10-K 1 doc1.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003 COMMISSION FILE NUMBER 0-12050 SAFEGUARD HEALTH ENTERPRISES, INC. (Exact name of registrant as specified in its charter) DELAWARE 52-1528581 (State or other jurisdiction of (I.R.S. Employer Identification Number) incorporation or organization) 95 ENTERPRISE, SUITE 100 ALISO VIEJO, CALIFORNIA 92656-2605 (Address of principal executive offices) (Zip Code) 949.425.4300 (Registrant's telephone number, including area code) 949.425.4586 (Registrant's fax telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $0.01 PAR VALUE NONE (Name of exchange on which listed) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2003, was $3,567,000. The number of shares of the registrant's common stock outstanding as of March 31, 2004, was 5,770,590 (not including 3,216,978 shares held in treasury).
SAFEGUARD HEALTH ENTERPRISES, INC. INDEX TO FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2003 PAGE ---- PART I. Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Item 2. Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Item 3. Legal Proceedings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Item 4. Submission of Matters to a Vote of Security Holders. . . . . . . . . . . . . . . . . . 19 PART II. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. . . . . . . . . 19 Item 6. Selected Financial Data. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. 22 Item 7A. Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . 31 Item 8. Financial Statements and Supplementary Data. . . . . . . . . . . . . . . . . . . . . . 31 Item 9. Changes in and Disagreements with Independent Accountants on Accounting and Financial Disclosures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Item 9A. Controls and Procedures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 PART III. Item 10. Directors and Executive Officers of the Registrant . . . . . . . . . . . . . . . . . . 31 Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Item 13. Certain Relationships and Related Transactions . . . . . . . . . . . . . . . . . . . . 37 Item 14. Principal Accountant Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . 37 PART IV. Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K . . . . . . . . . . . 38 Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
i PART I ITEM 1. BUSINESS ------------------ In addition to historical information, the description of business below includes certain forward-looking statements regarding SafeGuard Health Enterprises, Inc. and its subsidiaries (the "Company"), including statements about growth plans, business strategies, future operating results, future financial position, and general economic and market events and trends. The Company's actual future operating results could differ materially from the results indicated in the forward-looking statements as a result of various events that cannot be predicted by the Company. Those possible events include an increase in competition, changes in health care regulations, an increase in dental care utilization rates, new technologies, an increase in the cost of dental care, the inability to contract with an adequate number of participating providers, the inability to efficiently integrate the operations of acquired businesses, the inability to realize the carrying value of goodwill, intangible assets, and certain long-term promissory notes owed to the Company, natural disasters, loss of key management, and other risks and uncertainties as described below under "RISK FACTORS." The following should be read in conjunction with the Consolidated Financial Statements of the Company and Notes thereto. (a) GENERAL DEVELOPMENT OF BUSINESS The Company provides a wide range of dental benefit plans, including health maintenance organization ("HMO") plan designs and preferred provider organization ("PPO")/indemnity plan designs. The Company also provides vision benefit plans, administrative services, and preferred provider network rental. The Company conducts its business through several subsidiaries, one of which is an insurance company that is licensed in a number of states, and several of which are dental HMO plans that are each licensed in the state in which it operates. The Company's operations are primarily in California, Florida and Texas, but it also operates in a number of other states. The Company's predecessor, SafeGuard Health Plans, Inc., a California corporation, (the "California Plan") commenced operations in 1974 as a nonprofit corporation. The California Plan converted to for-profit status in December 1982 and is currently a subsidiary of the Company. SafeGuard Health Enterprises, Inc. (the "Parent") was incorporated in California in November 1982 and acquired the California Plan in December 1982. In August 1987 the Parent reincorporated in Delaware. Unless the context requires otherwise, all references to the "Company" or "SafeGuard" mean SafeGuard Health Enterprises, Inc. and its subsidiaries. The Company completed three (3) acquisitions during the last two (2) years. In October 2003, the Company made an acquisition that included a dental HMO company, a vision HMO company, and certain dental and vision PPO/indemnity business, all of which was located in California, and which had aggregate revenue of approximately $74 million in 2003. The total cost of the acquisition was approximately $15.2 million, which was paid in cash and was financed through the issuance of $19.0 million of convertible notes in October 2003. In March 2003, the Company acquired a dental HMO company located in California, which had approximately $3 million of annual revenue. The total cost of the acquisition was approximately $1.3 million. In August 2002, the Company acquired a dental HMO company located in Florida, which had approximately $7 million of annual revenue. The purchase price of the acquisition was approximately $6.7 million, which consisted of a cash payment of $3.0 million, a secured convertible note for $2,625,000, and 769,231 shares of the Company's common stock. The Company is currently licensed as a dental HMO in four states, and as an indemnity insurance company in 20 states. However, substantially all of its revenue is generated in California, Florida and Texas. The Company's executive offices are located at 95 Enterprise, Suite 100, Aliso Viejo, California 92656-2605, and its website address is www.safeguard.net. Its telephone number is 949.425.4300 and its fax number is 949.425.4586. DENTAL CARE MARKETPLACE The total market for dental care services and for dental benefit plans has grown rapidly in recent years. The United States Centers for Medicare & Medicaid Services (formerly known as the Health Care Financing Administration) ("CMS") reported that total expenditures for dental care in the United States increased from approximately $50.2 billion in 1997 to an estimated $70.3 billion in 2002. The National Association of Dental Plans (the "NADP") 1 estimated that the number of people in the United States that were enrolled in some type of dental benefit plan increased from 139 million in 1997 to 153 million in 2002, the last year for which this information is available. The cost of dental services has increased in recent years at a rate higher than that for consumer goods as a whole. The United States Bureau of Labor Statistics (the "BLS") reported that the consumer price index ("CPI") for dental services for all urban consumers increased by 24.0% from 1997 to 2002, while the CPI for all items for all urban consumers increased by 12.1% during the same period. CMS reported that expenditures for dental services accounted for approximately 4.5% of total national health care expenditures during 2002. As a result of increases in the cost of dental services, the Company believes that employers and other purchasers of dental care benefits have a significant interest in effectively managing the cost of dental care benefits. As noted above, the NADP estimated that approximately 153 million people, or approximately 54% of the total population of the United States, were enrolled in some type of dental benefit plan in 2002. The United States Census Bureau estimated that approximately 242 million people, or approximately 85% of the total population of the United States, were enrolled in some type of medical benefit plan in 2002. The Company believes the number of people without dental coverage represents an opportunity for dental benefits companies to increase their enrollments. The NADP estimated that enrollment in dental HMO plans decreased from approximately 27 million people in 1997 to approximately 23 million people in 2002. The Company believes the primary reason that total enrollment in dental HMOs has not increased in recent years is that most purchasers desire greater flexibility in the choice of providers than is generally afforded by dental HMOs, and the size of dental HMO provider networks has not kept pace with the growth in the dental benefits market. In recent years, there has been a significant increase in the enrollment in dental insurance plans that include PPO networks, which typically provide greater flexibility in the member's choice of providers than a dental HMO. Under these plans, the insurance company creates a PPO network by negotiating reduced fees with dentists in exchange for including the dentists in a "preferred provider" list that is distributed to subscribers who are enrolled in the PPO dental plan. The subscribers who are enrolled in the plan generally receive a higher level of benefits, in the form of reduced out-of-pocket expense at the time of service, if they choose to receive services from a dentist in the PPO network. The NADP estimated that enrollment in fully insured PPO dental plans has grown from approximately 15 million people in 1997 to approximately 33 million people in 2002. The Company believes that PPO dental plans have been rapidly gaining in popularity because they provide customers with a balance of cost-effectiveness and flexibility in the choice of providers. The dental benefit plan business is characterized by participation of several large national insurance companies, and numerous regional insurance companies, regional medical HMOs, and other independent organizations. The NADP estimated there were approximately 77 entities offering dental HMO plans, and approximately 67 entities offering dental PPO plans, in the United States in 2002. The average monthly cost of dental insurance coverage is much lower than medical insurance coverage. Dental care is provided almost exclusively on an outpatient basis, and general dentists, as opposed to specialists, perform most dental procedures. Most dental problems are not life threatening and do not represent serious impairments to overall health. Therefore, there is a higher degree of discretion exercised by patients in determining when or whether to obtain dental services, and a higher degree of sensitivity to the cost of dental services. Many dental conditions have a range of appropriate courses of treatment, each of which has a different out-of-pocket cost for patients who are covered by a dental insurance plan. For example, a deteriorated filling may be replaced with another filling (a low-cost alternative), a pin-retained crown build-up (a more costly alternative), or a crown with associated periodontal treatment (the most costly alternative). The design of a patient's dental insurance plan can have an impact on the type of dental services selected by the patient or recommended by the dentist. Dental benefit plans generally do not include coverage for hospitalization, which is typically the most expensive component of medical services. In