UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002, OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____ TO _____.
Commission File No.: 001-13457
ORTHODONTIC CENTERS OF AMERICA, INC.
(Exact name of registrant as specified in its charter)
Delaware 72-1278948
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
3850 N. CAUSEWAY BOULEVARD, SUITE 800
METAIRIE, LOUISIANA 70002
(504) 834-4392
(Address, including zip code, of principal executive offices and
Registrant's telephone number, including area code)
--------------------------------------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [ ]
As of August 13, 2002, there were approximately 51,307,000 outstanding shares of
the Registrant's Common Stock, $.01 par value per share.
ORTHODONTIC CENTERS OF AMERICA, INC.
TABLE OF CONTENTS
Page
----
Part I. Financial Information
Item 1. Consolidated Financial Statements (Unaudited):
Condensed Consolidated Balance Sheets -
June 30, 2002 and December 31, 2001.......................................................................3
Condensed Consolidated Statements of Income -
Three and Six Months Ended June 30, 2002 and 2001 ........................................................4
Condensed Consolidated Statements of Cash Flow -
Six Months Ended June 30, 2002 and 2001...................................................................5
Notes to Condensed Consolidated Financial Statements - June 30, 2002.........................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations...................12
Item 3. Quantitative and Qualitative Disclosures about Market Risk..............................................24
Part II. Other Information
Item 2. Changes in Securities and Use of Proceeds...............................................................25
Item 4. Submission of Matters To a Vote of Security Holders.....................................................25
Item 6. Exhibits and Reports on Form 8-K........................................................................26
FORWARD-LOOKING STATEMENTS
Certain statements contained in this Report may not be based on historical facts
and are "forward looking statements" within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended. These forward-looking statements may be identified by
reference to a future period(s) or by the use of forward looking terminology,
such as "anticipate," "estimate," "believe," "expect," "foresee," "may,"
"would," "could" or "will." These forward-looking statements include, without
limitation, statements regarding the Company's future growth, deferred tax
asset, liquidity, capital resources, amendments to existing service agreements,
stock repurchases, pending litigation against OrthAlliance, financial merits of
the OrthAlliance merger, advances to affiliated practices, repayment or
replacement of outstanding indebtedness and impairment of goodwill. We caution
you not to place undue reliance on these forward-looking statements, in that
they involve certain risks and uncertainties that could cause actual results to
differ materially from anticipated results. These risks and uncertainties
include potential adverse changes in the Company's financial results and
conditions, disruption of the Company's relationships with its affiliated
practices or loss of a significant number of the Company's affiliated practices,
failure or delay in integrating OrthAlliance's affiliated practices, adverse
outcomes of litigation pending against the Company and OrthAlliance,
competition, failure or delay in obtaining lender approval of the stock
repurchase program, failure to consummate proposed developments or acquisitions,
inability to effectively manage an increasing number of affiliated practices,
changes in the general economy of the United States and the specific markets in
which the Company operates, risks relating to the Company's foreign operations,
changes in the Company's operating or expansion strategy, inability of the
Company to attract and retain qualified personnel, and affiliated practitioners,
inability of the Company to effectively market its services and those of its
affiliated practices, changes in regulations affecting the Company's business,
inability to obtain alternative financing or to obtain financing on acceptable
terms, and other factors identified in the Company's Annual Report on Form 10-K
for the year ended December 31, 2001 and from time to time in other filings with
the Securities and Exchange Commission or in other public announcements by the
Company. We undertake no obligation to update these forward-looking statements
to reflect events or circumstances that occur after the date of this Report.
2
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
Orthodontic Centers of America, Inc.
Condensed Consolidated Balance Sheets
June 30, December 31,
2002 2001(1)
--------- ------------
(Unaudited)
(dollars in thousands, except share amounts)
ASSETS:
Current assets:
Cash and cash equivalents ................................................. $ 12,825 $ 14,172
Service fees receivable, net of allowance for uncollectible amounts ....... 79,901 58,610
Deferred income taxes ..................................................... 5,150 4,374
Advances to affiliated practices, net ..................................... 14,690 13,846
Supplies inventory ........................................................ 8,503 8,843
Prepaid expenses and other assets ......................................... 7,775 6,963
--------- ---------
Total current assets .................................................. 128,844 106,808
Property, equipment and improvements, net ...................................... 93,004 91,843
Advances to affiliated practices, less current portion, net .................... 11,737 11,381
Deferred income taxes, less current portion .................................... 56,791 56,694
Intangible assets, net ......................................................... 224,395 229,276
Goodwill ....................................................................... 75,572 71,782
Other assets ................................................................... 7,384 6,173
--------- ---------
Total assets .......................................................... $ 597,727 $ 573,957
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
Accounts payable .......................................................... $ 4,725 $ 11,321
Accrued salaries and other accrued liabilities ............................ 13,945 18,142
Deferred revenue .......................................................... 2,038 1,929
Income taxes payable ...................................................... 19,611 1,363
Service fee prepayments ................................................... 12,693 13,976
Amounts payable to affiliated practices ................................... 1,724 3,118
Current portion of notes payable to affiliated practices .................. 2,565 4,036
--------- ---------
Total current liabilities ............................................. 57,301 53,885
Notes payable to affiliated practices, less current portion .................... 10,264 11,564
Long-term debt ................................................................. 108,030 119,000
Non-controlling interest in subsidiary ......................................... 25 56
Stockholders' equity:
Preferred stock, $.01 par value; 10,000,000 shares authorized;
no shares outstanding ................................................... -- --
Common stock, $.01 par value per share; 100,000,000 shares
authorized; 51,217,000 shares outstanding at June 30, 2002
and 50,914,000 shares outstanding at December 31, 2001 .................. 512 509
Additional paid-in capital ................................................ 211,838 208,949
Retained earnings ......................................................... 213,291 182,715
Accumulated other comprehensive loss ...................................... (2,802) (1,989)
Due from key employees for stock purchase program ......................... (488) (488)
Capital contribution receivable from stockholders ......................... (244) (244)
--------- ---------
Total stockholders' equity ............................................ 422,107 389,452
--------- ---------
Total liabilities and stockholders' equity ............................ $ 597,727 $ 573,957
========= =========
------------------
(1) The consolidated balance sheet at December 31, 2001 has been derived from
the Company's audited consolidated financial statements at that date, but
does not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements.
See notes to condensed consolidated financial statements.
3
Orthodontic Centers of America, Inc.
Condensed Consolidated Statements of Income
Three months ended Six months ended
June 30, June 30,
--------------------------- ---------------------------
2002 2001 2002 2001
--------- --------- --------- ---------
(Unaudited)
(in thousands, except per share data)
Fee revenue ................................. $ 113,432 $ 82,228 $ 224,755 $ 159,712
Direct expenses:
Employee costs ......................... 32,079 23,309 63,905 45,652
Orthodontic supplies ................... 9,550 6,456 19,128 12,693
Rent ................................... 10,064 7,079 20,139 13,888
Marketing and advertising .............. 7,964 6,457 16,915 12,698
--------- --------- --------- ---------
Total direct expenses .............. 59,657 43,301 120,087 84,931
General and administrative .................. 14,770 9,150 29,173 17,412
Non-recurring recruiting expense ............ 12,772 -- 12,772 --
Depreciation and amortization ............... 5,839 4,624 11,294 9,014
--------- --------- --------- ---------
Operating profit ............................ 20,394 25,153 51,429 48,355
Interest income (expense), net .............. (992) (1,148) (2,342) (2,247)
Non-controlling interest in subsidiary ...... 7 (190) 31 (80)
--------- --------- --------- ---------
Income before income taxes .................. 19,409 23,815 49,118 46,028
Provision for income taxes .................. 7,327 8,989 18,542 17,374
--------- --------- --------- ---------
Net income .................................. $ 12,082 $ 14,826 $ 30,576 $ 28,654
========= ========= ========= =========
Net income per share:
Basic .................................. $ 0.24 $ 0.30 $ 0.60 $ 0.59
========= ========= ========= =========
Diluted ................................ $ 0.23 $ 0.30 $ 0.59 $ 0.57
========= ========= ========= =========
Average shares outstanding:
Basic .................................. 51,188 48,837 51,362 48,813
========= ========= ========= =========
Diluted ................................ 51,999 50,218 52,174 50,083
========= ========= ========= =========
See notes to condensed consolidated financial statements.
4
Orthodontic Centers of America, Inc.
