ON 8/21/97 IN STOCK OR INDEX- INCLUDING REINVESTMENT OF DIVIDENDS. FISCAL YEAR ENDING DECEMBER 31.
THE STOCK PRICE PERFORMANCE GRAPH SHALL NOT BE DEEMED INCORPORATED BY REFERENCE BY ANY GENERAL STATEMENT INCORPORATING BY REFERENCE THIS FORM 10-K INTO ANY FILING UNDER THE ACTS EXCEPT TO THE EXTENT THAT THE COMPANY SPECIFICALLY INCORPORATES THIS INFORMATION BY REFERENCE, AND SHALL NOT OTHERWISE BE DEEMED FILED UNDER SUCH ACT.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) The following documents as filed as part of this registrant:
(1) Financial Statements
The list of consolidated financial statements contained in the accompanying Index to Consolidated Financial Statements covered by the Report of Independent Public Accountants is herein incorporated by reference.
(2) Financial Statement Schedules
The list of financial statement schedules contained in the accompanying Index to Consolidated Financial Statements is incorporated by reference. All other schedules are omitted because they are not applicable or the required format is included in the Consolidated Financial Statements and Notes thereto.
(3) Exhibits
The list of exhibits on the accompanying Exhibit Index is herein incorporated by reference.
EXHIBIT INDEX
- --------------- (b) Reports on Form 8-K.
The Company did not file any reports on Form 8-K during the fourth quarter of 2000.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the 1934 Act, the Company has duly caused this Form 10-K to be signed on behalf of the undersigned, thereunto duly authorized, on March 31, 2001.
ORTHALLIANCE, INC.
By: /s/ W. DENNIS SUMMERS ------------------------------------ W. Dennis Summers President, Chief Executive Officer and Chairman of the Board (Principal Executive Officer)
By: /s/ JAMES C. WILSON ------------------------------------ James C. Wilson Chief Financial Officer (Principal Financial and Accounting Officer)
Pursuant to the Requirements of the 1934 Act, this Form 10-K has been signed below by the following persons in the capacities indicated on March 31, 2001.
ORTHALLIANCE, INC. AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS AND REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of OrthAlliance, Inc.:
We have audited the accompanying consolidated balance sheets of OrthAlliance, Inc. (a Delaware Corporation) and subsidiaries as of December 31, 2000 and 1999, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years ended December 31, 2000. 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 auditing standards generally accepted in the United States. 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 financial statements referred to above present fairly, in all material respects, the financial position of OrthAlliance, Inc. and subsidiaries as of December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the three years ended December 31, 2000, in conformity with accounting principles generally accepted in the United States.
/s/ ARTHUR ANDERSEN LLP
Arthur Andersen LLP
Los Angeles, California March 7, 2001
ORTHALLIANCE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
ASSETS
The accompanying notes are an integral part of these consolidated balance sheets.
ORTHALLIANCE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The accompanying notes are an integral part of these consolidated financial statements.
ORTHALLIANCE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
ORTHALLIANCE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 2000, 1999, AND 1998 (DOLLARS AND SHARE AMOUNTS IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
ORTHALLIANCE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1. BUSINESS AND ORGANIZATION
a. ORGANIZATION
OrthAlliance, Inc. ("OrthAlliance"), a Delaware corporation, was incorporated on October 21, 1996 and provides practice management and consulting services to orthodontic and pediatric dental practices throughout the United States. Effective prior to the closing of the initial public offering of shares of OrthAlliance's Class A Common Stock (the "Offering" or "IPO"), Premier Orthodontic Group, Inc. ("Premier") and US Orthodontic Care, Inc. ("USOC") merged with and into OrthAlliance. In the merger, the outstanding common stock of USOC and Premier converted into shares of Class A Common Stock ("Common Stock") and shares of Class B Common Stock ("Class B Common Stock"). On August 26, 1997, OrthAlliance acquired (the "Acquisitions") simultaneously with the closing of the IPO certain operating assets of or the stock of entities holding certain tangible and intangible assets and assumed certain liabilities of 55 orthodontic practices in exchange for shares of Common Stock and cash. The Acquisitions were accounted for in accordance with the Securities and Exchange Commission's Staff Accounting Bulletin No. 48.
OrthAlliance's wholly-owned subsidiaries, incorporated in Delaware, include PedoAlliance, Inc. ("PedoAlliance") and OrthAlliance Finance, Inc. ("OA Finance") were formed in December 1997. PedoAlliance Properties Inc., a wholly-owned subsidiary of PedoAlliance, OrthAlliance Properties, Inc. and OrthAlliance Services, Inc. were incorporated in California in April 1999. OrthAlliance Holdings, Inc., incorporated in Texas, and OrthAlliance New Image, Inc. ("OA New Image") were formed in January 2000. These subsidiaries were formed to provide practice management, patient financing, consulting and other services (collectively "Management Services") to allied orthodontic and pediatric dental practices (the "Allied Practices") or their patients. OrthAlliance, Inc. and its subsidiaries are collectively referred to as "OrthAlliance" or the "Company".