addition, co-payments and co-insurance payments made by patients under dental plans typically represent a larger share of the total cost of dental care, compared to the share of the total cost of medical care that is paid by patients under medical coverage plans. Common features of dental PPO and indemnity plans include annual deductibles of varying amounts, maximum annual benefits of $2,000 or less per person and significant cost sharing by the patient. Patient cost sharing typically varies by the type of dental procedure, ranging from little or no cost sharing for preventive procedures to 50% or 2 more cost-sharing for bridgework or dentures, and even greater cost-sharing for orthodontic care. The relatively high patient cost-sharing and the relatively predictable nature of the need for dental services substantially reduces the underwriting risk of dental PPO and indemnity plans, compared to the underwriting risk of a medical insurance plan, which typically covers catastrophic illnesses and injuries. Under a dental PPO or indemnity plan, dentists have little incentive to deliver cost-effective treatments because they are compensated on a unit-of-service basis. In contrast, under a dental HMO plan, each general dentist is typically reimbursed primarily in the form of a fixed monthly payment for each member who selects that dentist as his or her primary dental care provider (a "capitation" payment). In some cases, the general dentist also receives supplemental payments from the dental HMO for performing certain procedures, in addition to the capitation payments. Under a dental HMO plan, each dentist also typically receives co-payments from the patient for certain dental services, in addition to the capitation and supplemental payments from the dental HMO. The co-payments and supplemental payments mitigate the level of utilization risk assumed by the dentist, but are typically small enough to discourage the dentist from delivering treatments that are not cost-effective. Capitation payments create an incentive for dentists to emphasize preventive care, to deliver cost-effective treatments, and to develop a long-term relationship with their patients. Capitation payments also substantially reduce the dental HMO plan's underwriting risk associated with varying utilization of dental services. (b) FINANCIAL INFORMATION ABOUT SEGMENTS Management views certain geographic areas as separate operating segments, and therefore, measures the Company's operating results separately for each of those geographic areas. The Company provides essentially the same products and services in all of the geographic areas in which it operates. For financial reporting purposes, all the Company's operating segments are aggregated into one reporting segment, which provides dental benefit plans and other related products to employers, individuals and other purchasers. (c) NARRATIVE DESCRIPTION OF BUSINESS GENERAL DESCRIPTION OF THE COMPANY The Company provides dental benefit plans, vision benefit plans and other related products, to government and private sector employers, government programs for low-income beneficiaries, labor unions, associations, and individuals. The Company also provides dental benefit plans to medical HMOs, which include the Company's dental coverage in their product offerings. The Company currently has contracts with approximately 8,000 employers, medical HMOs, government programs, labor unions and associations, and delivers dental or vision benefits, or related services, to a total of approximately 1.5 million covered individuals. Dental care is provided to covered individuals through the Company's HMO network of approximately 6,000 dentists, and through its PPO network of approximately 16,000 dentists. Vision care is provided to covered individuals through the Company's HMO network of approximately 2,700 optometrists and ophthalmologists, and through its PPO network of approximately 3,700 optometrists and ophthalmologists. Under the Company's dental benefit plans that have an HMO plan design, its customers pay a monthly premium for each subscriber enrolled in the plan, which is generally fixed for a period of one to two years. The amount of the monthly premium varies depending on the dental services covered, the amount of the member co-payments that are required for certain types of dental services, the geographic location of the group, and the number of dependents enrolled by each subscriber. Each subscriber and dependent is typically required to select a general dentist from the Company's HMO provider network, and to receive all general dental services from that dentist. Under some benefit plans with an HMO plan design, the subscribers and dependents don't have to select a specific general dentist, but they still have to receive services from a provider in the Company's HMO network in order for the services to be covered by the Company's benefit plan. A referral to a specialist must be requested by the general dentist and approved in advance by the Company. The approval by the Company confirms that the referral is for a service covered by the member's benefit plan. Under HMO plan designs, subscribers and dependents are not required to pay deductibles or file claim forms, and are not subject to a maximum annual benefit. Under the Company's dental benefit plans that have a PPO/indemnity plan design, its customers also pay a monthly premium for each subscriber enrolled in the plan, which is generally fixed for a period of one year. The amount of the monthly premium varies depending on the dental services covered, the amount of the annual deductible, the 3 portion of the cost of dental services that is paid by the subscriber or dependent, the maximum annual benefit amount, the geographic location of the group, and the number of dependents enrolled by each subscriber. Under PPO/indemnity plan designs, subscribers are required to pay deductibles and co-insurance amounts that are typically higher than the co-payments required under a dental HMO plan, and the benefits covered are typically subject to an annual maximum amount. However, under PPO/indemnity plan designs, subscribers and dependents can choose to receive dental services from any dentist of their choice. If the subscriber or dependent chooses to receive services from a dentist in the PPO network, the services will typically cost less than if the services were delivered by a dentist not contracted with the Company's PPO network. The Company's goal is to be a leading dental benefits provider in its primary markets of California, Florida and Texas, but it also provides dental benefit plans in a number of other states. The Company offers a comprehensive range of dental benefit plans that is based on a set of standard plan designs that are generally available in each of the markets in which the Company operates. Additionally, for large clients, the Company has the information technology and flexibility to deliver highly customized benefit plans. Under the Company's vision benefit plans, customers pay a monthly premium for each subscriber enrolled in the plan, which is typically fixed for a period of one to two years. The monthly premium varies depending on the vision services covered, the member co-payments required for certain vision services, and the number of dependents enrolled by each subscriber. Under the Company's vision plans with an HMO plan design, subscribers and dependents must receive services from a provider in the Company's HMO network in order for the services to be covered by the Company's benefit plan. Under the Company's vision plans with a PPO/indemnity plan design, subscribers and dependents can choose to receive services from any licensed provider. If the subscriber or dependent chooses to receive services from a provider in the PPO network, the amount paid by the subscriber or dependent at the time of service is typically less than it would be if the services were delivered by a provider outside of the PPO network. The Company uses multiple distribution channels to sell its products. The Company targets the large employer market by developing relationships with benefits consulting firms that are often engaged by large employers to assist them in selecting the best dental plans. The Company utilizes its senior management, outside consultants, and its internal sales force to develop relationships with benefits consulting firms and potential large customers. The Company primarily uses its internal sales force to sell the Company's products to mid-size employer groups, by developing relationships with independent brokers, and to a lesser extent, by contacting potential customers directly. The Company has a telephonic small group sales and service function in each of its primary geographic markets, which focuses on developing the small group market and providing quality service to existing customers in a cost-effective manner. In addition, the Company has developed separate distribution channels for the individual dental benefit plan market, which the Company believes has growth potential. The Company's dental plans are also offered to medical HMOs, which include the Company's dental plans in comprehensive medical plans offered by those medical HMOs. In some cases, the Company utilizes general agency relationships to market its products, which generally target small employers and individuals. The Company is committed to providing quality dental and vision care to its members through its HMO and PPO networks of qualified, accessible providers. By providing a wide range of benefit plan designs, including HMO and PPO/indemnity plan designs, the Company is able to maintain a competitive network of providers by delivering patients to providers under both HMO and PPO contracts. In addition, the Company offers stand-alone administrative services and PPO access products to its customers, which deliver additional patient volume to its contracted providers. The Company has provider relations representatives who maintain the provider networks in each of the Company's significant geographic markets. The local knowledge and expertise of these representatives enables the Company to develop and maintain competitive provider networks, which is an important factor to employers in selecting a dental or vision benefit plan. ACQUISITIONS Effective October 31, 2003, the Company acquired all of the outstanding stock of Health Net Dental, Inc. ("HN Dental"), which was a California dental HMO, and Health Net Vision, Inc. ("HN Vision"), which was a California vision HMO, and certain PPO/indemnity dental and vision business underwritten by Health Net Life Insurance Company ("HN Life"), which was formerly an affiliate of HN Dental and HN Vision. The total cost of the acquisition was approximately $15.2 million, which was paid in cash and was financed through the issuance of 4 $19.0 million of convertible notes in October 2003. HN Dental and HN Vision were merged with the Company's preexisting dental HMO subsidiary in California effective April 1, 2004. The combined revenue of HN Dental, HN Vision, and the acquired PPO/indemnity business was approximately $74 million in 2003. In connection with the acquisition of HN Dental, the Company entered into an agreement to provide private label dental HMO and PPO/indemnity products to be sold in the marketplace by subsidiaries of Health Net, Inc., the former parent company of HN Dental and HN Vision, for a period of at least five years following the transaction, subject to certain conditions. The business purpose of these acquisitions was to increase the Company's market penetration in California, which is one of the Company's primary geographic markets, and to gain vision benefit products