Condensed Consolidated Statements of Cash Flows
Six months ended
June 30,
-------------------------
2002 2001
-------- --------
(Unaudited)
(in thousands)
Operating activities:
Net income .................................................................. $ 30,576 $ 28,654
Adjustments to reconcile net income to net
cash provided by operating activities:
Provision for bad debt expense ............................................ 2,271 274
Depreciation and amortization ............................................. 11,294 9,014
Deferred income taxes ..................................................... (873) 543
Non-recurring recruiting expense .......................................... 4,771 --
Non-controlling interest in subsidiary .................................... (31) 80
Changes in operating assets and liabilities:
Service fee receivables and prepayments ................................. (22,970) (9,049)
Supplies inventory ...................................................... 340 (55)
Prepaid expenses and other .............................................. (2,021) (1,366)
Amounts payable to affiliated practices ................................. (1,394) 882
Accounts payable and other current liabilities .......................... 7,565 (5,364)
-------- --------
Net cash provided by operating activities ...................................... 29,528 23,613
Investing activities:
Purchases of property, equipment and improvements ........................... (7,069) (9,976)
Intangible assets acquired .................................................. (5,276) (11,435)
Proceeds from available-for-sale investments ................................ -- 999
Payments received on management agreements .................................. 1,284 --
Advances to affiliated practices, net ....................................... (8,149) (2,685)
-------- --------
Net cash used in investing activities .......................................... (19,210) (23,097)
Financing activities:
Repayment of notes payable to affiliated practices .......................... (2,774) (989)
Repayment of long-term debt ................................................. (10,000) (2,106)
Proceeds from long-term debt ................................................ -- 3,128
Issuance of common stock .................................................... 2,892 2,086
-------- --------
Net cash (used in) provided by financing activities ............................ (9,882) 2,119
Effect of exchange rate changes on cash and cash equivalents ................... (1,783) --
Change in cash and cash equivalents ............................................ (1,347) 2,635
Cash and cash equivalents at beginning of period ............................... 14,172 4,689
-------- --------
Cash and cash equivalents at end of period ..................................... $ 12,825 $ 7,324
======== ========
Supplemental cash flow information: Cash paid during period for:
Interest ................................................................ $ 1,955 $ 2,400
======== ========
Income taxes ............................................................ $ 233 $ 19,433
======== ========
Supplemental disclosures of non-cash investing and financing activities:
Notes payable and common stock issued
to obtain Service Agreements ............................................. $ 835 $ 796
======== ========
See notes to condensed consolidated financial statements.
5
Orthodontic Centers of America, Inc.
Notes to Condensed Consolidated Financial Statements (Unaudited)
June 30, 2002
1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
Orthodontic Centers of America, Inc. (the "Company") provides integrated
business services to orthodontic and pediatric dental practices throughout the
United States and in Japan, Mexico, Puerto Rico and Spain.
The Company provides business operations, financial, marketing and
administrative services to orthodontic practices and pediatric dental practices.
These services are provided under service, management service and consulting
agreements (hereinafter referred to as "Service Agreements") with orthodontists
or pediatric dentists and/or their wholly-owned professional entities (hereafter
referred to as "Affiliated Practices"). Because the Company does not control the
Affiliated Practices, it does not consolidate their financial results.
The Company's consolidated financial statements include service fees earned
under the Service Agreements and the expenses of providing the Company's
services, which generally includes all expenses of the Affiliated Practices
except for the practitioners' compensation and certain expenses directly related
to the Affiliated Practices, such as professional insurance coverage.
Certain reclassifications have been made to the prior period's financial
statements in order to conform to the current period's presentation.
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments considered
necessary for a fair presentation have been included. Operating results for the
three- and six-month periods ended June 30, 2002 are not necessarily indicative
of the results that may be expected for the year ending December 31, 2002. For
further information, refer to the consolidated financial statements and
footnotes thereto included in the Company's Annual Report on Form 10-K for the
year ended December 31, 2001.
2. REVENUE RECOGNITION
Fee revenue consists of service fees earned by the Company under the Service
Agreements. Effective January 1, 2000, the Company changed its method of revenue
recognition for service fees earned under its Service Agreements. Fee revenue is
generally recognized as service fees are contractually due under the Company's
Service Agreements, except that recognition of a portion of the service fees is
deferred because patient contract revenue is calculated on a straight-line basis
over the term of the patient contracts (which, for orthodontic patients, average
about 26 months), and are reduced by amounts retained or to be retained by
Affiliated Practices.
Amounts retained or to be retained by an Affiliated Practice equal the
Affiliated Practice's proportionate share of the portion of that straight-line
allocation of patient contract revenue that is collected during the relevant
period, and the patient receivables that represent the uncollected portion of
that straight-line allocation of patient contract revenue. Amounts retained or
to be retained are reduced by any operating losses, depreciation, interest on
outstanding loans, bad debt or other expenses that the Company has incurred but
for which it has not been reimbursed by the Affiliated Practice; however, these
unreimbursed expenses reduce amounts retained by an Affiliated Practice only up
to the amounts that would otherwise be retained by the Affiliated Practice. Any
remaining unreimbursed expenses would reduce amounts retained or to be retained
6
by the Affiliated Practice in subsequent periods. For the Company's general form
of Service Agreements (under which service fees are generally determined, at
least in part, based upon a percentage of practice operating profit), the
amounts retained or to be retained by an Affiliated Practice are estimated using
the percentage of practice operating profits that may be retained by the
Affiliated Practice under the Service Agreement. For Service Agreements of
OrthAlliance, Inc. ("OrthAlliance"), which was acquired by the Company in
November 2001, under which service fees are generally determined, at least in
part, based upon a percentage of practice revenue and reimbursement of practice
related expenses, amounts retained or to be retained by an Affiliated Practice
are estimated using the percentage of practice revenue that may be retained by
the Affiliated Practice under the terms of the Service Agreement, minus the
estimated amount of practice related expenses for which OrthAlliance may be
reimbursed under the Service Agreement.
Many of OrthAlliance's Affiliated Practices require that their patients pay a
down payment of approximately 25% of the total treatment fee at the commencement
of treatment. This results in the Company receiving cash in advance of incurring
certain practice related expenses and recognizing certain service fees as fee
revenue, which are deferred and recorded as service fee prepayments. Service fee
prepayments represent cash received in excess of service fees that have been
recognized as fee revenue, less an estimate of the portion of that cash that the
applicable Affiliated Practice is to retain and practice related expenses that
have not yet been incurred.
Most of the Affiliated Practices pledge their billed and unbilled patient fees
receivable to the Company as collateral for the Company's service fees. The
Company is generally responsible for billing and collection of the patient fees
receivable, which are conducted in the name of the applicable Affiliated
Practice. Collections from patient fees receivable are generally deposited into
depository bank accounts that the Company establishes and maintains.
The Company generally collects its service fees receivable from funds that are
collected from patient fees receivable and deposited into depository bank
accounts. This results in deferral of collection of a portion of the Company's
service fees receivable until the related patient fees receivable that have been
pledged to the Company are collected and the funds are deposited into a
depository bank account. This deferral is generally for a period that averages
less than 90 days, as patient fees receivable are generally collected within
that period of time. The Company does not generally charge Affiliated Practices
any interest on these deferred balances of service fees receivable. For
newly-developed centers (which typically generate operating losses during their
first 12 months of operations), the Company generally defers payment of a
portion of its service fees relating to unreimbursed expenses over a five-year
period that generally commences in the second year of the center's operations,
and charges the Affiliated Practices interest on those deferred amounts at
market rates. Under the Company's revenue recognition policy, those unreimbursed
expenses are not recognized as revenue or recorded as service fees receivable
until such revenue is collateralized by patient fees receivable pledged by
Affiliated Practices. Pledged patient fees receivable which prove to be
uncollectible have the effect of reducing the amount of service fees receivable
collected by the Company.
In some cases, the Company assists Affiliated Practices in obtaining financing
for their share of operating expenses by providing a guaranty of loans from a
third-party lender. Information about amounts guaranteed by the Company is
provided in "ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL RESOURCES."
7
3. INTANGIBLE ASSETS
The Company generally affiliates with an existing orthodontic or pediatric
dental practice by acquiring substantially all of the non-professional assets of
the practice, either directly or indirectly through a stock purchase, and
entering into a Service Agreement with the orthodontist or pediatric dentist
and/or his or her professional corporation or other entity (the "Affiliated
Practice"). The acquired assets generally consist of equipment, furniture,
fixtures and leasehold interests. The Company records these acquired tangible
assets at their fair value as of the date of acquisition, and depreciates or
amortizes the acquired assets using the straight-line method over their useful
lives. The remainder of the purchase price is allocated to an intangible asset,
which represent the costs of obtaining the Service Agreement through which the
Company obtains the exclusive right to provide business operations, financial,
marketing and administrative services to the Affiliated Practice during the term
of the Service Agreement. The Service Agreements generally provide that the
professional corporation or entity is responsible for providing orthodontic or
pediatric dental services and for employing all orthodontists or pediatric
dentists. The terms of the Service Agreements range from 20 to 40 years, with
most ranging from 20 to 25 years. In many cases, the Affiliated Practice has the
option to terminate the Service Agreement, upon written notice, after a certain
length of time as prescribed in the Service Agreement. In the event the
Affiliated Practice terminates its affiliation with the Company, it generally is
required to purchase all of the related assets, including the unamortized
portion of intangible assets, at the current book value or sell its interests in
the practice to another licensed orthodontist or pediatric dentist who agrees to
assume the obligations under the Service Agreement.