b. AGREEMENTS WITH ALLIED PRACTICES
The Company is party to management service agreements with the Allied Practices. These are either "Service Agreements", "Consulting Agreements", or "Management Service Agreements", collectively "Management Agreements." The type of Management Agreements are determined by the Company and each Allied Practice based primarily on applicable state laws and regulations and are as follows:
Service Agreements
The parties to each Service Agreement include the Company and the Allied Practice, which typically is a professional corporation or association owned by the related Orthodontist or Pediatric Dentist. Each Service Agreement generally requires the Company to perform the following services for the Allied Practices: provide and maintain specified furnishings and equipment; provide necessary employees (except Orthodontists and Pediatric Dentists, and where applicable law requires, hygienists and dental assistants); establish appropriate business systems; purchase and maintain inventory; perform payroll and accounting functions; provide billing and collection services with respect to patients, insurance companies, and third-party payors; arrange certain legal services not related to malpractice litigation; design and execute a marketing plan; advise with respect to new office locations; and manage and organize the Allied Practices' files and records, including patient records where permitted by applicable law. If the Allied Practice lacks sufficient funds to pay its current operating expenses, the Company is also required to advance funds to the Allied Practice for the purpose of paying such expenses. In exchange for performing the services described above, the Company receives a management fee based on one of the three fee structures described in section c. below.
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The term of each Service Agreement is 20 to 25 years, subject to prior termination by either party in the event the other party becomes subject to voluntary or involuntary bankruptcy proceedings or materially breaches the agreement, subject to a cure period. In addition, the Allied Practices may terminate the Service Agreements upon the occurrence of a change of control of OrthAlliance (as defined therein, which does not include a transaction approved by the Company's Board of Directors). Upon the expiration or termination of the Service Agreement, the Allied Practice may, and in certain circumstances must, repurchase for cash (at book value) certain assets, including all equipment, and assume certain liabilities of the Company related to the Allied Practice.
Service Agreements are generally not assignable by either party thereto without the written consent of the other party; however, the Company may assign the Service Agreement without the Allied Practice's consent to any entity under common control of the Company. The Company and the Allied Practice agree to indemnify each other for costs and expenses incurred by such other party that are caused directly or indirectly by, as the case may be, the Company's or the Allied Practice's intentional or negligent acts or omissions. In the case of the Allied Practice's obligation to indemnify the Company, such obligation also applies to intentional or negligent acts and omissions occurring prior to the date of the Service Agreement.
Consulting Agreements
The parties to each Consulting Agreement include the Company and the Allied Practice. Certain provisions of the Consulting Agreement are substantially similar to the Service Agreement, including provisions relating to the Company's obligation to loan funds to the Allied Practice in the event the Allied Practice is unable to pay its current operating expenses; termination of the Consulting Agreement; repurchase of assets and assumption of liabilities by the Allied Practice upon expiration or termination; assignment; and indemnification.
The services provided by the Company to the Allied Practice under each Consulting Agreement generally include consulting with respect to equipment and office needs; preparing staffing models appropriate for an Allied Practice; advising and training with respect to business systems; purchasing and maintaining inventory; advising with respect to and providing or arranging accounting and bookkeeping services; advising with respect to developing a marketing plan; assessing the financial feasibility of establishing new offices; providing billing and collection services; and assisting the Allied Practice in organizing and developing filing and recording systems. In exchange for such services, the Company receives a consulting fee based on one of the three fee structures described below.
Management Service Agreements.
In March 2000, the Company and OA New Image assumed the obligations of New Image under the various Management Service Agreements ("MSA") between New Image and the orthodontic practices with whom it had entered into MSAs. The form of MSA provides for a variation of the service fee calculation compared to the traditional Company form defined in the service or consulting agreement. Under the MSAs, the service fee amount varies monthly depending on the Allied Practices financial performance and represents the residual amount after the payment of practice expenses and contractually determined practice distributions. The service fee is affected by two variables, (1) total Allied Practice gross revenue, less refunds, and (2) overhead. Service fees are calculated based on two separate standardized grids set forth in the MSA that determine (i) the percent of practice revenue that is distributed to the Allied Practice based on that Allied Practice's gross revenue, less refunds, ("Gross Revenue Grid") and (ii) any additional or offsetting percentage of gross revenue, less refunds, that is distributed to the Allied Practice based upon that Allied's Practice's overhead ("Overhead Grid"). Pursuant to the Gross Revenue Grid, in general, the Company's
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
retained service fees increase if the Allied Practice's gross revenue increases and decrease if the Allied Practice's gross revenue decreases. Pursuant to the Overhead Grid, in general, the Company's retained service fees decrease if the Allied Practice's overhead expenses increase and the retained service fees increase if the Allied Practice's overhead decreases. The maximum retained service fee percentage is 20.0%. The average service fee percentage for the OA New Image Allied Practices is approximately 16.1%. In addition, a few OA New Image MSAs provide for a fixed percentage service fee.
c. CALCULATION OF MANAGEMENT FEES
Management fees are calculated pursuant to the Management Agreements based upon the Allied Practice's Adjusted Patient Revenue calculated on the accrual basis. There are three economic models by which the management fee may be calculated under the Management Agreements discussed above which are as follows:
(i) a designated percentage ranging from 13.5% to 20% of Adjusted Patient Revenue. The average designated percentage is 17% for the Allied Practices subject to this fee structure. In some cases, the Allied Practice must guarantee a minimum level of management fees to be paid by the Allied Practice for a portion of the agreement ranging from one to 25 years.