that are internally administered by the Company. As a result of the acquisitions, the number of individuals in California for which the Company provides dental benefits increased from approximately 350,000 members to approximately 800,000 members, and the number of individuals in California for which the Company provides vision benefits increased from approximately 20,000 members to approximately 150,000 members. A significant portion of the business of HN Dental consists of approximately 125,000 members enrolled through a contract with the California Managed Risk Medical Insurance Board, under a program known as "Healthy Families," which provides coverage to low-income families and individuals, and approximately 60,000 members who are enrolled under California Medi-Cal programs. These government programs represent a new customer segment for the Company, as it has no similar business prior to the acquisition of HN Dental. During November 2003, the Company integrated the employees of HN Dental and HN Vision into its California operations, and in April 2004 the Company integrated a majority of the information systems activities and business operations of the acquired business into its primary information systems application, moved all of the former HN Dental and HN Vision employees to its Aliso Viego National Service Center, and is in the process of integrating the remaining aspects of the acquired business into the Company's operations. In March 2003, the Company acquired all of the outstanding stock of Ameritas Managed Dental Plan, Inc. ("Ameritas"), which was a dental HMO company with approximately $3 million of annual revenue located in California. The total cost of the acquisition was approximately $1.3 million. Ameritas was merged with the Company's preexisting dental HMO subsidiary in California effective upon the closing of the acquisition. The business purpose of the acquisition was to increase the Company's market penetration in California, which is one of the Company's primary geographic markets. As a result of the acquisition, the number of individuals in California for which the Company provides dental benefits increased from approximately 300,000 members to approximately 330,000 members. The business of Ameritas, including all of its information systems activities, was integrated into the Company's California operations in April 2003. In connection with this acquisition, the Company entered into a five-year marketing services agreement with Ameritas Life Insurance Corp., the former parent company of Ameritas, ("ALIC"). Under this marketing services agreement, ALIC markets the Company's dental HMO benefit plans to clients that purchase dental PPO and indemnity benefit plans and other employee benefits products from ALIC. In August 2002, the Company acquired all of the outstanding stock of Paramount Dental Plan, Inc. ("Paramount"), which was a dental HMO company with approximately $7 million of annual revenue located in Tampa, Florida. The purchase price of the acquisition was approximately $6.7 million, which consisted of a cash payment of $3.0 million, a secured convertible note for $2,625,000, and 769,231 shares of the Company's common stock. Paramount was merged with the Company's preexisting dental HMO subsidiary in Florida effective upon the closing of the acquisition. The business purpose of the acquisition was to increase the Company's market penetration in Florida, which is one of the Company's primary geographic markets. The acquisition increased the number of members in Florida for which the Company provides dental benefits from approximately 50,000 members to approximately 275,000 members. During September 2002, the Company integrated the employees of Paramount into its Florida operations, and the former chief executive officer of Paramount is currently President of the Company's Florida operations. The Company integrated a majority of the information systems activities of Paramount into its primary information systems application in January 2003. GEOGRAPHIC MARKETS The Company operates primarily in California, Florida and Texas and its marketing activities are currently focused on these states. It also maintains dental HMO or dental PPO provider networks in several other states, and obtains new business in those other states from time to time. The Company uses its provider networks in other states primarily to serve customers in California, Florida or Texas that have a portion of their employees located in other states. 5 The Company started its business in California, and expanded to Texas and Florida primarily through the acquisition of two dental HMO companies located in those two states. It is possible that the Company could expand its operations to additional states as a result of future acquisitions or new or expanded customer contracts, although the Company has no current plans to do so. PRODUCTS The Company operates primarily in a single business segment, which is providing dental benefit plans to employers, labor unions, medical HMOs, state government agencies, individuals and other purchasers. The Company provides a broad range of dental benefit plan designs, depending on the demands of its customers. In addition to offering a range of benefit plan designs, the Company offers dental benefit plans with a restricted choice of providers, through its HMO plans, plans with financial incentives to use network providers, through its PPO plans, and benefit plans with an unrestricted choice of providers, through its indemnity plans. Premium rates for each benefit plan are adjusted to reflect the benefit design, the cost of dental services in each geographic area, and whether the covered individuals can select any provider at the time of service. In addition to dental benefit plans, the Company also offers other related products, as described below. The revenue currently generated by these other related products is not significant compared to the revenue generated by the Company's dental benefit plans. Dental HMO Plan Designs. The Company offers a comprehensive range of dental HMO plan designs, which typically cover basic dental procedures, such as examinations, x-rays, cleanings and fillings, for no additional charge at the time of service, although some benefit designs require the member to pay a small co-payment for each office visit. Dental HMO plans also typically cover more extensive procedures provided by the general dentist, such as root canals and crowns, as well as procedures performed by specialists contracted with the Company, including oral surgery, endodontics, periodontics, orthodontics, and pedodontics, in exchange for member co-payments that vary depending on each member's benefit plan design. In order for a member to be treated by a specialist, the member's general dentist must initiate a referral to a specialist, and the Company reviews each referral request prior to the member's visit to the specialist. The Company's dental HMO plan designs also cover emergency out-of-area treatments that are required when a member is temporarily outside the geographic area served by his general dentist. Under a dental HMO plan, each subscriber or dependent typically selects a general dentist from the Company's HMO provider network, and receives all general dental services from that dentist. The general dentist selected by each member receives a monthly capitation payment from the Company, which is designed to cover a majority of the total cost of the general dental services delivered to that member. The monthly capitation payment does not vary with the nature or the extent of dental services provided to the member by the general dentist, but is variable based on the particular benefit plan purchased by each member. In addition to the capitation payments, the general dentist also receives co-payments from the members for certain types of services, and may receive supplemental payments from the Company for certain types of services. The Company typically pays for services delivered by a specialist based on a negotiated fee schedule. In addition to the dental HMO plan designs described above, the Company also provides a dental HMO plan design in Florida that covers only semi-annual exams and cleanings, but also provides a schedule of negotiated discounts which the member can use when obtaining other dental services. Under this type of plan design, the subscribers and dependents do not have to select a specific dentist, but they must receive services from a dentist in the Company's HMO network in order to receive the benefits of the plan. Dental PPO/Indemnity Plan Designs. The Company offers a comprehensive range of dental PPO/indemnity plan designs, subject to regulatory restrictions. Dental PPO/indemnity plan designs typically cover the same dental procedures as dental HMO plan designs. Under the Company's dental PPO/indemnity plan designs, the covered individuals are required to make a co-insurance payment at the time of each service, which is typically higher than the co-payments required under a dental HMO plan design. In addition, the benefits covered under the Company's dental PPO/indemnity plan designs are subject to annual deductibles and annual benefit maximums, which is not the case under the Company's dental HMO plan designs. Under dental PPO/indemnity plan designs, subscribers and dependents can choose to receive covered services from any licensed dentist. In the case of a benefit plan that includes a PPO component, the co-insurance amounts paid by the covered individual are reduced if he or she chooses to receive services from a dentist in the Company's preferred provider network. In addition, the covered individual's annual deductible is sometimes waived if he or she chooses 6 to receive all dental services from a dentist in the Company's preferred provider network, depending on the specific benefit plan. The Company pays for services delivered by dentists in its PPO network based on negotiated fee schedules, which, together with any co-insurance payment due from the patient, constitutes payment in full for the services delivered (i.e., there is no "balance billing" by the provider). The Company pays for services delivered by non-contracted providers based on usual and customary dental fees in each geographic area, and the provider may bill the patient for any difference between his or her standard fee and the amount paid by the Company. The Company believes that offering an indemnity dental plan with a PPO network is an attractive way to enter geographic areas where few dentists have agreed to participate in HMO networks. In such areas, participation in the PPO network can serve as a transitional step for dentists, between the traditional system of reimbursement based on usual and customary fees, to participation in an HMO network. Dental PPO/indemnity plan designs subject the Company to more significant underwriting risks than dental HMO plan designs, because the Company assumes all the risk related to varying utilization rates. The Company believes that PPO/indemnity plan designs are attractive to employers and other purchasers because they are a cost-effective alternative to traditional indemnity insurance, and they offer more freedom of choice of providers than dental HMO plan designs. Defined Benefit Dental Plans. The Company offers a range of defined benefit dental insurance plans. Under these plans, subscribers and dependents are reimbursed a fixed amount for each procedure performed, regardless of which provider performs the procedure. One innovative feature of this product is that certain plan designs include coverage for dental implants, which are typically excluded from other types of dental benefit