Subsequent to affiliation, an Affiliated Practice may acquire an existing
practice, center or patient base, and the Company may pay consideration to the
Affiliated Practice to amend its Service Agreement to extend the Company's
affiliation to such newly acquired practice, center or patient base, which
provides the Company with the opportunity to earn additional service fees. This
consideration is also allocated to an intangible asset.
Service Agreements are amortized on a straight-line basis over the shorter of
their term or 25 years. Amortization expense was $2.7 million and $5.4 million,
respectively, for the three- and six-month periods ended June 30, 2002, compared
to $2.0 million and $4.1 million, respectively, for the three- and six-month
periods ended June 30, 2001. Accumulated amortization was $37.5 million and
$24.8 million as of June 30, 2002 and 2001, respectively. Intangible assets and
the related accumulated amortization are written off when fully amortized.
4. EARNINGS PER SHARE
Basic and diluted earnings per share are based on the weighted average number of
shares of common stock and common stock equivalents (e.g., stock options)
outstanding during the period.
5. ACCOUNTING CHANGE
On January 1, 2002, the Company adopted Statement of Financial Accounting
Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets," which requires
that goodwill and intangible assets with indefinite lives, including such assets
recorded in past business combinations, no longer be amortized, but instead be
tested for impairment by measuring the reporting unit at fair value with the
initial impairment test performed within six months from the beginning of the
year in which the standard is adopted. SFAS No. 142 also requires that the
impairment test be performed at least annually thereafter, with interim testing
required if circumstances warrant. Intangible assets with finite lives will
continue to be amortized over their useful lives and reviewed for impairment. In
the quarter ended June 30, 2002, the Company completed its initial evaluation of
goodwill impairment as required with the adoption of SFAS No. 142 and determined
that the existing goodwill balance was not impaired. However, no assurances can
be given regarding future impairment.
8
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets,"
requires the Company to evaluate whether events or circumstances have occurred
that indicate all or a portion of the carrying amount of the Company's
intangible assets may not be recoverable. The recoverability takes into account
whether these intangibles should be completely or partially written off or the
amortization period accelerated based on management's estimate of future
operating income over the remaining term of the Service Agreement. If the
intangible assets is considered to be impaired, the impairment to be recognized
is measured by the amount by which the carrying amount of the intangibles
exceeds its fair value using estimated discounted cash flows. The Company
adopted SFAS No. 144 on January 1, 2002, which did not impact the Company's
financial position or results of operations. For the quarter ended June 30,
2002, the Company performed valuations on the carrying amount of the Company's
intangibles and determined that impairment did not exist at June 30, 2002.
6. BUSINESS COMBINATION WITH ORTHALLIANCE
On November 9, 2001, a newly-formed subsidiary of the Company merged with and
into OrthAlliance. As a result of the merger, OrthAlliance became a wholly-owned
subsidiary of the Company. OrthAlliance provides management and consulting
services to orthodontic and pediatric dental practices throughout the United
States.
The merger was accounted for using the purchase method of accounting. The
results of operations of OrthAlliance subsequent to November 9, 2001 have been
included in the Company's consolidated statements of income. The results of
OrthAlliance do not include results of operations relating to Service Agreements
with certain affiliated practices that are parties to litigation pending against
OrthAlliance and have ceased remitting service fees to OrthAlliance (the
"Excluded OrthAlliance Affiliated Practices"). The purchase price has been
allocated to the acquired assets, including identifiable intangible assets, and
liabilities assumed based on their estimated fair values as of November 9, 2001
with an amount of $71.8 million recorded in goodwill. The Company has begun its
assessment of recoverability for certain assets acquired as part of its
initiative to finalize its purchase accounting for the merger and has determined
that collectibility of these amounts is uncertain and has, therefore, adjusted
goodwill for the amount that the Company believes will not be recovered.
Additional adjustments may be required as the Company completes its assessment
of recoverability. Also, during April 2002, the Company received proceeds from
an OrthAlliance Affiliated Practice to terminate its Service Agreement and,
accordingly, the Company adjusted the goodwill balance recorded in connection
with the merger to reflect the consideration received. The goodwill balance at
June 30, 2002 was $75.6 million. These purchase price allocations are
preliminary and, therefore, subject to change as the Company obtains more
information and as certain pre-acquisition contingencies, particularly those
related to litigation, are resolved.
Following the announcement of the merger agreement with OrthAlliance, a number
of OrthAlliance's affiliated practices commenced litigation against
OrthAlliance, alleging, among other things, that OrthAlliance breached the terms
of their Service Agreements by failing to provide certain services and/or that
certain provisions of their Service Agreements may be unenforceable. In
determining the purchase price allocation, the Company has assigned no value to
advances to affiliated practices, property, equipment and improvements, notes
receivable, and Service Agreements relating to the Excluded OrthAlliance
Affiliated Practices because of the inherent uncertainties of the litigation
process, the relatively early stages of these lawsuits and the recentness of the
merger, all of which create uncertainties with respect to the recoverability of
these assets. Also, the allocation does not reflect any proceeds that may be
received by OrthAlliance from these Affiliated Practices in consideration for
certain assets or termination of their Service Agreements. Therefore, the
estimated values are preliminary and may change as more facts become known. The
assignment of no value to assets related to these Affiliated Practices does not
reflect a belief by management that these lawsuits have merit or that the
plaintiffs will ultimately prevail in these actions. In connection with the
OrthAlliance merger, the Company assumed a liability for certain estimated
additional merger-related costs that may be incurred by the Company, including
estimated attorneys fees and legal expenses anticipated to be incurred in
connection with these lawsuits.
9
Intangible assets associated with OrthAlliance's Service Agreements are being
amortized on a straight-line basis over the terms of the Service Agreements (up
to 25 years), with a weighted-average life of approximately 20 years. A portion
of the amortization expense generated with respect to these intangible assets is
not deductible for federal income tax purposes.
OrthAlliance's Service Agreements are with a professional corporation or other
entity owned by an orthodontist or pediatric dentist. OrthAlliance's Service
Agreements generally provide that the professional corporation or other entity
is responsible for providing orthodontic or pediatric dental services and for
hiring orthodontists or pediatric dentists. These Service Agreements also
generally provide that OrthAlliance services are feasible only if the
professional entity operates an active orthodontic or pediatric dental practice
to which it and each orthodontist associated with the professional entity
devotes their full time and attention. These Service Agreements also generally
require that the professional entity enter into an employment agreement with the
owner of the professional entity and other practitioners providing services in
the respective practice. These employment agreements are generally for a term of
five years, which generally automatically renew for one year terms unless
earlier terminated. Under these employment agreements, the orthodontist or
pediatric dentist may generally terminate their employment (subject to a
covenant not to compete) following the initial term of the agreement by giving
at least one year's prior written notice. Approximately five of OrthAlliance's
affiliated practitioners formerly affiliated with New Image Orthodontic Group,
Inc. ("New Image") (not including nine of the Excluded OrthAlliance Affiliated
Practices) may terminate their employment agreement prior to expiration of their
term by giving at least one year's prior written notice and by paying a
termination fee ranging from $300,000 to $1,000,000.
In connection with the OrthAlliance merger, the Company assumed liabilities for
estimated employee severance and for operating lease agreements expected to be
terminated. The severance accrual relates to approximately 30 OrthAlliance
corporate employees. The operating lease payment accrual relates to facility
leases assumed by the Company for facilities that are being vacated. Amounts
accrued represent management's estimates of the cost to exit these leases.
Components and activity for the liabilities assumed are as follows:
December 31, Charges and June 30,
2001 adjustments 2002
------------ ----------- --------
(in thousands)
Accrued severance liability ............ $2,579 $ 988 $1,591
Accrued operating facility leases ...... 1,203 277 926
------ ------ ------
$3,782 $1,265 $2,517
====== ====== ======
7. INCOME TAXES
As of June 30, 2002, the Company has approximately $56.8 million of deferred tax
assets resulting from its change in method for recognizing fee revenue effective
January 2000. In April 2002, the Company filed an application with the Internal
Revenue Service ("IRS") to change the Company's tax accounting method of
recognizing revenue. The Company has not made any estimated federal income tax
payments during 2002 based on the expectation that the authorized change in
accounting will at least alleviate the Company's tax liability for the first two
quarterly estimated federal income tax installments and, accordingly, has
recorded such estimated payments as income taxes payable. To the extent the IRS
approves the change in accounting, the deferred tax assets will be used to
reduce the income tax payable for 2002.
8. NON-RECURRING RECRUITING EXPENSE
On April 30, 2002, the Company and a former employee reached agreement on the
number of affiliated orthodontists that the former employee was credited with
recruiting and the amount payable to the former
10
employee in consideration for his prior services in recruiting these affiliated
orthodontists. These amounts had been disputed by the parties and were the
subject of a lawsuit pending between the parties, which was commenced on October
17, 2000. On May 10, 2002, that lawsuit was dismissed, and the Company paid the
former employee approximately $8.0 million in cash and forgave approximately
$4.8 million of indebtedness owed by the former employee to the Company. These
amounts have been included in the Company's Condensed Consolidated Statements of
Income for the three and six months ended June 30, 2002 as a non-recurring
recruiting expense. The Company does not have similar recruiting arrangements
with any other employee or affiliated practitioner.