(ii) a designated percentage of Adjusted Patient Revenue, ranging from 14% to 17%, subject to an annual adjustment based upon improvements in the Allied Practice's operating margin in the most recent calendar year as compared with the immediately preceding calendar year. No annual adjustment will be made which would result in reducing the designated percentage below the percentage applicable during the first year of the Management Agreement. Operating margin is defined as the percentage determined by dividing operating profit by Adjusted Patient Revenue. Operating profit is equal to Adjusted Patient Revenue less operating expenses, excluding the management fee and such expenses associated with the Allied Practices which the Company is prohibited from incurring, primarily consisting of orthodontist compensation. The average designated percentage is 16.2% for the Allied Practices subject to this fee structure.
(iii) a fixed dollar fee with annual established fixed increases for each year of the Management Agreement.
The Company has entered into agreements with certain Allied Practices to make the payment of service fees after the first two years contingent on various factors, including practice profitability compared to acquisition consideration, timely reporting of information, participation in practice improvement programs and orthodontist hours worked.
The Company earns revenue by providing services pursuant to Management Agreements with Allied Practices. The Company provides management or consulting services to each Allied Practice and assumes substantially all operating expenses except for compensation to the allied orthodontists and pediatric dentists ("Allied Practitioners") and other employees that the Company may not employ according to applicable state laws. In exchange for assuming these expenses and providing services, the Company records revenues in amounts equal to the assumed expenses plus a service fee or consulting fee, as described below.
Patient revenue is recognized as services are performed. For orthodontic services, approximately 20% of the orthodontic patient contract revenues are recognized at the time of initial treatment. The balance of the contract revenue is recognized evenly over the remaining treatment period. The 25% estimated revenue at the initial treatment date is based on the estimated costs incurred by the Company at that time as compared to the total costs of providing the contracted services. The percentage includes the estimated costs of diagnosis and
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treatment plan development, initial treatment by Company personnel, orthodontic supplies, and associated administrative services.
Expenses reported by the Company include certain of the expenses to operate the orthodontic or pediatric dental offices and all of the expenses of any corporate offices, facilities or functions.
d. PATIENT RECEIVABLES AND PATIENT PREPAYMENTS
The difference in the timing of the recognition of adjusted patient revenue and the collection of cash related thereto results in unbilled receivables or patient prepayments. Unbilled patient receivables represent the earned revenue in excess of billings to patients as of the end of each period. Patient prepayments represent collections from patients or their insurance companies which are received in advance of the performance of the related services.
Patient receivables are recorded at net realizable value on the date of affiliation and subsequent collections are used to pay Allied Practice operating expenses, the Company's management fee, and payments to the Allied Practices. Generally, any subsequent uncollectible accounts are recorded as a reduction of net revenues, which reduces the Company's management fees at the applicable service fee percentage.
Generally, the Allied Practices require approximately 25% of the treatment contract to be paid upon installation of the braces, and the remaining 75% evenly over the remainder of the treatment term.
e. AMOUNTS DUE FROM ALLIED PRACTICES
Amounts due from Allied Practices include short-term advances for operating capital and short-term receivables related to a timing difference between when the service fees are paid from the Allied Practice's accounts and when the service fees are deposited by the Company. These items are advanced and repaid in a revolving manner. Generally, advances are repaid when Allied Practices deposit patient revenue into their depository accounts. Advances occur when the Allied Practice operating expenses paid exceed patient revenue earned. Service fees outstanding are generally paid within 30 days.
f. OPERATING EXPENSES OF ALLIED PRACTICES
The Company is responsible for the payment of all operating expenses incurred by the Allied Practice, except for compensation to Allied Practitioners and other expenses of the Allied Practices that the Company is prohibited from paying. Expenses that are the responsibility of the Company include the following: (i) salaries, benefits, payroll taxes, workers compensation, health insurance and other benefit plans, and other direct expenses of all employees of OrthAlliance at each practice office, excluding those costs associated with orthodontists and any other classification of employee which OrthAlliance is prohibited from employing by applicable state laws or regulations; (ii) direct costs of all employees or consultants that provide services to each practice office except for Affiliated Orthodontists and other employees of the Allied Practices that the Company is prohibited from employing, (iii) dental and office supplies as permitted by applicable state laws or regulations, (iv) lease or rent payments as permitted by state laws or regulations, utilities, telephone and maintenance expenses for practice facilities, (v) property taxes on OrthAlliance assets located at Allied Practice offices, (vi) property, casualty, and liability insurance premiums, (vii) orthodontists recruiting expenses, and (viii) advertising and other marketing expenses attributable to the promotion of practice offices.