plans. This product is also sold with or without orthodontic coverage. Defined benefit plans are designed for customers who want to avoid the restrictions of a network-based plan, while paying a monthly premium that is significantly less than that of a typical PPO/indemnity plan. Because this product is not dependent on a provider network, it can be marketed to potential customers who are located outside of the geographic areas covered by the Company's HMO and PPO provider networks. Dual Option Product. The Company frequently combines one of its dental HMO plan designs with one of its PPO/indemnity plan designs to create a "dual option" product for its customers. As a result, each subscriber can choose whether to enroll in the dental HMO plan design or the PPO/indemnity plan design. By offering a dual option product, the Company can offer its subscribers more flexibility, and can capture a larger portion of the total dental benefits expenditures by each of its customers. This product allows the Company to offer a dental HMO plan design to cost-conscious customers, while also providing a PPO/indemnity plan design for coverage of employees located outside the geographic area served by the Company's HMO provider network, and for employees who are willing to pay higher premiums for greater flexibility. Certain states, including Nevada, require that dental HMO plan designs be offered only as part of a dual option product and other states may do so in the future. Vision Benefit Plans. The Company offers a range of vision benefit plans to employer groups and other purchasers, which cover routine eye care in exchange for a fixed monthly premium. In addition to routine optometric care, vision plans offered by the Company generally cover a portion of the cost of glasses or contact lenses. The vision plans generally cover only frames, lenses and contact lenses if the covered individual has separate medical coverage for the cost of routine eye exams. The vision benefit plans offered by the Company include plans with an HMO plan design and plans with a PPO/indemnity plan design. Under the plans with an HMO plan design, subscribers must receive services from an optometrist or ophthalmologist in the Company's HMO network in order for the services to be covered by the benefit plan. Under the plans with a PPO/indemnity plan design, subscribers can choose to receive services from any licensed optometrist or ophthalmologist, but if they choose to receive services from an optometrist or ophthalmologist in the preferred provider network, their co-insurance payments at the time of service would generally be reduced. The Company's revenue from vision benefit plans was not material during the year ended December 31, 2003. However, the acquisition of HN Vision and the related PPO/indemnity vision business added approximately $9 million of annual vision revenue to the Company, and the Company intends to increase its vision revenue in the future. Other Dental Benefits Products. For self-insured customers, the Company offers claims administration under an administrative services only ("ASO") arrangement, under which the Company does not assume any of the underwriting risk. The Company receives an administrative fee to process claims and the underwriting risk is retained by the customer sponsoring the self-insured plan. The Company also provides access to its PPO network for a fixed monthly fee based on the number of subscribers covered by the product. Under this product, the providers in 7 the PPO network offer a reduced fee schedule for services provided to participating patients. The Company makes no payments to the providers in the PPO network under this product. In addition, in one of its primary geographic markets, the Company sells dental PPO/indemnity benefit plans that are underwritten by an unrelated insurance company, and provides certain administrative services related to these plans. In exchange for its sales efforts and administrative services, the Company receives a fixed monthly fee for each subscriber enrolled. Currently, the Company's revenue from these other products is not material. MARKETING The Company markets its products to employer groups, labor unions, individuals and other purchasers primarily through independent brokers and consultants. Independent brokers are typically engaged by employer groups and other purchasers to select the dental plan that best suits the needs of the purchaser's employees, in terms of price, benefit design, geographic coverage of the provider network, financial stability, reputation for customer service, and other factors. Brokers are typically paid by the Company, based on a specified percentage of the premium revenue collected from each customer generated by the broker. Large employers typically engage consultants, instead of brokers, to assist them in selecting the dental plan that best suits their needs. The consultants generally perform the same function as brokers, but are typically paid by the employer instead of the Company. Consequently, large employers expect to pay premium rates that have been reduced to reflect the fact that the Company is not paying a broker commission. Brokers and consultants do not market the Company's benefit plans on an exclusive basis. The Company has an internal sales force that is paid through a combination of salary and incentive compensation based on the revenue generated by each salesperson. The function of the internal sales force is primarily to cultivate relationships with brokers and consultants, and to help brokers and consultants present the Company's benefit plans to their clients in the most favorable way. A small portion of the Company's sales is generated directly by its internal sales force. The Company generally uses the same brokers, consultants and internal sales force to market all of its products. After an employer group or other purchaser decides to make the Company's benefit plan available to its employees, the Company's marketing efforts shift to the Company's employees (potential subscribers). Typically, employees participate in an annual open enrollment process, under which they select the employee benefit plans they wish to use for the upcoming year. During the open enrollment process, employees typically choose between benefit plans offered by the Company and benefit plans offered by competitors of the Company, and in some cases, whether to purchase any benefit plans at all. In the case of some employers, the Company's benefit plans are offered to employees on an exclusive basis. Generally, employees can enroll in the Company's benefit plans or cancel their participation in the Company's benefit plans only during this annual open enrollment process. In addition to an internal sales force, the Company also employs account managers who are responsible for promoting retention of the clients and subscribers enrolled in the Company's benefit plans, and marketing additional products to existing customers. These account managers are responsible for supporting the customer's open enrollment process to ensure that difficulties experienced by the customer during this process are minimized, and that the number of subscribers who enroll in the Company's benefit plans is maximized. The account managers perform this function for both new employer groups and renewing employer groups. Account managers are paid a salary plus incentive compensation for selling additional products to existing customers. The Company markets its benefit plans to medical HMOs primarily through direct contact between executives of the Company and the medical HMO. The Company's existing contracts with medical HMOs typically cover a relatively large number of subscribers, and accordingly, executives of the Company directly maintain these relationships and provide customer service support on an ongoing basis. The Company markets its products to government programs primarily through direct contact between executives of the Company and the government programs. The Company's government contracts each cover a relatively large number of subscribers, and accordingly, executives of the Company directly maintain these relationships and provide customer service support on an ongoing basis The Company also has a dedicated government client service staff to provide service to its government clients. 8 RATING AND UNDERWRITING The Company develops the premium rates for each of its benefit plans, including rate adjustments that depend on various group-specific underwriting variables, based on past experience with similar products, and based on actuarial analysis using industry claims cost information. When the Company has the opportunity to submit a proposal for a benefit plan to a potential customer, it first obtains certain basic underwriting information from the prospective client. This information includes whether the potential customer currently has dental coverage, the benefit design of the existing dental coverage, the geographic location of the potential customer's employees, the number of employees and dependents who are currently enrolled and the number who are eligible for coverage, the portion of the cost of dental coverage that is paid by the employer, whether the potential customer is considering making the Company the exclusive provider of dental coverage, and other similar information. The Company then evaluates this information to assess the underwriting risk associated with providing a dental benefit plan to the potential customer. Based on this evaluation, the Company either makes a proposal that includes a benefit design and premium rates that take into account the Company's risk assessment, or declines to make a proposal due to an excessive amount of underwriting risk, or the lack of compatibility between the Company's provider network and the location of the potential client's employees. CLIENTS AND CUSTOMER CONTRACTS The Company currently provides dental or vision coverage, or related services, to an aggregate of approximately 1.5 million individuals, who participate in the Company's benefit plans primarily through group contracts with approximately 8,000 employers, medical HMOs, state government agencies, labor unions and other purchasers of dental or vision benefits. The Company's customers include many large employers, including Boeing Corporation, City of Dallas, County of Los Angeles, County of San Diego, Joint Council of Teamsters No. 42 Welfare Trust, North Broward Hospital District, Southern California Edison, Southern California Gas Company, and State of California, among others. A small portion of the total covered individuals participates in the Company's benefit plans through individual dental HMO plans purchased from the Company. The Company's contract with the California Managed Risk Medical Insurance Board ("MRMIB"), under which approximately 130,000 members are currently enrolled in one of the Company's dental plans under the "Healthy Families" program, currently accounts for approximately 10% of the Company's total premium revenue. The Company acquired the contract with MRMIB in connection with the acquisition of HN Dental on October 31, 2003, and accordingly, the contract did not account for a significant portion of the Company's revenue in 2003. No other customer accounts for five percent (5%) or more of the Company's total premium revenue. The Company's group contracts generally provide for a specified benefit program to be delivered to plan participants for a period of one to two years at a fixed monthly premium rate for each subscriber type. The contracts typically provide for termination by the customer upon 60 days written notice to the Company. PROVIDER NETWORKS The Company