9. COMMITMENTS AND CONTINGENCIES
The Company and its subsidiaries are parties to other pending litigation, as
disclosed in footnote 12 of the Company's Annual Report on Form 10-K for the
year ended December 31, 2001. Except as previously disclosed, there has not been
any material changes to such litigation.
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion summarizes the financial position of Orthodontic
Centers of America, Inc. ("we," "our," "OCA" or the "Company") at June 30, 2002,
and the results of operations for the three and six months ended June 30, 2002,
and should be read in conjunction with the condensed consolidated financial
statements and related notes included elsewhere in this Report.
GENERAL
Our business was established in 1985. At June 30, 2002, we provided business
services to 370 orthodontic and pediatric dental practices operating in 869
orthodontic and pediatric dental centers in which 626 orthodontists, pediatric
dentists and general dentists were practicing as of June 30, 2002. These amounts
do not include the Excluded OrthAlliance Affiliated Practices, which are 49
orthodontists and pediatric dentists, as of June 30, 2002, that are involved in
litigation with OrthAlliance, Inc. ("OrthAlliance"), which we acquired in
November 2001, and have ceased paying service fees to OrthAlliance.
Generally, when we develop a new center, all patients treated at the center are
new patients and, in the first several months after commencing operations, the
center is open only for a limited number of days each month as new patients are
added. Our affiliated centers have generally become increasingly more productive
and profitable as more new patients are added and existing patients return for
monthly follow-up visits. After approximately 26 months of operations, a
center's growth in patient base has typically begun to stabilize as the initial
patients complete treatment. At that point, a center can increase the number of
patients treated by improving the efficiency of its clinical staff, increasing
patient treatment intervals and adding operating days or practitioners. Our
affiliated centers may also increase revenue by implementing periodic price
increases. Established practices with which we have affiliated have typically
increased their revenue by applying our operating strategies and systems.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
We provide integrated business services to orthodontic and pediatric dental
practices, and our consolidated financial statements include service fees earned
under our service and consulting agreements and the expenses of providing these
services. We do not consolidate the patient revenue and other operations and
accounts of our affiliated practices. The preparation of financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
During the six months ended June 30, 2002, there were no material changes to or
in the application of our critical accounting policies presented in our Annual
Report on Form 10-K for the year ended December 31, 2001.
For further discussion of our accounting policies, see Note 2 to our Condensed
Consolidated Financial Statements included elsewhere in this Report, primarily
related to revenue recognition.
REVENUE RECOGNITION
We recognize fee revenue based on a straight-line allocation of patient contract
revenue over the terms of our affiliated practices' patient contracts (which,
for orthodontic patients, average about 26 months), minus the portion of that
straight-line allocation retained or to be retained by our affiliated practices.
Amounts retained or to be retained by an affiliated practice equal the
practice's proportionate share of the portion of that straight-line allocation
of patient contract revenue that is collected during the relevant period, and
the patient
12
receivables that represent the uncollected portion of that straight-line
allocation of patient contract revenue. Amounts retained or to be retained are
reduced by any operating losses, depreciation, interest on outstanding loans,
bad debt or other expenses that we have incurred but for which we have not been
reimbursed by the practice; however, these unreimbursed expenses reduce amounts
retained by an affiliated practice only up to the amounts that would otherwise
be retained by the practice. Any remaining unreimbursed expenses would reduce
amounts retained or to be retained by the practice in subsequent periods. For
OCA's general form of service and consulting agreements (under which service
fees are generally determined, at least in part, based upon a percentage of
practice operating profit), the amounts retained or to be retained by an
affiliated practice are estimated using the percentage of practice operating
profits that may be retained by the practice under the service or consulting
agreement. For OrthAlliance's service, management service and consulting
agreements (under which service fees are generally determined, at least in part,
based upon a percentage of practice revenue and reimbursement of practice
related expenses), amounts retained or to be retained by an affiliated practice
are estimated using the percentage of practice revenue that may be retained by
the practice under the terms of the service, management service or consulting
agreement, minus the estimated amount of practice related expenses for which
OrthAlliance may be reimbursed under that agreement.
Many of OrthAlliance's affiliated practices require that their patients pay a
down payment of approximately 25% of the total treatment fee at the commencement
of treatment. This results in us receiving cash in advance of incurring certain
practice related expenses and recognizing certain service fees as fee revenue,
which are deferred and recorded as service fee prepayments. Service fee
prepayments represent cash received in excess of service fees that have been
recognized as fee revenue, less an estimate of the portion of that cash that the
applicable affiliated practice is to retain and practice related expenses that
have not yet been incurred.
EXPENSES
Operating expenses of our affiliated centers are our expenses and are recognized
as incurred. Employee costs consist of wages, salaries and benefits paid to all
of our employees, including orthodontic assistants, business staff and
management personnel. General and administrative expenses consist of, among
other things, provision for losses on service fees receivable, professional
fees, maintenance and utility costs, office supply expense, telephone expense,
taxes, license fees, printing expense and shipping expense.
OVERVIEW OF SERVICE AND CONSULTING AGREEMENTS
We provide a wide range of services to our affiliated practices, including
marketing and advertising, management information systems, staffing, supplies
and inventory, scheduling, billing, financial reporting, accounting and other
administrative and business services. These services are provided under
long-term agreements with affiliated orthodontists and pediatric dentists and/or
their wholly-owned professional corporation or other entity, with terms that
generally range from 20 to 40 years (with most ranging from 20 to 25 years).
The specific form of agreement is based upon the dental regulatory provisions of
the particular state in which an affiliated practice is located. In most states,
we use a form of service agreement, with some minor variations from state to
state. In a small number of states with particularly stringent laws relating to
the practice of dentistry, we use a consulting agreement, which also varies
somewhat from state to state. OrthAlliance and its affiliated practices are
parties to service, management service and consulting agreements that differ in
some respects from the service and consulting agreements that OCA has
historically used.
OCA SERVICE AGREEMENTS. Under OCA's general form of service agreement,
we provide affiliated practices with a wide range of business services in
exchange for monthly service fees. The monthly service fees under these service
agreements are generally computed based upon 24% of new patient contract
balances in the first month of treatment plus the balance of the patient
contract balances allocated equally over the remaining terms of the patient
contracts (which average about 26 months), minus amounts retained by the
affiliated practice. The amounts retained by an affiliated practice are based on
a percentage of the operating
13
profits of the practice on a cash basis, generally cash collections minus
expenses during the period (in some cases, after reduction for any hourly-based
service fees or hourly-based amounts retained by the affiliated practice), plus,
in some cases, certain hourly-based amounts. These service fees generally
represent reimbursement for direct and indirect expenses that we incur in
providing services to an affiliated practice (including employee costs,
marketing and advertising costs, office rent, utilities expense, supply costs
and general and administrative expenses), a portion of the operating profits of
the affiliated practice on a cash basis and, in some cases, hourly-based service
fees. Excluding reimbursement of direct and indirect expenses and any
hourly-based service fees, service fees based on the operating profits of the
affiliated practice generally range from 40% to 50% of a mature practice's cash
operating profits (in some cases, after reduction for any hourly-based service
fees or hourly-based amounts retained by an affiliated practice).
OCA CONSULTING AGREEMENTS. Under OCA's general form of consulting
agreement, the types of services we provide to affiliated practices are
generally similar to the services we provide under our general form of service
agreement. Fees paid to us under the consulting agreements generally are a
combination of, depending on the service being performed, cost-based types of
fees, flat monthly fees and hourly fees.
ORTHALLIANCE SERVICE, MANAGEMENT SERVICE AND CONSULTING AGREEMENTS.
Under OrthAlliance's general form of service agreements, OrthAlliance generally
must provide or arrange for certain services for its affiliated practices, and
advise and assist the practices with respect to certain other services. These
services are generally similar to those provided under OCA's service agreements.
OrthAlliance is generally responsible for paying certain practice expenses, for
which it is to be reimbursed by the affiliated practice. If the practice's
collections are insufficient to fund the practice's current practice expenses,
then OrthAlliance is generally obligated to advance funds for those expenses.
Under these service agreements, OrthAlliance generally receives service fees
based on either (1) a percentage of adjusted practice revenue (generally about
17%), which is to be earned by OrthAlliance on an accrual basis of accounting
and received on a cash basis, subject, in some cases, to a minimum dollar amount
of annual service fees during the first five years of the agreement, (2) a
percentage of adjusted practice revenue (generally about 17%), which is to be
earned by OrthAlliance on an accrual basis of accounting, and received on a cash
basis, subject to annual adjustments based upon improvements in the affiliated
practice's operating margin, and, in some cases, subject to a minimum dollar
amount of annual service fees during the first five years of the agreement, or
(3) a flat monthly fee with annual fixed-dollar increases.
Under OrthAlliance's general form of consulting agreements, OrthAlliance must
provide certain specified services to its affiliated practices, provide other
services at the request of the practices and consult with or advise the
affiliated practices with respect to other services. These services are
generally similar to those provided under OCA's service agreements. Under these
agreements, OrthAlliance receives a consulting fee based on one of the three fee
structures described above with respect to OrthAlliance's service agreements.