All of the above expenses are paid directly to the third party provider of the goods or services indicated. All of the above expenses are incurred by OrthAlliance. Such expenses are classified together with similar expenses of the Company in the consolidated statements of income. In exchange for incurring these expenses
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and providing management services, the Company records revenue in amounts equal to those incurred expenses.
The Allied Practices retain the responsibility for the payment of any and all direct employment expenses, including benefits, for any Orthodontist or other employee that OrthAlliance is prohibited from employing by applicable state laws or regulations. In addition, the Allied Practices retain the responsibility for the payment of continuing education expenses, seminars, professional licenses, professional membership dues and all other expenses of any Orthodontist.
g. NEW AFFILIATIONS
For the year ended December 31, 2000, the Company entered into or assumed agreements with 43 Allied Practices. Included were 31 practices acquired from New Image on March 1, 2000, as well as 2 pediatric dental practices, to provide management and consulting services and acquire certain operating assets for a total consideration (including acquisition costs) of $42.6 million. This consideration consisted of options to acquire Class A Common Stock with a fair value of $0.6 million, $14.8 million in cash, $27.2 million in affiliation and notes payables. These Allied Practices operate 76 locations.
For the year ended December 31, 1999, the Company entered into agreements with 36 Allied Practices, 11 of which were pediatric dental practices, to provide management services and acquire certain operating assets for a total consideration (including acquisition costs) of $39.5 million. This consideration consisted of 93,584 shares of Common Stock, from the Treasury, with an aggregate value at various acquisition dates of $0.8 million, payment of $33.0 million in cash, $5.7 million in affiliation and notes payable. These Allied Practices operate 73 locations.
For the year ended December 31, 1998, the Company entered into agreements with 36 Allied Practices, seven of which were related to pediatric dental practices, to provide management services and acquire certain operating assets for a total consideration (including acquisition costs) of $46.8 million. This consideration consisted of 1,640,492 shares of Common Stock with an aggregate value at various acquisition dates of $19.8 million and payment of $24.5 million in cash and issuance of notes payable of $2.5 million. These Allied Practices operate 70 locations.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
a. PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include OrthAlliance, Inc. and its wholly owned subsidiaries. The Company does not consolidate the operations of the Allied Practices which it manages as the Company's arrangements with its Allied Practices do not meet the requirements for consolidation as set forth in Emerging Issues Task Force consensus opinion 97-2 ("EITF 97-2"). All significant intercompany accounts and transactions have been eliminated in consolidation.
b. USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
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c. CASH AND CASH EQUIVALENTS
The Company considers all highly-liquid investments with a maturity of three months or less at the date of purchase to be cash equivalents. All cash equivalents are recorded at cost, which approximates fair value.
d. PROPERTY AND EQUIPMENT, NET
Property and equipment are stated at cost or fair value at acquisition date if acquired upon affiliation with an Allied Practice. Routine maintenance and repairs are expensed when incurred, while costs of improvements and renewals are capitalized. Depreciation of property and equipment is calculated using the straight-line method over the estimated useful lives of the assets or remaining lease terms as follows:
Depreciation expense for the years ended December 31, 2000, 1999 and 1998 was approximately $1.8 million, $1.2 million, and $0.9 million, respectively.
e. INTANGIBLE ASSETS, NET
The Management Agreements with Allied Practices include the acquisition of certain tangible and intangible assets and the assumption of certain liabilities of the Allied Practices. The Company allocates the purchase price to the tangible assets acquired and liabilities assumed based on their estimated fair values. Intangible assets related to the Management Agreements are being amortized using the straight-line method over their respective terms. The Company periodically evaluates whether events and circumstances have occurred that indicate the remaining useful life of the intangible assets may warrant revision or that the remaining balance of the intangible assets may not be recoverable. As of December 31, 2000 and 1999, there were no events or circumstances to indicate that any portion of the recorded net intangible assets may not be recoverable.
Amortization expense related to these intangible assets for the years ended December 31, 2000, 1999 and 1998 was $4.9 million, $2.8 million, and $1.5 million, respectively.
f. OTHER, NET
Other, net consists primarily of deferred costs related to the Company's bank credit facility. These costs are amortized using the straight-line method over the expected period to be benefited. The amortization of deferred costs related to the line of credit borrowings is included in interest expense.
g. NET REVENUES
Net revenues primarily consist of management fee income and reimbursed practice operating expenses (See Note 1). Such reimbursed practice operating expenses amounted to $106.1 million, $68.9 million, and $54.4 million for the years ended December 31, 2000, 1999, and 1998, respectively.
h. INCOME TAXES
The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The statement requires recognition of deferred tax assets and liabilities for expected future tax consequences of events that have been recognized in the financial statements or tax returns. Deferred income taxes are provided for temporary differences in the
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recognition of certain income and expense items for financial reporting and tax purposes given the provisions of the enacted tax laws.
i. FAIR VALUE OF FINANCIAL INSTRUMENTS
As of December 31, 2000 and 1999 the carrying amounts of the Company's financial instruments, which include cash and cash equivalents, notes receivable, accounts payable and accrued liabilities, notes payable and line of credit borrowings, approximates fair value.
j. RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), as amended by SFAS 137 and SFAS 138. SFAS 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. It requires that entities recognize all derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair value. Management anticipates that the adoption of SFAS 133 will not have a material affect on the Company's results of operations or financial position.