currently has approximately 6,000 providers in its dental HMO network, and has approximately 16,000 providers in its dental PPO network. The Company also has approximately 2,700 providers in its vision HMO network, and has approximately 3,700 providers in its vision PPO network. The Company believes that a key element in the success of a dental or vision benefits company is an extensive network of participating providers in convenient locations. The Company believes that providers who participate in its HMO and PPO networks are willing to provide their services at reduced fees in exchange for a steady stream of revenue from patients enrolled in the Company's benefit plans. In addition, this revenue source for the provider is relatively free from collection problems and administrative costs sometimes associated with other types of patients. Therefore, qualified providers and/or provider groups have generally been available and willing to participate in the Company's HMO and PPO networks in order to supplement the patients for which they are paid usual and customary fees. The Company requires that all providers in its dental and vision HMO networks meet certain quality assessment program standards. Those standards include current professional license verification, adequate liability insurance coverage, a risk management review of the provider's office facility to ensure that Occupational Safety and Health Act ("OSHA") requirements and other regulatory requirements are met, an inspection of a dental office's 9 sterilization practices, and a general review of the office location, including parking availability and handicap access. The Company compensates the general dentists in its HMO network primarily through monthly capitation payments and supplemental payments. Each general dentist typically receives a fixed monthly capitation payment for each subscriber or dependent that selects that dentist as his or her primary dentist. The amount of the capitation payment related to each member varies based on the plan design in which the member is enrolled, but does not vary with the nature or extent of the dental services provided to the member. In addition to capitation payments, the general dentists may receive supplemental payments from the Company and co-payments from the patients, depending on the plan design purchased by each patient. The Company typically makes a fixed supplemental payment to the general dentist each time the dentist delivers specified procedures to members enrolled in certain benefit plans. The amount of the supplemental payment varies depending on the specific procedure performed and the amount of the co-payment collected from the member, which varies with the benefit plan design. Supplemental payments are designed to mitigate the risk to the dentist associated with procedures that require the payment of a laboratory fee by the dentist, and members who require an extensive amount of dental services. Supplemental payments are low enough to avoid providing an incentive for the dentist to deliver services that are not cost-effective. The Company believes the use of supplemental payments provides for a higher level of member and provider satisfaction with the Company's dental HMO plan designs. The general dentist also typically receives co-payments from members for certain types of services, which vary based on the plan design under which each member is covered. Although most general dentists in the Company's HMO network are compensated through capitation and supplemental payments, in some cases, general dentists are compensated based on a negotiated fee for each procedure performed. No individual dental office provides services to five percent (5%) or more of the members enrolled in the Company's dental HMO plan designs. The Company's dental HMO network also includes specialists in the areas of endodontics, oral surgery, orthodontics, pedodontics, and periodontics. In order for a member to receive services from a specialist, those services must be requested by the member's general dentist and approved in advance by the Company. The approval by the Company confirms that the referral is for a service covered by the member's benefit plan. Specialists are reimbursed by the Company based on a negotiated fee schedule, and also receive co-payments from members based on the benefit plan design under which each member is covered. Dentists in the Company's PPO network are compensated based on a negotiated fee schedule that is generally 20 to 40 percent less than the usual and customary fees in that provider's geographic area. Non-contracted dentists who provide services to subscribers and dependents enrolled in PPO plan designs are compensated based on usual and customary fees in each geographic area, and may bill the subscriber or dependent for any remaining balance. Under some benefit plan designs offered by the Company, the Company compensates non-contracted dentists based on a fixed amount for each procedure, regardless of the geographic area, and the dentist may bill the patient for any remaining balance. The Company compensates the providers in its vision HMO and PPO networks based on a negotiated fee schedule that is generally 20 to 40 percent less than the usual and customary fees in that provider's geographic area. The vision providers in both the HMO and PPO networks also generally collect co-payments or co-insurance amounts from the patients, depending on the plan design purchased by each patient. Non-contracted vision providers who deliver services to subscribers and dependents enrolled in PPO plan designs are generally compensated based on a fixed amount for each procedure, and may bill the subscriber or dependent for any remaining balance. The Company employs provider relations representatives who are based in the geographic markets served by the Company. These representatives are responsible for developing and maintaining the Company's network of dental and vision HMO and PPO providers. They negotiate contracts with dentists, optometrists and ophthalmologists and also assist the network providers in the administration of the Company's benefit plans. In the event that a network provider terminates his relationship with the Company, the provider relations representative is responsible for recruiting new providers to meet the needs of the members enrolled in the Company's benefit plans. The providers in the Company's dental and vision HMO and PPO networks are free to contract with other dental and vision benefit plans, and both the provider and the Company can typically terminate the contract at any time upon 60 days prior written notice. In accordance with the contract, the Company may also terminate the contract "for cause" upon 15 days prior written notice. The Company can also change the reimbursement rates, member co-payments, 10 and other financial terms and conditions of the contract at any time, with ten to fifteen days notice to the provider. The Company's contracts with providers in its dental HMO and PPO networks require the providers to maintain professional liability insurance with a minimum coverage of $200,000 per claim, and $600,000 in the aggregate per year, and to indemnify the Company for claims arising from the provider's acts or omissions. QUALITY MANAGEMENT The Company maintains a quality management program with respect to its dental HMO business under the direction of its Dental Director. The Company's quality management program includes verification of provider credentials, assessment of each dentist's compliance with applicable state regulatory standards and practice standards established by the Company, monitoring of patient appointment availability and accessibility of dental care, monitoring of patient satisfaction through member surveys and other tools, analysis of dental care utilization data, addressing member complaints and grievances, and assessment of other qualifications of dentists to participate in the Company's HMO network. The Company maintains a credentialing committee for its dental HMO network, which uses information provided by an NCQA-certified Credentialing Verification Organization ("CVO") to verify each provider's licensing status, insurance coverage, and compliance with applicable federal and state regulations, and to review the National Practitioners Data Bank for complaints filed against the provider. The Company also uses an outside contracting service to perform on-site dental office quality assessment reviews to determine appropriateness of care and review treatment outcomes. The Company uses an independent outside service to conduct regular member satisfaction surveys with respect to its dental HMO business. These surveys monitor the level of member satisfaction with respect to the services provided by dentists in the Company's network, the choice of providers and availability of appointments within the Company's network, the benefits covered by the Company's benefit plans, and the customer service provided by the Company. The results are used by the Company to determine how it can improve its provider network and the level of service provided to its members. The Company also maintains a quality management program with respect to its vision HMO business under the direction of its Vision Director. The Company's quality management program includes verification of provider credentials, assessment of each dentist's compliance with applicable state regulatory standards and practice standards established by the Company, monitoring of patient appointment availability and accessibility of dental care, monitoring of patient satisfaction through member surveys and other tools, analysis of dental care utilization data, addressing member complaints and grievances, and assessment of other qualifications of optometrists and ophthalmologists to participate in the Company's HMO network. UTILIZATION REVIEW The Company monitors the utilization rates for various dental procedures provided by general dentists in its HMO network, as well as the frequency of specialist referrals initiated by those dentists, based on paid claim information and encounter data submitted by the dentists. The analysis of this information, including comparisons among providers in the network, enables the Company to determine whether any of its providers display practice patterns that are not cost-effective, or practice patterns that are otherwise inappropriate. When this information shows a potentially inappropriate practice pattern, the Company conducts a more focused review of the dental practice in question. The Company also monitors the utilization rates for various dental procedures provided by dentists in its PPO network, based on paid claim information. The analysis of this information, including comparisons among providers in the network, enables the Company to focus its provider contracting efforts to develop a more cost-effective PPO network, as well as to improve the design of its benefit plans with a PPO/indemnity plan design. This information also allows the Company to demonstrate savings achieved by the Company and its subscribers and dependents, as a result of the contracting arrangements between the Company and the providers in its network. 