Under OrthAlliance's general form of management service agreements, which are
used for practices that were affiliated with New Image Orthodontic Group, Inc.
prior to OrthAlliance's acquisition of those agreements in March 2000,
OrthAlliance is to provide and remit payment for a wide range of services for
its affiliated practices, including providing facilities, equipment, support
personnel, utilities, supplies, bookkeeping, marketing and billing and
collections services. These management service agreements generally provide for
a service fee that varies from month to month depending on the particular
practice's practice revenue and operating expenses. Service fees are calculated
based on two grids set forth in the management service agreement that determine
the portion of practice revenue, on a cash basis, that is to be retained by the
affiliated practice. One grid determines a percentage of practice revenue, on a
cash basis, to be retained by the affiliated practice based on the amount of
such practice revenue during the prior calendar quarter. Pursuant to this grid,
OrthAlliance's service fees generally increase if the affiliated practice's
practice revenue increases and the service fees generally decrease if the
affiliated practice's practice revenue decreases. The other grid determines an
offsetting or additional percentage of such practice revenue to be retained by
the affiliated practice, based on the practice's operating expenses during the
prior calendar quarter. Pursuant to this grid, OrthAlliance's service fees
generally decrease if the affiliated practice's operating expenses increase and
the
14
service fees generally increase if the affiliated practice's operating expenses
decrease. The management service agreements generally provide for maximum
service fees of 19.5% of the practice's practice revenue on a cash basis. A few
of OrthAlliance's management service agreements provide for a fixed percentage
service fee.
SEASONALITY
Our affiliated practices have experienced their highest volume of new cases in
the summer and other periods when schools are not typically in session. During
these periods, children have a greater opportunity to visit an orthodontist or
pediatric dentist to commence treatment. Consequently, our affiliated practices
have experienced higher revenue during the first and third quarters of the year
as a result of increased patient starts. During the Thanksgiving and Christmas
seasons, our affiliated practices have experienced reduced volume and fourth
quarter revenue for our affiliated practices has been generally lower as
compared to other periods. Seasonality in recent periods has been mitigated by
the impact of additional affiliated practices.
EMERGING ISSUES TASK FORCE ISSUE NO. 97-2
We do not have a controlling financial interest in our affiliated practices. In
accordance with guidance in Emerging Issues Task Force Issue No. 97-2, we do not
consolidate the patient revenue and other operations and accounts of our
affiliated practices within our financial statements.
BUSINESS COMBINATION WITH ORTHALLIANCE
OrthAlliance became our wholly-owned subsidiary in a stock-for-stock merger in
November 2001. The OrthAlliance merger was accounted for using the purchase
method of accounting, and the results of operations of OrthAlliance have been
included in our consolidated financial statements for the period from November
9, 2001 through December 31, 2001 and the six months ended June 30, 2002.
However, our condensed consolidated financial statements for the three- and
six-month periods ended June 30, 2002 do not include any results of operations
associated with the Excluded OrthAlliance Affiliated Practices, which are
engaged in litigation with OrthAlliance and have ceased paying service fees to
OrthAlliance.
We believe that the OrthAlliance merger is a strategically important
transaction, which we believe will provide opportunities for growth in our fee
revenue and increases in our operating margin. Our objective is to build sound,
long-term business relationships with OrthAlliance's affiliated practices, and
to increase the number of these practices that use our suite of integrated
business systems and services. Since entering into a merger agreement with
OrthAlliance in May 2001, we have devoted substantial resources to attempting to
integrate OrthAlliance's affiliated practices into our network of other
affiliated practices. Some of OrthAlliance's affiliated practices began using
part of our computer and business systems prior to the merger, under a license
that we granted to OrthAlliance in October 2001. In addition, approximately 70
of OrthAlliance's affiliated practices (not including six of the Excluded
OrthAlliance Affiliated Practices) have agreed, in amendments to their service,
management service or consulting agreements with OrthAlliance, to use our
proprietary computer software and business systems in their practices. We
continue to implement our business systems for these practices. We also continue
to inform other OrthAlliance affiliated practices about the quality and benefits
of our systems and services, which we hope will persuade additional practices to
use a wide range of these systems and services.
Before we entered into the merger agreement with OrthAlliance, we anticipated
that some portion of OrthAlliance's affiliated practices would oppose such a
merger because of, among other things, disappointment with the market price of
OrthAlliance's common stock (which many practices received in connection with
their affiliation with OrthAlliance), unwillingness to affiliate with a
competitor of OrthAlliance or perceived differences in the companies' cultures
and operating strategies. Accordingly, we factored the likelihood of a number of
dissident practices into our analysis of the economic merits of the merger, and
into the structure of the merger agreement and merger consideration (which was
based on the
15
number of practices that entered into amendments to their employment agreements
and service, management service and consulting agreements with OrthAlliance
prior to the merger). Following the announcement of the merger agreement with
OrthAlliance in May 2001, a number of OrthAlliance's affiliated practices did,
in fact, file lawsuits against OrthAlliance and/or notify OrthAlliance that it
was in default under their service, management service and consulting
agreements, in response to which OrthAlliance engaged outside counsel to
represent its interests. We believe that, despite these lawsuits, the
OrthAlliance merger has financial merit and was a positive development for our
company.
OrthAlliance intends to defend each of these lawsuits vigorously, and to
continue to demand that these practices honor their commitments under their
agreements with OrthAlliance. We believe that the plaintiffs' claims in these
actions lack merit, and that OrthAlliance has meritorious claims against each of
these plaintiffs. Based on our prior experience and discussions with some of
these litigating practices or their representatives, we currently believe that
some of these practices will settle their lawsuits by paying us an amount of
cash in exchange for termination or modification of their service, management
service and consulting agreements with OrthAlliance, depending upon the parties'
ability to reach an agreement as to the amount to be paid. We cannot assure you
that such an agreement or settlement will be reached in any of these lawsuits.
We also cannot, at this time, predict the outcome of these lawsuits or assure
you that we will prevail in any of them, nor can we estimate at this time the
amount of damages that we might incur or receive in these actions. Due to the
uncertainty of this litigation, we have currently assigned no value to service,
management service and consulting agreements with the Excluded OrthAlliance
Affiliated Practices, which were engaged in litigation with OrthAlliance and
which had ceased to pay service fees to OrthAlliance as of June 30, 2002, for
purposes of allocating the purchase price that we paid in the OrthAlliance
merger.
RESULTS OF OPERATIONS
The following table provides information about the percentage of fee
revenue represented by some of the items in our condensed consolidated
statements of income. These amounts exclude the Excluded OrthAlliance Affiliated
Practices.
Three months Six months
ended ended
June 30, June 30,
--------------------- ---------------------
2002 2001 2002 2001
------ ------ ------ ------
Fee revenue ..................................................... 100.0% 100.0% 100.0% 100.0%
------ ------ ------ ------
Direct expenses:
Employee costs ............................................. 28.3 28.3 28.4 28.6
Orthodontic supplies ....................................... 8.4 7.9 8.5 7.9
Rent ....................................................... 8.9 8.6 9.0 8.7
Marketing and advertising .................................. 7.0 7.9 7.5 8.0
------ ------ ------ ------
Total direct expenses .................................. 52.6 52.7 53.4 53.2
General and administrative ...................................... 13.0 11.1 13.0 10.9
Non-recurring recruiting expense ................................ 11.3 -- 5.7 --
Depreciation and amortization ................................... 5.1 5.6 5.0 5.6
------ ------ ------ ------
Operating profit ................................................ 18.0 30.6 22.9 30.3
Interest (income) expense ....................................... 0.9 1.4 1.0 1.4
Non-controlling interest in subsidiary .......................... 0.0 0.2 0.0 0.1
------ ------ ------ ------
Income before income taxes ...................................... 17.1 29.0 21.9 28.8
Provision for income taxes ...................................... 6.5 10.9 10.9
------ ------ ------ ------
8.2
Net income ...................................................... 10.6% 18.0% 13.7% 17.9%
====== ====== ====== ======
16
OVERVIEW. Our net income decreased $2.7 million and increased $1.9
million for the three and six months ended June 30, 2002, respectively, compared
to the same periods in 2001. During the three months ended June 30, 2002, we
recorded a non-recurring recruiting expense of $12.8 million ($8.0 million, net
of income tax benefit) for amounts paid to a former employee for his past
recruiting services in accordance with the our accounting policies for such
costs. Excluding the impact of this non-recurring expense, net income increased
$5.2 million and $9.9 million for the three and six months ended June 30, 2002,
respectively, compared to the same periods in 2001. These increases were
primarily due to significant growth in fee revenue from centers opened since
June 30, 2001, including increases in fee revenue resulting from our merger with
OrthAlliance in November 2001. Fee revenue increased $31.0 million and $65.0
million for the three and six months ended June 30, 2002, respectively, compared
to the same periods in 2001. Our operating margin (or operating profits as a
percentage of fee revenue) for the three months ended June 30, 2002 was $20.4
million, or 18.0%, compared to $25.2 million, or 30.6%, for the three months
ended June 30, 2001. Operating margin for the six months ended June 30, 2002 was
$51.4 million, or 22.9%, compared to $48.4 million, or 30.3%, for the six months
ended June 30, 2001. Excluding the impact of the non-recurring expense,
operating margin was $33.2 million, or 29.2%, for the three months ended June
30, 2002 and $64.2 million, or 28.9%, for the six months ended June 30, 2002.