The SEC issued Staff Accounting Bulletin Number 101, Revenue Recognition in Financial Statements, on December 3, 1999 ("SAB 101"). This pronouncement clarifies existing revenue recognition principles and states that revenue is generally realized or realizable and earned when all of the following criteria are met: i) persuasive evidence of an arrangement exists, ii) delivery has occurred or services rendered, iii) the seller's price to the buyer is fixed or determinable and iv) collectibility is reasonably assured. Management believes the Company is in compliance with SAB 101.
k. RECLASSIFICATIONS
Certain prior year reclassifications have been made to conform to classifications used in the current period.
3. ACQUISITION OF NEW IMAGE
Effective March 1, 2000, the Company acquired substantially all of the assets of New Image Orthodontic Group, Inc. ("New Image"), a privately held Georgia corporation based in Atlanta, Georgia, for a total consideration (including acquisition costs) of approximately $33.8 million. New Image was founded in February 1997 and provided business operations, financial, marketing and administrative services to orthodontic practices in 9 states in accordance with long term service and employment agreements and had practice management agreements with 36 orthodontists operating in 50 locations.
Total consideration (including acquisition costs) consisted of $5.6 million paid in cash, an estimated $0.3 million in acquisition costs, promissory notes issued of approximately $12.9 million, the assumption of approximately $13.4 million of existing debt due to New Image's former orthodontic practices, and the issuance of approximately 273,000 stock options with an aggregate fair value of $0.6 million. The promissory notes issued and assumed have interest rates ranging from 6% - 10% and are repayable over a one to five year period. The Company will utilize substantially all the acquired assets in the continued operation of the business. The acquisition has been accounted for using the purchase method of accounting. Intangible assets of approximately $32.9 million resulted from the acquisition. The results of operations of New Image are included with the results of operations of the Company from March 1, 2000. The Company obtained the appropriate consents from its lenders with regard to this transaction.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The following pro forma results of operations are presented to illustrate the effect of the acquisition on the historical operating results of OrthAlliance and New Image for the twelve month periods ended December 31, 1999 and December 31, 2000. These pro forma results of operation gives effect to the acquisition as if it occurred as of January 1, 2000 and January 1, 1999, respectively. The pro forma results of operations are based on management's current estimates and may not be indicative of the results of operations that actually would have occurred if the transaction had been at the dates indicated.
- --------------- (a) Because the transaction with New Image was effective March 1, 2000, the results of operations for New Image and the proforma adjustments are for the two months period ended February 29, 2000.
(b) Proforma adjustments are presented to illustrate the effect of the acquisition on the historical operating results of OrthAlliance and New Image, as if the acquisition occurred as of that date. The proforma adjustments include the effect of increased amortization of goodwill and interest expense, due to the additional goodwill acquired and increased debt levels relating to the financing of the acquisition. Other proforma adjustments reflect cost savings relating to the elimination of duplicate general and administrative expenses included in the New Image and OrthAlliance corporate overhead structures.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
4. OTHER CURRENT ASSETS
Other current assets consist of the following:
5. PROPERTY AND EQUIPMENT, NET
Property and equipment, net consist of the following:
6. NOTES RECEIVABLE, NET
Notes receivable consist of the following:
Certain Allied Practices have signed promissory notes due to the Company. Generally, principal and interest payments are due monthly, with interest accruing at prime plus 1%. Generally, these notes have maturity dates ranging from three to five years, are unsecured and are personally guaranteed by the respective practitioners. As of December 31, 2000 and 1999, the prime interest rate was 9.0% and 8.50%, respectively.
During 2000 and 1999, OA Finance financed approximately $0.8 million and $1.0 million, respectively, of patient loans from certain Allied Practices. OA Finance was formed to provide patient financing options to all Allied Practices. The loans outstanding are generally without recourse and principal and interest are due monthly, with interest rates, varying between 9.9% and 16.9 %, depending on the credit risk of the borrower. The terms of these loans range from one to five years.