11 MEMBER SERVICES The Company provides basic member services from its National Service Center in Aliso Viejo, California through the use of toll-free telephone numbers. The toll-free telephone numbers provide members and provider offices with access to automated services 24 hours per day, and with access to member services representatives from 6:00 a.m. to 7:00 p.m. Pacific Time. Automated service is available 24 hours a day for inquiries such as selection of a network dentist, requests for identification cards, and eligibility verification. The Company uses an automated call distribution ("ACD") system for its management of customer service calls. The Company maintains Quality Management ("QM") Committees with respect to its dental and vision HMO businesses, under the direction of its Dental Director and Vision Director, respectively. Each QM Committee is responsible for the disposition of all types of member grievances with respect to the Company's dental and vision HMO plan designs. Member grievances are typically originated through a member services call or a letter written to the Company by the member. The Company has a standard grievance resolution process that begins with a member services representative who attempts to resolve the grievance. In the event this is not successful, or the grievance is related to dental or vision care issues that are beyond the expertise of a member services representative, the appropriate Quality Management department addresses the grievance. Each QM Committee addresses grievances that cannot be resolved by the Quality Management department. The Company responds to all member grievances with a written disposition of the grievance within 30 days of receipt of the grievance. After the QM Committee has responded to the grievance, the member has the option of submitting the grievance to binding arbitration, which is conducted according to the rules and regulations of the American Arbitration Association. Each QM Committee monitors the frequency of member grievances by type, and the average time in which the Company responds to grievances, in order to determine ways it can improve its communications with members and network providers, improve its customer service, and determine ways to improve the efficiency of the grievance resolution process. MANAGEMENT INFORMATION SYSTEMS The Company currently uses a single primary business application for the majority of its business. The source code for this application was purchased from a software vendor in 2002, and the Company made extensive modifications to it before converting substantially all of its business to this application in September 2003. The Company anticipates that it will continue to modify this system in the future to meet the changing needs of its business. The new application is used for eligibility files, billing and collections, specialty referral authorization, claims processing, commission payments, utilization management, provider file maintenance, and other similar activities. The application includes comprehensive information on the Company's eligibility records, benefit plan designs, premium rates, provider payment arrangements, and broker commission rates. This system provides the Company the ability to maintain combined records with respect to eligibility files, billing and collections, claim payments and other information related to all the products purchased from the Company by a single customer. The system is also flexible enough to accommodate a wide variety of benefit plan designs to meet the needs of the Company's customers. The business acquired in the acquisition of HN Dental, HN Vision and the related dental and vision PPO/indemnity business in October 2003 used a combination of several different business applications for different functions, all of which were acquired by the Company in the transaction. The Company converted a majority of the business acquired in this transaction to the primary business application described above in April 2004, and intends to convert the remainder of the acquired business to this system over the next several months. Prior to September 2003, the Company used two primary business applications, one of which was used for its dental HMO business and its vision PPO/indemnity business, and one of which was used for its dental PPO/indemnity business. The system used for the Company's dental HMO business and vision PPO/indemnity business was a proprietary application that was a predecessor version of its current primary application, and that was modified extensively by the Company. The system used for the Company's PPO/indemnity plan designs was a standard application purchased from a software vendor, which generally met the Company's needs for its PPO/indemnity business. The primary reason the Company invested in its new application was to develop a single system that could maintain combined records for all of the products purchased from the Company by a single customer. 12 A separate primary business application is used for a portion of the business acquired in the purchase of Paramount in August 2002, which consists of dental HMO benefit plans delivered to certain medical HMOs. This system is a standard application purchased from a software vendor, and generally meets the Company's needs for the products offered to medical HMOs. The Company is currently evaluating whether to convert this portion of its business to its primary software application that was implemented in September 2003. The Company is in the process of developing an enhanced web site that will allow customers to update their eligibility files online, allow providers to verify eligibility online, and provide other interactive features for customers, providers and brokers. The Company uses a personal computer network-based general ledger system that includes reporting and analysis tools that allow the extraction and download of data to spreadsheet programs for further analysis. The Company also makes extensive use of its email system in coordinating the activities of employees in various office locations and communicating with customers, brokers and providers. During 2002, the Company implemented a Customer Relationship Management system, as part of its long-term information systems strategic plan, which it uses to manage customer and provider relationships. The Company also uses a variety of other, less significant applications in various areas of its business. All of the Company's applications are integrated into a single network so employees can easily access any needed application from their desktop computers. RISK MANAGEMENT Providers in the Company's dental HMO and dental PPO networks generally indemnify the Company against professional liability claims and are required to maintain professional liability insurance with specified minimum amounts of coverage. The Company also maintains $5 million of general and professional liability insurance coverage, which covers losses on a "claims made" basis. The Company believes this amount of coverage is adequate to manage the ordinary exposure of operating its business. However, there can be no assurance that this amount of coverage would be adequate to cover potential claims against the Company, or that adequate general and professional liability insurance coverage will be available to the Company in the future at a reasonable cost. Prior to October 2002, the Company maintained $5 million of officers and directors liability insurance coverage, after a $250,000 deductible. Due to a significant increase in the cost of such insurance, the Company elected not to purchase this insurance coverage effective October 1, 2002. COMPETITION The Company operates in a highly competitive environment and faces numerous competitors in each of its geographic markets with respect to all products offered by the Company. The Company's competitors include several large national insurance companies that offer dental HMO plan designs and dental PPO/indemnity plan designs, numerous regional insurance companies and medical HMOs that offer dental benefit plans, and numerous local or regional dental HMOs and other companies that offer various types of dental benefit plans. Many competitors are significantly larger than the Company, and have substantially greater financial resources than the Company. In addition, many employers, union trust funds and other group purchasers provide self-insured dental plans to their employees or other constituents. The Company believes that the key factors in a purchaser's selection of a dental benefit plan include the premium rates charged, the comprehensiveness of the dental benefits offered, the range of benefit designs offered, the responsiveness related to customer service activities, and the perceived quality, accessibility and convenience of the dental offices in the provider network. There are competitors that compete aggressively with respect to all of these factors in each of the geographic markets in which the Company operates, and many employers, particularly large employers, make their selection of a dental benefit plan through a competitive bidding process. There is significant price competition in each of the Company's geographic markets, which could impair the Company's ability to sell its dental benefit plans at profitable premium rates. The Company anticipates that this price competition will continue to exist during the foreseeable future. Large national insurance companies that offer both dental HMO plan designs and dental PPO/indemnity plan designs may have a competitive advantage over smaller competitors, such as the Company, due to larger provider networks located across the United States, the availability of multiple product lines other than dental benefits, 13 established business relationships with large employers, better name recognition, and greater financial and information system resources. The Company believes it can effectively compete with these insurance companies by offering a flexible array of benefit plan designs, and by maintaining a high level of customer service with respect to its employer groups, members, dental service providers, and brokers. Some medical HMOs have developed dental benefit plans with both HMO and PPO/indemnity plan designs in-house, and others contract with dental benefits companies, such as the Company, to provide those products. The Company believes it can compete effectively with medical HMOs that offer dental benefit plans. The Company currently has relationships with certain medical HMOs, under which the medical HMOs offer the Company's dental benefit plans to their customers, and the Company intends to form relationships with additional medical HMOs in the future. Other than minimum net worth requirements imposed by state regulators, and the need to obtain a license from the applicable state regulator, which could take a substantial period of time, there are no significant barriers to entry into the dental benefits business by potential competitors. There can be no assurance that the Company will be able to compete successfully with any new competitors. Additional competition could adversely impact the Company's profitability and growth prospects through decreases in premium rates, and the loss of customers or dental service providers. GOVERNMENT REGULATION The Company's operations are subject to an extensive amount of state regulation in each of the states in which it operates. The Company's most significant dental and vision HMO subsidiaries are subject to regulation by the California Department of Managed Health Care, the Florida Department of Insurance and the Texas Department of Insurance. The Company's dental and vision insurance subsidiary is regulated primarily by the California Department of Insurance, and is also subject to regulation by state insurance regulatory agencies in all of the states in which it is licensed. The Company's dental and vision HMO subsidiaries are subject to regulations that vary from state to state, and generally include regulations with respect to the scope of benefits provided to members, the content of all contracts with customers, dental and vision providers and