The factors affecting our net income are discussed below.
FEE REVENUE. Fee revenue during the three months ended June 30, 2002
was $113.4 million, an increase of 37.9% from $82.2 million for the same period
in 2001. We attribute $14.2 million of this increase to the growth in fee
revenue of centers open throughout both periods and $17.0 million of this
increase to centers opened since June 30, 2001 or added through our acquisition
of OrthAlliance in November 2001. For the six months ended June 30, 2002, fee
revenue was $224.8 million, an increase of 40.7% from $159.7 million for the
comparable period in 2001 or added through our acquisition of OrthAlliance in
November 2001. We attribute $28.3 million of this increase to the growth in fee
revenue of centers open throughout both periods and $36.8 million of this
increase to centers opened since June 30, 2001. The increase in fee revenue
during 2002 was also due to an increase in the number of patients being treated
by our affiliated practices and an increase in the average amount of fees that
patients were charged for treatment. During the six months ended June 30, 2002,
our affiliated practices initiated treatment of about 59,800 patients, an
17
increase of 27.7% from about 46,800 patients during the same period in 2001.
This represents new patient contract balances of $194.1 million at June 30,
2002, compared to $149.7 million at June 30, 2001. At June 30, 2002, our
affiliated practitioners were treating a total of 515,300 patients, an increase
of 35.9% from approximately 379,100 patients at June 30, 2001.
We adopted a change in accounting for revenue effective January 1, 2000
and recorded a cumulative effect of change in accounting principles of $50.6
million, net of an income tax benefit, in 2000. During the three and six months
ended June 30, 2001, we recognized revenue of $7.4 million and $16.9 million,
respectively, that was included in the cumulative effect of change in accounting
principles.
EMPLOYEE COSTS. Employee costs was $32.1 million for the three months
ended June 30, 2002, an increase of 37.6% from $23.3 million for the comparable
period in 2001. For the six months ended June 30, 2002, employee costs was $63.9
million, an increase of 40.0% from $45.7 million for the comparable period in
2001. These increases primarily resulted from the addition of employees in
connection with the OrthAlliance merger in November 2001. As a percentage of fee
revenue, employee costs was 28.3% and 28.4% for the three and six months ended
June 30, 2002, respectively, compared to 28.6% and 28.6%, respectively, for the
same periods in 2001. As a result of developments in orthodontic technology, a
patient may be seen every six to eight weeks, rather than the traditional four
weeks, without compromising quality of care and without extending the patient's
total term of treatment. Consistent with industry trends, our affiliated
orthodontists have begun increasing the intervals between patient treatments.
During the six months ended June 30, 2002, patients in our affiliated
orthodontic centers averaged 46.9 days between office visits, compared to an
average of 45.6 days during the comparable period in 2001. This increase in
patient treatment interval reduces the number of office visits during the term
of a patient's treatment, which continues to average about 26 months, and
results in lower employee costs per patient. The increased interval does not,
however, reduce the amount of treatment fees per patient. Therefore, the
increased interval reduces the employee costs incurred with respect to an
individual patient relative to the patient's treatment fee.
ORTHODONTIC SUPPLIES. Orthodontic supplies was $9.6 million for the
three months ended June 30, 2002, an increase of 47.9% from $6.5 million for the
comparable period in 2001. For the six months ended June 30, 2002, orthodontic
supplies was $19.1 million, an increase of 50.7% from $12.7 million for the
comparable period in 2001. As a percentage of fee revenue, orthodontic supplies
increased to 8.4% and 8.5% for the three and six months ended June 30, 2002,
respectively, from 7.9% for each of the same periods in 2001. These increases
were primarily due to increases in prices charged for orthodontic supplies by
certain of our vendors beginning in the fourth quarter of 2001.
RENT. Rent expense was $10.1 million for the three months ended June
30, 2002, an increase of 42.2% from $7.1 million for the comparable period in
2001. For the six months ended June 30, 2002, rent expense was $20.1 million, an
increase of 45.0% from $13.9 million for the comparable period in 2001. These
increases were primarily due to centers acquired, affiliated, opened or
relocated after June 30, 2001, including OrthAlliance affiliated practices. As a
percentage of fee revenue, rent expense increased to 8.9% for the three months
ended June 30, 2002 from 8.6% for the comparable period in 2001, and increased
to 9.0% for the six months ended June 30, 2002 from 8.7% for the comparable
period in 2001. These increases were primarily attributable to rent increases in
certain markets and to an overall increase in common area maintenance charges
incurred during the six months ended June 30, 2002, compared to the same period
in 2001.
MARKETING AND ADVERTISING. Marketing and advertising expense was $8.0
million for the three months ended June 30, 2002, an increase of 23.3% from $6.5
million for the comparable period in 2001. For the six months ended June 30,
2002, marketing and advertising expense was $16.9 million, an increase of 33.2%
from $12.7 million for the comparable period in 2001. The increase in this
expense primarily resulted from increases in marketing and advertising related
to growth in fee revenue for existing centers as well as marketing and
advertising for centers added after June 30, 2001. As a percentage of fee
revenue, marketing and advertising decreased to 7.0% and 7.5% for the three and
six months ended June 30, 2002, respectively,
18
from 7.9% and 8.0%, respectively, for the same periods in 2001. These decreases
were primarily due to OrthAlliance affiliated practices generally advertising
less than other OCA affiliated practices.
GENERAL AND ADMINISTRATIVE. General and administrative expense was
$14.8 million for the three months ended June 30, 2002, an increase of 61.4%
from $9.2 million for the comparable period in 2001. For the six months ended
June 30, 2002, general and administrative was $29.2 million, an increase of
67.5% from $17.4 million for the comparable period in 2001. As a percentage of
fee revenue, general and administrative expense increased to 13.0% for the three
and six months ended June 30, 2002 from 11.1% and 10.9%, respectively, for the
same periods in 2001. These increases were primarily due to our recording of an
allowance of $1.9 million for uncollectible advances to affiliated practitioners
in the second quarter of 2002 based on our assessment of the recoverability of
these advances. The impact of OrthAlliance affiliated practices on our general
and administrative expense and an increase in office supplies expense
contributed to the increase for the three and six months ended June 30, 2002
compared to the same periods in 2001. The increase in office supplies expense
was primarily attributable to price increases by certain vendors beginning in
the fourth quarter of 2001 and an increase in office supplies use due to an
increased number of patients and affiliated practices during the six months
ended June 30, 2002. For the three and six months ended June 30, 2001, we
incurred several non-recurring accounting and legal expenses.
NON-RECURRING RECRUITING EXPENSE. During the three months ended June
30, 2002, we recorded a non-recurring charge of $12.8 million ($8.0 million, net
of income tax benefit) for amounts paid to a former employee for past recruiting
services. We reached an agreement during this quarter with the former employee
regarding the previously disputed amounts and, in accordance with our accounting
policies for such costs, the amounts paid to the former employee were treated as
a non-recurring recruiting expense.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization was $5.8
million for the three months ended June 30, 2002, an increase of 26.3% from $4.6
million for the comparable period in 2001. For the six months ended June 30,
2002, depreciation and amortization was $11.3 million, an increase of 25.3% from
$9.0 million for the comparable period in 2001. The increase in this expense is
a result of the fixed assets acquired and service agreements entered into for
centers developed, acquired or relocated after 2001. As a percentage of fee
revenue, depreciation and amortization decreased to 5.1% and 5.0% for the three
and six months ended June 30, 2002, respectively, from 5.6% for each of the same
periods in 2001, primarily due to an increase in fee revenue at centers
affiliated with OrthAlliance and at centers open throughout both periods, which
required significantly less investment in additional fixed assets or service
agreements than new centers. There was no amortization of the goodwill amount
recorded in connection with the OrthAlliance acquisition.
INTEREST. Net interest expense for the three months ended June 30, 2002
was $0.9 million, a decrease of 13.6% from $1.2 million for the comparable
period in 2001. For the six months ended June 30, 2002, net interest expense was
$2.3 million, an increase of 4.2% from $2.2 million for the comparable period in
2001. As a percentage of fee revenue, interest expense decreased to 0.9% and
1.0% for the three and six months ended June 30, 2002, respectively, from 1.4%
for each of the comparable periods in 2001.
PROVISION FOR INCOME TAXES. Our effective income tax rate was 37.8% for
each of the three and six months ended June 30, 2002 and 2001.