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7. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable and accrued liabilities consist of the following:
8. LINE OF CREDIT BORROWINGS
On December 30 1997, the Company entered into a credit agreement with First Union National Bank to provide a $25 million revolving line of credit. The interest on borrowings accrues at either the bank's prime rate or LIBOR, plus a margin. Amounts borrowed are secured by security interests in the Company's assets, which include accounts receivable, Management Agreements and the capital stock of the Company's wholly-owned subsidiaries. The Company expanded the credit facility ("the Revolving Credit Facility") with on March 26, 1999 from $25 million to $55 million and from $55 million to $75 million on April 14, 2000. Outstanding amounts under the April 14, 2000 agreement are repayable in full on April 13, 2003. As of December 31, 2000 and 1999, the outstanding balance under this credit facility was $62 million and $47.5 million, respectively. As of December 31, 2000 the Company was in compliance with the terms and covenants of the Revolving Credit Facility.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
9. NOTES PAYABLE
Notes payable as of December 31, 2000 and 1999 are summarized in the following table:
Future maturities of notes payable are as follows as of December 31, 2000:
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10. CLASS B COMMON STOCK
Each share of Class B Common Stock will automatically convert into eight shares of Class A Common Stock upon the attainment of certain conversion prices. Twenty percent of the Class B Common Stock shares will convert at each of the following conversion prices: $18.00, $21.60, $25.92, $31.10, and $37.32. The conversion will be effected when the average Class A Common Stock closing price for 20 consecutive trading days exceeds the threshold. Class B Common Stock is also convertible to an equal number of Class A Common Stock shares at any time at the option of the holder. Any Class B Common Stock shares not converted to Class A Common Stock, because the necessary conversion prices were not attained, will automatically convert to one share of Common Stock upon the sixth anniversary of the IPO. Class B Common Stock shares are not transferable, except to a holder's direct relatives or as determined by will or the laws of descent. The holders of Class B Common Stock enjoy the same share-for-share voting rights with holders of the Class A Common Stock, with whom they vote as a single class.
11. PREFERRED STOCK
The Company is authorized to issue up to 20.0 million shares of preferred stock. The Board of Directors, from time to time and without stockholder action or approval, may fix the relative rights and preferences of the preferred shares, including voting powers, dividend rights, liquidation preferences, redemption rights and conversion privileges. No preferred stock was outstanding as of December 31, 2000 and 1999, respectively.
12. TREASURY STOCK
On December 1, 2000, the Company announced that its common stock repurchase program ("Stock Repurchase Program"), instituted in October 1998, would be extended through December 2001. In connection with the program, the Company is authorized to purchase up to $6.8 million in shares at prices prevailing on the market. The Company uses the cost method to account for treasury stock. During 2000 and 1999, the Company repurchased 876,100 and 241,286 shares of its Common Stock, respectively under the Stock Repurchase Program. As of December 31, 2000, the Company's aggregate purchase price of Common Stock shares held in treasury was $6.6 million.
During 1998, the Company acquired 170,024 shares of its common stock in transactions with certain Allied Practices, with a market valuation at the date of the transactions of $2.3 million. These transactions included a mutual rescission and forgiveness of a note receivable, with a value equal to the shares acquired.
13. STOCK OPTIONS AND WARRANTS
The Company has five stock option plans, the Amended and Restated 1997 Employee Stock Option Plan ("1997 Employee Plan"), the 1997 Director Stock Option Plan ("Director Plan") the 1997 Orthodontist Stock Option Plan ("1997 Orthodontist Plan") the 1999 Orthodontist Stock Option Plan ("1999 Orthodontist Plan") and 2000 Employee Stock Option Plan ("2000 Employee Plan"). In addition, the Company issued warrants to certain executives in 1997. Options may be granted as incentive or nonqualified stock options. The Company accounts for the 1997 Employee Plan and the Director Plan under APB Opinion No. 25, under which no expense has been recognized.
The Company may grant options to purchase up to 2.0 million shares of Common Stock under the 1997 Employee Plan, 500,000 shares of Common Stock under the Director Plan, 300,000 shares of Common Stock under the 1997 Orthodontist Plan, 280,000 shares of Common Stock under the 1999 Orthodontist Plan and 500,000 shares of Common Stock under the 2000 Employee Plan. The options are issued with exercise prices equal to the Company's stock price at the date of grant. Options granted under the 1997 Employee Plan and
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2000 Employee Plan vest over one to five years; are exercisable in whole or in installments; and expire ten years from date of grant. Options granted under the Director Plan vest over one year; are exercisable in whole or in installments; and also expire ten years from date of grant. Options granted under the 1997 Orthodontist Plan and 1999 Orthodontist Plan vest at grant; are exercisable in whole or in installments; and expire five years and three years, respectively, from the grant date.
In connection with the IPO, the Company issued warrants to purchase 593,622 shares of Common Stock with exercise prices ranging from $0.01 to $14.38. The weighted average fair value of the warrants granted was $4.74. The vesting period for those warrants ranged from immediate to one year. These warrants expire five years from date of grant and their weighted average exercise price is $11.01 per warrant. Certain of these warrants have incidental registration rights pursuant to which the Company is obligated to use reasonable efforts to register the shares of Common Stock issued upon their exercise if the Company initiates a public offering and files a registration statement in connection therewith, excluding the registration of shares issued pursuant to an employee stock purchase or option plan or an acquisition or proposed acquisition by the Company.