others, advertising, the maintenance of a minimum amount of net worth, the maintenance of restricted deposits, procedures related to quality assurance, enrollment procedures, the maximum percentage of premium revenue that may be spent on general and administrative expenses, minimum loss ratios, certain "any willing provider" requirements which may limit the Company's ability to restrict the size of its provider network, the relationship between the Company and the providers in its dental and vision provider networks, the Company's procedures for resolving member grievances, and premium rates. The Company's dental and vision insurance subsidiary is subject to state regulations with respect to the maintenance of a minimum amount of net worth, the maintenance of restricted deposits for the benefit of certain state regulators, the nature of investments held by the Company, insurance policy forms, advertising, and claims processing procedures. Insurance companies in general are subject to extensive regulation and are typically required to have significantly greater financial resources than dental or vision HMOs. The Company's ability to expand its operations into states in which it is not currently licensed is dependent on the regulatory review process conducted by the applicable state regulatory agency in each state. Such reviews may take from six to twenty-four months, and would have to be satisfactorily completed before the Company could commence operations in the applicable state. Since some states will only license full service HMO entities, the Company would not be able to offer its dental or vision HMO plan designs in those states, except pursuant to an arrangement with a full service medical HMO. Other states permit only nonprofit organizations to become licensed as dental or vision HMO plans, again limiting the Company's access to business in those states. The heavily regulated nature of the Company's business imposes a variety of potential obstacles to any geographic expansion by the Company, and could limit the Company's future growth potential. This regulatory environment also governs the conduct and expansion prospects of existing and new competitors, thereby providing a potential barrier to entry for potential competitors. The Company is subject to the Health Insurance Portability and Accountability Act of 1996 ("HIPAA"). HIPAA imposes responsibilities on the Company, including but not limited to, privacy notice requirements to members of the Company's benefit plans, the security and privacy of individually identifiable health information, the use of 14 unique identifiers for all of the contractual relationships the Company has with members, providers and group and individual contract holders, the adoption of standardized electronic transaction code sets, and prevention of unauthorized use or disclosure of personal data maintained by the Company. The Company has developed policies and procedures to comply with these requirements and has provided privacy notices as required by HIPAA and the Gramm-Leach-Bliley Act. There is currently no other regulation of the Company's business at the federal level. TRADEMARKS, SERVICE MARKS AND TRADE NAMES The Company currently markets all of its products under the brand names "SafeGuard" and "Paramount Dental Plan." The Company has filed, received approval, and obtained renewal protection from the United States Patent and Trademark office for certain trademarks and trade names for names and products used by the Company in its ordinary course of business. The Company has also received approvals for the use of its trademarks and trade names from state governmental agencies, as applicable. The Company has received a trademark, service mark or trade name for the following words and phrases used with and without distinctive logos maintained by the Company: - SafeGuard(R) used with a distinctive logo depicting a modified smile used in connection with all the products offered by the Company; - SafeGuard Health Plans(R) used in descriptive material to describe the products offered by the Company; - SafeGuard Dental Plans(TM) used to describe the various dental HMO plan designs offered by the Company; - SafeHealth Life(R) used with a descriptive logo depicting a modified smile used by the Company to describe its dental and vision PPO/indemnity plan designs; and - Paramount Dental Plan with a distinctive logo of three triangles stacked on top of each other used by the Company in the integration of its acquisition of Paramount into the Company's Florida operations. Collectively, these trademarks, service marks and trade names were first used in interstate commerce in 1984 and have been continuously used thereafter. In addition, the Company has received trademark/service mark protection from the United States Assistant Commissioner for Trademarks of its distinctive logo depicting a smile that the Company is currently utilizing in interstate commerce. EMPLOYEES At March 31, 2004, the Company had approximately 360 employees, of which approximately 50 were represented by a labor union. The Company considers its relations with its employees to be satisfactory. The Company provides typical employee benefits, including paid vacation, holiday and sick time, a portion of the cost of health insurance, dental and vision coverage for the employee's family, life insurance, a 401(k) plan that includes a matching contribution consisting of the Company's common stock, and the opportunity to take advantage of a flexible spending account under Section 125 of the Internal Revenue Code. Employees are eligible to participate in the 401(k) plan upon completion of three months of service with the Company. Under the 401(k) plan, an employee is allowed to contribute up to 20% of his total compensation to the plan each pay period, subject to the annual limit prescribed by the Internal Revenue Code, and subject to certain anti-discrimination provisions. Effective July 1, 2001, the Company adopted a matching contribution program, under which the Company makes a contribution equal to a specified percentage of each employee's contribution, in the form of common stock of the Company. The matching contribution percentage, which was 25% for 2003, 2002 and 2001, is set in advance of each fiscal year by the Company's board of directors, and has been set at 25% for 2004. The Company contributed 73,000 shares, 66,000 shares and 33,000 shares of its common stock to the 401(k) plan for the years ended December 31, 2003, 2002 and 2001, respectively. Employees become vested in the Company's contributions to the 401(k) plan at the rate of 20% for each of the first five years of employment with the Company, with credit given for past service. Employees are fully vested in their contributions to the 401(k) plan at all times. 15 RISK FACTORS The Company's business and competitive environment includes numerous factors that expose the Company to risk and uncertainty. Some risks are related to the dental and vision benefits industries in general and other risks are related to the Company specifically. Due to the risks and uncertainties described below, as well as other risks described elsewhere in this Annual Report on Form 10-K, there can be no assurance that the Company will be able to maintain its current market position or its profitability. Some of the risk factors described below have adversely affected the Company's operating results in the past, and all of these risk factors could affect its future operating results. Integration of Business Acquired in October 2003. The Company is in the process of integrating the business operations of HN Dental, HN Vision, and the related dental and vision PPO/indemnity business, all of which was acquired in October 2003, into the Company's operations. The revenue of the acquired business was an aggregate of approximately $74 million in 2003, which is very significant compared to the size of the pre-existing operations of the Company. Due to the complexities inherent in this integration process, there is a risk that the Company may not be able to complete such integration activities in a timely and effective manner. In such case, the profitability of the acquired business could be lower than expected, and the general and administrative expenses of the Company could be higher than expected, which could have a negative impact on the Company's overall profitability. Government Regulation. The dental and vision benefits industries are subject to extensive state and local laws, rules and regulations. Each of the Company's operating subsidiaries is subject to various requirements imposed by state laws and regulations related to the operation of a dental or vision HMO plan or a dental and vision insurance company, including the maintenance of a minimum amount of net worth by certain subsidiaries. In addition, regulations applicable to dental or vision benefits companies could be changed in the future. There can be no assurance that the Company will be able to meet all applicable regulatory requirements in the future. Government Sponsored Contracts. As a result of the acquisition of HN Dental, the Company has several dental benefits contracts that are administered by state government agencies. These contracts collectively account for approximately 15% of the Company's total revenue. These contracts have expiration dates in 2005. The loss of one or more of these contracts could have a material adverse affect on the Company's operating results. Health Insurance Portability and Accountability Act of 1996 ("HIPAA"). HIPAA imposes various responsibilities on the Company, as described above under "Government Regulation." The Company has developed policies and procedures to comply with these requirements, but the total cost of compliance with HIPAA is not known at this time. There is a risk that the Company will not be able to satisfactorily comply all of the HIPAA requirements. There is also a risk that the cost of compliance with HIPAA could have a material adverse impact on the Company's financial position. Contingent Lease Obligations. The Company sold all of its general dental practices and orthodontic practices in 1996, 1997 and 1998. All of the office lease agreements related to those practices either have been assigned to the respective purchasers of the practices, or have expired. As of December 31, 2003, the Company is contingently liable for an aggregate of approximately $2.0 million of office lease obligations related to those practices for which the leases have been assigned. Although the leases have been assigned to the purchasers of those practices, there can be no assurance that the persons and/or entities to which these office leases were assigned will make the lease payments, and that the Company will not become liable for those payments. Payments Due on Promissory Notes. In connection with the sale of certain dental practices, the dentists who purchased those practices issued long-term promissory notes to the Company, which are secured by the assets purchased. There can be no assurance that each of these dentists will make timely payments on the promissory notes in the future. Possible Volatility of Stock Price. The market price of the Company's common stock has fluctuated significantly during the past few years. Stock price volatility can be caused by actual or anticipated variations in operating results, announcements of new developments, actions of competitors, developments in relationships with clients, and other events or factors. Even a modest shortfall in the Company's operating results, compared to the expectations of the investment community, can cause a significant decline in the market price of the Company's common