NET INCOME. Net income for the three months ended June 30, 2002 was
$12.1 million, a decrease of 18.5% from $14.8 million for the three months ended
June 30, 2001. Excluding the non-recurring recruiting expense of $8.0 million
(net of income tax benefit), net income for the three months ended June 30, 2002
was $20.0 million, an increase of $5.2 million, or 35.1%, compared to the three
months ended June 30, 2001. Net income for the six months ended June 30, 2002
was $30.6 million, a decrease of 6.7% from $28.7 million for the six months
ended June 30, 2001. Excluding the non-recurring recruiting expense, net income
for the six months ended June 30, 2002 was $38.5 million, an increase of $9.8
million, or 34.1%, compared to the six months ended June 30, 2001.
19
LIQUIDITY AND CAPITAL RESOURCES
CASH FLOW
The following table summarizes cash flow information for the six months ended
June 30, 2002 and 2001:
Six months ended
June 30,
---------------------------
2002 2001
---------- ------------
(in thousands)
Net cash provided by operating activities...................... $ 29,528 $ 23,613
Net cash used in investing activities.......................... (19,210) (23,097)
Net cash provided by (used in) financing activities............ (9,882) 2,119
OPERATING ACTIVITIES. Net cash provided by operating activities was
$29.5 million for the six months ended June 30, 2002, an increase of 25% from
$23.6 million for the six months ended June 30, 2001. This increase was
primarily due to increases in service fees receivable and prepayments of $13.9
million and in amounts payable to affiliated practices of $2.3 million during
the six months ended June 30, 2002, as compared to the same period in 2001,
which were partially offset by increases in certain noncash items of $9.0
million and in accounts payable and other current liabilities of $13.0 million
during the six months ended June 30, 2002, as compared to the same period in
2001.
o Noncash items. As discussed above in "--RESULTS OF OPERATIONS," we
recorded $12.8 million in non-recurring recruiting expense during the
second quarter of 2002 related to amounts paid to a former employee for
his past recruiting services. Of this amount, $8.0 million was paid in
cash and the remaining amount of $4.8 million, which is included in the
$9.0 million of noncash items, relates to forgiven debt owed by the
former employee. The remaining noncash items are due to an increase in
provision for bad debt expense of $2.0 million and in depreciation and
amortization of $2.3 million during the six months ended June 30, 2002,
as compared to the same period in 2001.
o Accounts payable and other current liabilities. The increase in
accounts payable and other current liabilities during the six months
ended June 30, 2002, as compared to the same period in 2001, was
primarily due to an increase in our income taxes payable. In April
2002, we filed an application with Internal Revenue Service ("IRS") to
change our tax accounting method of recognizing revenue. We have not
made any estimated federal income tax payments during 2002 based on our
expectation that the authorized change in accounting will at least
alleviate any liability for the first two quarterly estimated federal
income tax installments and, accordingly, we have recorded such
estimated payments as income taxes payable. To the extent the IRS
approves the change in tax accounting method, the deferred tax assets
of approximately $56.8 million will be used to reduce the income tax
payable for 2002.
o Service fees receivables and prepayments. The increase in service fees
receivable and prepayments during the six months ended June 30, 2002,
as compared to the same period in 2001, was primarily attributable to
an increase in the number of patients being treated by our affiliated
practices. At June 30, 2002, our affiliated practices were treating
approximately 515,000 patients compared to 379,000 at June 30, 2001.
Our working capital at June 30, 2002 was $71.5 million, including cash and cash
equivalents of $12.8 million, compared to working capital at December 31, 2001
of $52.9 million, including cash and cash equivalents of $14.2 million. The
increase of $18.6 million in working capital during the six months ended June
30, 2002 was primarily due to an increase of $21.3 million in service fees
receivables. An increase in income taxes payable during the six months ended
June 30, 2002 was mostly offset by an aggregate decrease in all other current
liabilities.
20
INVESTING ACTIVITIES. Net cash used in investing activities was $19.2
million for the six months ended June 30, 2002, a decrease of 18.6% from $23.6
million for the six months ended June 30, 2001. This decrease was primarily due
to the use of $6.2 million less cash to acquire service or consulting agreements
and $2.9 million less cash to purchase property, equipment and improvement
during the six months ended June 30, 2002, as compared to the same period of
2001. In addition, a purchase accounting adjustment of $1.3 million to goodwill,
which was recorded during the second quarter of 2002, reduced the amount of cash
used for investing activities during the six months ended June 30, 2002.
Partially offsetting the overall decrease in cash used was an increase of $5.5
million in advances to affiliated practices during the six months ended June 30,
2002, compared to the same period in 2001.
o Intangible assets acquired. We paid $5.3 million during the six months
ended June 30, 2002, compared to $11.4 million during the six months
ended June 30, 2001, to acquire and amend service or consulting
agreements, pursuant to which we obtain the exclusive right to provide
operations, financial, marketing and administrative services to the
practice during the term of the service agreement. We may from time to
time, provide consideration to existing practices in return for the
practices amending their service agreements. Subsequent to affiliation,
an affiliated practice may acquire an existing practice, center or
patient base. We may amend the service agreement to include these newly
acquired practice, center or patient base as they may potentially
provide earnings leverage to us. Of the $5.3 million paid for
intangibles during the six months ended June 30, 2002, approximately
93.5% related to new affiliations and 6.5% related to existing
affiliated practices.
o Purchases of property, equipment and improvement. We purchased $7.3
million and $10.0 million in property, equipment and improvement for
the six months ended June 30, 2002 and 2001, respectively. The
following table provides information about the composition of these
purchases during the six months ended June 30, 2002 (in millions):
Center additions............................................... $ 1.9
Remodeling of existing centers................................. 1.6
Additional capital expenditures at existing centers............ 0.8
International development...................................... 2.8
------
Total....................................................... $ 7.1
======
o Advances to affiliated practices. We advanced to affiliated practices
$8.1 million during the six months ended June 30, 2002, compared to
$2.7 million for the six months ended June 30, 2001.
o Payments received on management agreements. In April 2002, we received
proceeds from an OrthAlliance affiliated practice to terminate its
service agreement and, accordingly, we reduced the goodwill recorded in
connection with the OrthAlliance merger to reflect the consideration
received.
FINANCING ACTIVITIES. Net cash used in financing activities for the six
months ended June 30, 2002 was $9.9 million, compared to $2.1 million provided
by financing activities during the six months ended June 30, 2001. The increase
in net cash used during the six months ended June 30, 2002 was primarily due to
increased repayments of $7.9 million of indebtedness outstanding under our
revolving and bridge credit facilities and increased repayments of $4.9 million
of notes payable to affiliated practices during the six months ended June 30,
2002, as compared to the six months ended June 30, 2001.
USES OF CAPITAL
CAPITAL EXPENDITURES. Our capital expenditures consist primarily of the
costs associated with expenditures to facilitate growth and development in
existing centers, maintenance expenditures to sustain current levels of business
activity at existing centers, acquisitions of the fixed assets of newly
affiliated
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practices and development of de novo centers in the United States and abroad.
The average cost of developing a new orthodontic center in the United States is
about $325,000, including the cost of equipment, leasehold improvements, working
capital and start-up losses associated with the initial operations of the
orthodontic center. These costs are shared by us and the particular affiliated
practice. We generally bear an affiliated practice's share of these costs until
we are reimbursed by the practice. In some cases, we assist our practices in
obtaining financing for their share of these costs by providing a guaranty of
loans from our primary lender. At each of June 30, 2002 and December 31, 2001,
the outstanding balance of these amounts that we guaranteed was approximately
$2.0 million.
During the stages of rapid growth in the number of our affiliated practices in
the 1990's, we expended a disproportionately high amount of our capital
investment on de novo centers relative to expenditures on our existing centers.
During recent years, however, our capital expenditures have been increasingly
directed toward remodeling, improving and expanding our existing affiliated
centers to facilitate internal growth. During recent years, we also invested
significantly in computer systems infrastructure and other technology for our
affiliated centers, such as advanced digital cameras or DSL data delivery
capability. In addition, we continue to invest in the foundational
infrastructure of our international operations.
OTHER USES OF CAPITAL. Newly-developed affiliated practices and
existing affiliated practices that expand their capacity by adding additional
centers or practitioners typically experience cash flow needs until they begin
generating sufficient operating profits at the newly-developed or newly-expanded
centers. We may advance funds to affiliated practices to assist them in
maintaining affiliated practitioner compensation during the start up or
expansion phase of their practices, as an advance against future service fees,
as part of our role to facilitate growth of our affiliated practices while
reducing the financial stress associated with that growth so that our affiliated
practitioners can focus on patient care. These advances are interest free,
unsecured loans to the affiliated practices. The affiliated practice generally
begins to repay the advances once the practice or center becomes profitable,
generally at the beginning of the second year that the practice or center is
open. We intend to fund these advances and any continued financing through a
combination of bank borrowings and cash from operations.
On August 6, 2002, our Board of Directors approved a common stock repurchase
program. Under the program, we may repurchase up to 2.0 million shares of our
common stock from time to time in the open market at prevailing market prices or
in privately-negotiated transactions during the 18 months following approval of
the repurchase program, subject to approval by our lenders. The extent and
timing of any repurchases would depend on market conditions, lender approval and
other corporate considerations. Repurchased shares may be held in treasury
stock, and may be available for use in connection our stock option plans, stock
programs and acquisitions, or for other corporate purposes as determined by us.