The following summarizes stock option and warrant activity of the plans:
The shares under option and warrants at December 31, 2000, were in the following exercise price ranges:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
In accordance with Statement of Financial Accounting Standards No. 123 "Accounting for Stock-Based Compensation" ("SFAS 123"), the fair value of option grants is estimated using the Black-Scholes option pricing model for pro forma footnote purposes. The following weighted average assumptions were used for grants:
As permitted by SFAS 123, the Company has chosen to continue accounting for employee and director stock options at their intrinsic value. Accordingly, no compensation expense has been recognized for its stock option compensation plans. Had the fair value method of accounting been applied to the Company's stock option plans, the tax- effected impact follows (unaudited):
14. COMMITMENTS AND CONTINGENCIES
The Company leases office space for the use of the Allied Practices and corporate offices under operating leases, which have current expiration terms at various dates through 2015. Certain of these leases have renewal options for specified periods subsequent to their current terms. The annual lease payments under the lease agreements have provisions for annual increases based on the Consumer Price Index or other amounts specified within the lease agreements.
Future minimum annual lease payments on operating leases as of December 31, 2000 are as follows:
Rent expense for the years ended December 31, 2000, 1999 and 1998 approximated $11.8 million, $8.3 million, and $6.3 million, respectively.
The Company may be subject to certain government regulation at the federal and state levels. To comply with certain regulatory requirements, the Company does not control the practice of the Orthodontists, or control or employ the Orthodontists. There can be no assurance that the legality of any long-term management services agreements that have been entered into will not be successfully challenged. There also
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can be no assurance that the laws and regulations of states in which the Company maintains operations will not change or be interpreted in the future to restrict or further restrict the Company's relationship with the Orthodontists.
From time to time the Company is involved in various legal proceedings, claims and litigation matters arising in the ordinary course of business, including labor and personnel related issues. In the opinion of management, the outcome of such routine matters will not have a material adverse effect on the Company's business, financial condition or results of operations.
From time to time the Company has been, and can expect to be, involved in litigation with certain of its Allied Practices. Such litigation has involved claims that the Company failed to provide required services under the Management Agreements with the Allied Practices and that certain provisions of the Management Agreements may be unenforceable, among other claims. The Company vigorously defends against such claims and believes that such claims are without merit. As of December 31, 2000, the Company did not have any pending legal proceedings that separately, or in the aggregate, if adversely determined, would have a material adverse effect on the Company.
15. INCOME TAXES
The provision for income taxes is comprised of the following:
A reconciliation of the statutory federal income tax rate to the effective tax rate as a percentage of income before income taxes follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The tax effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows:
As a result of the acquisitions of the Allied Practices, temporary differences were created for the differences between the financial statement carrying amounts and the tax basis of assets acquired. Such temporary differences predominantly relate to property and equipment and related depreciation.
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16. EARNINGS PER SHARE
The Company adopted SFAS No. 128, Earnings per Share ("SFAS 128") effective December 15, 1997. Basic earnings per share of Common Stock is computed by dividing the net income for the year by the weighted average number of shares of Common Stock outstanding during the year.
The following table sets forth the computation of basic and diluted earnings per share:
Securities, including those issuable pursuant to the conversion of Class B Common Stock to Class A Common Stock, which could potentially dilute EPS in the future were not included in the computation of diluted EPS because of its anti-dilutive effect or its conversion contingencies were not met. Potential dilutive shares (in thousands) include the following:
17. 401(K) PLAN
The Company administrates a voluntary retirement plan ("the Plan") under section 401(k) of the Internal Revenue Code. The Plan covers all eligible, non-highly compensated employees with at least twelve months of employment with the Company. Currently, the Plan does not provide for Company matching contributions.
18. RELATED PARTY TRANSACTIONS
FOR THE YEAR ENDED DECEMBER 31, 2000, the Company entered into the following related party transactions:
(i) On December 27, 2000, the Company and its former President and Chief Executive Officer Sam Westover ("Westover"), entered into a Severance Agreement and General Release dated December 27, 2000 (the "Westover Severance Agreement") pursuant to which Westover agreed to resign as President and Chief Executive Officer of the Company. As part of the severance, the Company and Westover agreed to a lump sum pay-out of approximately $0.6 million payable upon separation. This expense is reflected in salaries and benefits expenses in the accompanying consolidated statements of income. Furthermore, to ensure an orderly transition, the Company and Westover agreed to a one year consulting
ORTHALLIANCE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
agreement effective January 1, 2001. The consulting agreement with Westover requires payment of approximately $12 per month.
(ii) The Company incurred $51 of legal expenses with a law firm that has a partner who also serves on the Company's Board of Directors.
(iii) Dr. Randall Bennett, a director and shareholder, serves as Chairman of the OrthAlliance Clinical Advisory Committee as an independent contractor at the rate of $2 per month. In addition, Dr. Bennett assists in the development and improvement of OrthAlliance's orthodontic programs, procedures and training materials as a part-time employee of OrthAlliance Properties, Inc. for a salary of $2 per month. On April 7, 1998, the Company loaned $50 to Randall K. Bennett, D.D.S., M.S., P.C. of which Dr. Bennett, a director of the Company, is the 100% owner to purchase office equipment. Interest in the loan accrues at the prime rate plus 10% and the term of the loan is thirty-six months. At March 31, 2001, principal in the amount of $2 was outstanding.