As of the filing of this Report, we had not yet repurchased any shares under
this program.
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CAPITAL RESOURCES
We maintain a $100.0 million revolving line of credit, of which $68.0 million
was outstanding at June 30, 2002, with a lending group that consists of Wachovia
Bank, N.A., Bank of America FSB, Bank One, N.A., and Hibernia National Bank. The
revolving line of credit, which expires in October 2003, provides funding for
our general working capital and expansion of the number of affiliated centers,
and bears interest at varying rates above the lender's prime rate or LIBOR.
Amounts borrowed under the line of credit are secured by a security interest in
our ownership interests in our operating subsidiaries.
In November 2001, we obtained a $50.0 million bridge credit facility from Bank
of America FSB, of which $40.0 million was outstanding at June 30, 2002.
Borrowings under this bridge credit facility bear interest at varying rates
above the lender's prime rate or LIBOR. Under the bridge credit facility, we
have the right, upon written notice at least 30 days prior to November 9, 2002,
to extend the bridge credit facility to October 7, 2003. We anticipate that we
will further repay a portion of the bridge credit facility through cash flow
from operations, enter into a new long-term financing arrangement to replace the
bridge credit facility or extend the term of the bridge credit facility to
October 2003. We are currently reviewing our projections for cash needs and the
possibility of obtaining a new long-term financing arrangement providing more
favorable interest rates and terms.
Our revolving line of credit and our bridge credit facility require that we
maintain certain financial and nonfinancial covenants under the terms of the
credit agreements, including a maximum leverage ratio, minimum fixed charge
coverage ratio and minimum consolidated net worth ratio. These credit agreements
also impose restrictions on our acquisitions, investments, dividends, stock
repurchases and other aspects of our business. If we do not comply with these
covenants and restrictions, the lenders could demand immediate payment of all
amounts borrowed under both the revolving line of credit and the bridge credit
facility, and terminate our ability to borrow funds under those credit
facilities. At June 30, 2002, we were in compliance with these covenants and
restrictions.
We believe that our cash needs will primarily relate to development of
additional centers and affiliation with additional practices in the United
States and other countries, capital expenditures for our affiliated centers and
computer systems, repayment of amounts owing under our bridge credit facility
and other indebtedness, payment of income taxes, potential acquisitions of other
companies or assets and general corporate purposes. Our cash needs could vary
significantly depending upon our growth, results of operations and ability to
affiliate with additional centers and practices, as well as the outcome of
pending litigation and other contingencies. We expect to fund these cash needs
through a combination of cash flow from our operations and funds available under
our revolving line of credit, as well as a replacement or extension of our
bridge credit facility. We currently believe that we will be able to meet our
anticipated funding requirements for at least the next 12 months; however, our
ability to meet these funding needs could be adversely affected if we were to
suffer adverse results from our operations or lose a material portion of our
affiliated practices, if our affiliated practices were to suffer adverse results
of operations or a material loss of patients, if we suffer adverse outcomes from
pending litigation and other contingencies, if we are unable to replace our
bridge credit facility on favorable terms or if we violate the covenants and
restrictions to which we are subject under our revolving line of credit and
bridge credit facility.
NEW ACCOUNTING PRONOUNCEMENTS
On January 1, 2002, we adopted Statement of Financial Accounting Standards
(SFAS) No. 142, "Goodwill and Other Intangible Assets," which requires that
goodwill and intangible assets with indefinite lives, including such assets
recorded in past business combinations, no longer be amortized, but instead be
tested for impairment by measuring the reporting unit at fair value with the
initial impairment test performed within six months from the beginning of the
year in which the standard is adopted. SFAS No. 142 also requires that the
impairment test be performed at least annually thereafter, with interim testing
required if circumstances
23
warrant. Intangible assets with finite lives will continue to be amortized over
their useful lives and reviewed for impairment. On June 12, 2002, we completed
our initial evaluation of goodwill impairment as required with the adoption of
SFAS No. 142 and determined that the existing goodwill balance was not impaired.
However, no assurances can be given regarding future impairment.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
During the six months ended June 30, 2002, there were no material changes to the
quantitative and qualitative disclosures about market risks presented in our
Annual Report on Form 10-K for the year ended December 31, 2001.
24
PART II. OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
In June 2002, pursuant to exemptions from registration provided in Section 4(2)
of the Securities Act of 1933 (the "Securities Act") and Rule 506 under the
Securities Act, we offered certain OrthAlliance affiliated practitioners the
opportunity to participate in two incentive programs under which participants
may be issued shares of our common stock or a promissory note in the future
depending in part upon the future financial performance of the affiliated
practitioners' respective practices. Offers to participate in the incentive
program were made on a private basis to a limited number of individuals who had
a pre-existing relationship with our subsidiary, OrthAlliance. To participate in
the incentive programs, participants must, among several other prerequisites to
participation, enter into amendments to their service, consulting or management
service agreements with OrthAlliance and to their employment agreements with
their professional entities, or enter into our general form of business services
agreement. As of the date of the filing of this Report, 44 OrthAlliance
affiliated practitioners (including 40 practitioners who had previously entered
into other amendments to their agreements in connection with the OrthAlliance
merger) were participating in the incentive programs and no shares of our common
stock or promissory notes have been issued under these incentive programs. No
underwriters are involved with these incentive programs.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The annual meeting of our stockholders was held on May 17, 2002. At this
meeting, the following matters were voted upon by our stockholders:
(a) Election of Class II Directors
Ashton J. Ryan, Jr., W. Dennis Summers and Edward J. Walters, Jr. were
elected to serve as Class II directors until the annual meeting of stockholders
in 2005 or until their successors are elected and qualified. The vote was as
follows:
Votes Cast Votes Cast Against Abstentions/
Name In Favor or Withheld Non Votes
---- ---------- ------------------ ------------
Ashton J. Ryan, Jr.................... 46,730,145 1,117,261 3,692,594
W. Dennis Summers..................... 45,970,121 1,877,285 3,692,594
Edward J. Walters, Jr................. 46,722,399 1,125,007 3,692,594
The terms of the following directors continued following the meeting:
Name Term Expires
---- ------------
Bartholomew F. Palmisano, Sr............................ 2003
Hector M. Bush, D.M.D................................... 2003
Jack P. Devereux, Jr., D.D.S., M.S...................... 2003
Dennis J.L. Buchman, D.M.D., M.S........................ 2004
John J. Sheridan, D.D.S., M.S.D......................... 2004
David W. Vignes......................................... 2004
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(b) Amendment and Restatement of 1994 Incentive Stock Plan
Our stockholders approved the amendment and restatement of our 1994
Incentive Stock Plan by the following vote:
Votes Cast Votes Cast Abstentions/
In Favor Against or Withheld Non Votes
---------- ------------------- ------------
44,309,871 3,443,236 3,786,893
(c) Selection of Independent Auditors
Our stockholders ratified the appointment of Ernst & Young LLP as our
independent auditors for the fiscal year ending December 31, 2002 by the
following vote:
Votes Cast Votes Cast Abstentions/
In Favor Against or Withheld Non Votes
-------- ------------------- ------------
46,212,729 1,595,702 3,731,569
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Exhibit number Description
3.1 Bylaws of the Registrant (incorporated by reference to
exhibits filed with the Registrant's Registration Statement on
Form S-1, Registration Statement No. 33-85326)
3.2 Restated Certificate of Incorporation of the Registrant
(incorporated by reference to exhibits filed with the
Registrant's Registration Statement on Form S-1, Registration
Statement No. 33-85326)
4 Specimen Stock Certificate (incorporated by reference to
exhibits filed with the Registrant's Registration Statement on
Form S-1, Registration Statement No. 33-85326)
(b) REPORTS ON FORM 8-K
During the three months ended June 30, 2002, we did not file any
current reports on Form 8-K (excluding a current report on Form 8-K filed on May
9, 2002 reporting information under "Item 9. Regulation FD Disclosure").
26
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Orthodontic Centers of America, Inc.
--------------------------------------
(Registrant)
Date: August 14, 2002 /s/ Bartholomew F. Palmisano, Sr.
--------------------------------------
Bartholomew F. Palmisano, Sr.
Chairman of the Board, President
and Chief Executive Officer
/s/ John C. Glover
--------------------------------------
John C. Glover
Chief Financial Officer
27
EXHIBIT INDEX
Exhibit number Description
-------------- -----------
3.1 Bylaws of the Registrant (incorporated by reference to
exhibits filed with the Registrant's Registration Statement on
Form S-1, Registration Statement No. 33-85326)
3.2 Restated Certificate of Incorporation of the Registrant
(incorporated by reference to exhibits filed with the
Registrant's Registration Statement on Form S-1, Registration
Statement No. 33-85326)
4 Specimen Stock Certificate (incorporated by reference to
exhibits filed with the Registrant's Registration Statement on
Form S-1, Registration Statement No. 33-85326)