FOR THE YEAR ENDED DECEMBER 31, 1999, the Company entered into the following related party transactions:
(i) Referral Commissions for recruiting new Allied Practices of options to purchase 72,015 shares of Common Stock were granted to an Allied Orthodontist who was also a director.
(ii) The Company incurred $68 of legal expenses with a law firm that has a partner who also serves on the Company's Board of Directors.
FOR THE YEAR ENDED DECEMBER 31, 1998, the Company entered into the following related party transaction:
(i) Referral Commissions for recruiting new Allied Practices of $0.2 million and options to purchase 82,042 shares of Common Stock were paid and granted to an Allied Orthodontist who was also a director.
19. OPERATING SEGMENTS AND RELATED INFORMATION
The Company adopted Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131") in 1998. This statement establishes standards for the reporting of information about operating segments and also requires disclosures about products and services, geographic areas and major customers.
The Company has two reportable segments organized as business units that provide management or consulting services to the two distinct types of allied practices: OrthAlliance Allied Orthodontists and PedoAlliance Allied Dentists. Each business unit provides similar management and consulting services to the respective Allied Practices and the Company does not manage the business units separately. The remaining segments identified as "All Other" derive revenues from interest income and primarily consist of patient contract financing operations.
Management utilizes multiple views of data to measure segment performance and to allocate resources to the segments. The accounting policies of the segments are consistent with those described in the summary of significant accounting policies, as discussed in Note 2.
ORTHALLIANCE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The following is a summary of certain financial data for each of the segments:
Included in the operating income of the orthodontic practice segment are certain corporate expenses that are not allocated to the pediatric practice segment or to the "all others" category. Examples of these expenses are corporate office salaries, rent, overhead expenses, and amortization expense.
A reconciliation between segment operating income and consolidated net income is set forth below:
20. SUBSEQUENT EVENTS (UNAUDITED)
NASDAQ Notification:
The Company's common stock is traded on the NASDAQ National Market and is subject to certain continued listing requirements. As of December 31, 2000 the Company was not in compliance with Rule 4450(b)(4) which requires among other things a minimum bid price of $1.00 and tangible net assets of $4 million. On February 28, 2001 the Company was notified by the National Market that the Company's stock did not meet the compliance requirements of Rule 4450(b)(4) and that the stock may be subject to removal from the NASDAQ National Market. The Company has requested a hearing before the NASDAQ Listing Qualifications Panel, which has been scheduled for April 6, 2001.
There can be no assurance that the Company will satisfy the NASDAQ National Market conditions or be able to maintain the continued listing requirements in the future. If the Company's Common stock is delisted from the NASDAQ National Market trading of the Company's Common Stock, if any, would be conducted on the NASDAQ Small Cap Market, in the over-the-counter market on the so called "pink sheets" or, if available, the NASD's Electronic Bulletin Board." In any of those cases, investors could find it more difficult to dispose of, or to obtain accurate quotations as to the value of, its Common Stock. The trading price per share of the Company's Common Stock could be reduced as a result.
ORTHALLIANCE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Internal Revenue Service Examination
The Internal Revenue Service (the "IRS") has completed its examination of the Company's federal income tax return for the year ended December 31, 1998. The Company has agreed with the IRS' proposed adjustment of approximately $0.6 million of additional tax payments for the years ended 1998 and 1999 which was paid in March 2001. The adjustment related to timing differences between book and tax with regard to certain capitalized practice acquisition costs. The Company adequately provided reserves in prior years and the additional tax payments did not result in additional income tax expense in fiscal 2000.
Practice Affiliations
Subsequent to December 31, 2000, the Company entered into a practice affiliation agreement with a orthodontic practitioner to provide management services and acquire certain operating assets for a total cash consideration of $0.9 million. The acquired practice operates a single location and generated historical patient revenue over the prior 12 months of approximately $1.0 million. Prior patient revenue is not necessarily indicative of the level of revenue that these practices may be expected to generate in the future.
Treasury Stock
Subsequent to December 31, 2000 the Company acquired 4,300 shares of its common stock at a cost approximating $13.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of OrthAlliance, Inc.:
We have audited in accordance with auditing standards generally accepted in the United States, the consolidated financial statements of OrthAlliance, Inc. and subsidiaries included in this Form 10-K and have issued our report thereon dated March 7, 2001. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule identified as "Schedule II -- Valuation and Qualifying Accounts" is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly states in all material respects the financial data to be set forth therein in relation to the basic financial statements taken as a whole.
/s/ ARTHUR ANDERSEN LLP Arthur Andersen LLP
Los Angeles, California March 7, 2001
ORTHALLIANCE, INC. AND SUBSIDIARIES
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998 (DOLLARS IN THOUSANDS)
(A) Represents a reduction of management's estimate of required allowance for doubtful accounts based upon updated write-off studies.
EXHIBIT INDEX
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(b) Reports on Form 8-K.
The Company did not file any reports on Form 8-K during the fourth quarter of 2000.