stock. In addition, the trading volume of the Company's common stock is relatively low, which can cause fluctuations in the 16 market price and a lack of liquidity for holders of the Company's common stock. The fact that the Company's common stock is not listed on an exchange and is traded on the Over The Counter Bulletin Board can have a negative influence on the trading volume of the stock. Broad stock market fluctuations, which may be unrelated to the Company's operating performance, could also have a negative effect on the Company's stock price. Competitive Market. The Company operates in a highly competitive industry. Its ability to operate on a profitable basis is affected by significant competition for employer groups and for contracting dental and vision providers. Dental providers are becoming more sophisticated, their practices are busier, and they are less willing to join the Company's networks under capitation arrangements or discounted fees. There can be no assurance the Company will be able to compete successfully enough to be profitable. Existing or new competitors could have a negative impact on the Company's revenues, earnings and growth prospects. The Company expects the level of competition to remain high for the foreseeable future. Utilization of Dental Care Services. Under the Company's dental PPO/indemnity plan designs, the Company assumes the underwriting risk related to the frequency and cost of dental care services. If the Company does not accurately assess these underwriting risks, the premium rates charged to its customers might not be sufficient to cover the cost of the dental services delivered. This could have a material adverse effect on the Company's operating results. Under the Company's dental HMO plan designs, the Company assumes underwriting risk related to the frequency and cost of specialist services, the cost of supplemental payments made to general dentists, and the frequency and cost of dental services provided by general dentists with whom the Company does not have standard capitation arrangements. If the Company does not accurately assess these underwriting risks, the premium rates charged to its customers might not be sufficient to cover the cost of the dental services delivered to subscribers and dependents. This could have a material adverse effect on the Company's operating results. Effect of Adverse Economic Conditions. The Company's business could be negatively affected by periods of general economic slowdown, recession or terrorist activities which, among other things, may be accompanied by layoffs by the Company's customers, which could reduce the number of subscribers enrolled in the Company's benefit plans, and by an increase in the pricing pressure from customers and competitors. Relationships with Providers. The Company's success is dependent on maintaining competitive networks of dental and vision providers in each of the Company's geographic markets. Generally, the Company and the network providers enter into nonexclusive contracts that may be terminated by either party with limited notice. The Company's operating results could be negatively affected if it is unable to establish and maintain contracts with a competitive number of providers in locations that are convenient for the subscribers and dependents enrolled in the Company's benefit plans. Dependence on Key Personnel. The Company believes its success is dependent to a significant degree upon the abilities and experience of its senior management team. The loss of the services of one or more of its senior executives could negatively affect the Company's operating results. CONVERTIBLE NOTES The acquisition of HN Dental, HN Vision and the related dental and vision PPO/indemnity business was financed through the issuance of $19.0 million of unsecured convertible promissory notes to certain of the Company's principal stockholders in October 2003. The proceeds from the convertible notes were used to finance the acquisitions, to satisfy the increase in the Company's regulatory net worth requirements related to the PPO/indemnity dental and vision business that was acquired, which is estimated to be $3.8 million, to provide working capital that may be required in connection with the integration of the acquired businesses into the Company's pre-existing operations, and for general corporate purposes. The convertible notes bear interest at 6.0% annually, and are convertible into the Company's common stock at the rate of $1.75 per share, at the option of the holder. There are no principal payments due under the convertible notes prior to January 31, 2010, then principal payments are due beginning on January 31, 2010, and each three months thereafter through July 31, 2013, pursuant to a ten-year amortization schedule, and the remaining balance is payable in full on October 31, 2013. The convertible notes are payable in full upon a change in control of the Company, at 17 the holder's option. The Company has the option of redeeming the convertible notes for 229% of face value during the first seven years after the date of issuance, for 257% of face value during the eighth year after issuance, for 286% of face value during the ninth year after issuance, and for 323% of face value during the tenth year after issuance, provided that it redeems all the convertible notes held by each holder for which it redeems any of the notes. RECAPITALIZATION TRANSACTION On March 1, 2000, the Company entered into a recapitalization transaction with an investor group (the "Investors"), the revolving credit facility lender (the "Bank"), and the holder of the senior notes payable (the "Senior Note Holder"). In this transaction, the Investors loaned $8.0 million to the Company in the form of an investor senior loan, due April 30, 2001. As part of this transaction, the Investors, the Bank, and the Senior Note Holder agreed to convert the $8.0 million investor senior loan, the outstanding balance of $7.0 million under the revolving credit facility plus accrued interest, and the $32.5 million of senior notes payable plus accrued interest, to convertible preferred stock, subject to regulatory approval and an increase in the authorized shares of the Company's common stock. Effective as of January 31, 2001, the Company completed the conversion of this debt into 30 million shares of convertible preferred stock. The estimated value of the convertible preferred stock was $1.375 per share as of January 31, 2001, which is based on the closing price of the Company's common stock on January 31, 2001, which was $1.375 per share, and the fact that each share of convertible preferred stock is convertible into one share of common stock. Based on this estimated value, the conversion resulted in a pre-tax gain of $11.3 million, which is net of approximately $350,000 of transaction costs. There was no income tax effect related to this transaction, due to the Company's net operating loss carry-forwards for tax purposes, as discussed in Note 11 to the accompanying consolidated financial statements. As a result of the conversion, the ownership interest of the previously existing common stockholders of the Company was reduced to approximately 14% of the common stock interests of the Company. The convertible preferred stock does not accrue dividends of any kind, but participates in any dividends paid on the Company's common stock on an as-converted basis. Each share of convertible preferred stock is convertible into one share of common stock at the option of the holder. The convertible preferred stock entitles the holder to one vote for each share of common stock into which the preferred stock is convertible, with respect to all matters voted on by the common stockholders of the Company, except for the election of directors. The holders of the convertible preferred stock have the right to elect a total of five members of the board of directors, and the holders of the common stock have the right to elect the remaining two directors. The convertible preferred stock has a $30 million liquidation preference over the Company's common stock. In 1999, in connection with a previous restructuring of the senior notes payable, the Company issued warrants to purchase 382,000 shares of its common stock for $4.51 per share to the Senior Note Holder. The warrants were canceled without being exercised, in connection with the conversion of the senior notes payable into convertible preferred stock effective January 31, 2001. ITEM 2. PROPERTIES -------------------- The Company leases a total of approximately 68,000 square feet of office space in a single location in Aliso Viejo, California, under a lease agreement that expires in 2008. Approximately 12,000 square feet of this space is not currently used by the Company, but is subleased to unrelated third parties. The remaining 56,000 square feet of office space is used for the Company's corporate headquarters and its National Service Center, which includes member services activities, eligibility file maintenance, billing and collections, claims processing and other similar customer support activities, and for its California regional office. In addition, the Company leases office space in Irvine, California; Walnut Creek, California; Coral Springs and Tampa, Florida; and Dallas and Houston, Texas. The Company leased all of the office space used by its previously owned dental and orthodontic practices. The Company remains contingently liable for a number of these leases, which expire on various dates through 2007, as discussed in Note 12 to the accompanying consolidated financial statements. In the opinion of management, the Company's facilities are adequate for its current needs. 18 ITEM 3. LEGAL PROCEEDINGS ---------------------------- The Company is subject to various claims and legal actions arising in the ordinary course of business. The Company believes all pending claims either are covered by liability insurance maintained by the Company or by providers in the Company's dental or vision provider networks, or will not have a material adverse effect on the Company's consolidated financial position or results of operations. In December 1999, a stockholder lawsuit against the Company was filed, which alleged that the Company and certain of its officers, who were then in office, violated certain securities laws by issuing alleged false and misleading statements concerning the Company's publicly reported revenues and earnings during a specified class period. During 2002 the Company settled the lawsuit for a payment of $1.25 million to the plaintiffs, without an admission of liability. The settlement was approved by the District Court in September 2002, and the lawsuit has been dismissed with prejudice. The Company's insurer paid $1.0 million of the cost of the settlement, and the Company recorded a $250,000 expense during 2002, which is included in selling, general and administrative expenses in the accompanying consolidated statement of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------------------------- None. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ------------------------------------------------------------------------------ (a) MARKET INFORMATION The Company's common stock is traded on the NASDAQ Over The Counter Bulletin Board under the symbol SFGD. The following table sets forth the high and low sale prices of the Company's common stock each calendar quarter. The prices shown are based on transactions between market makers in the Company's stock, and do not necessarily represent transactions between non-dealer principals.
HIGH LOW ----- ----- Year ended December 31, 2004: First Quarter. . . . . . . . . . . . . . . $2.10 $1.78 Year ended December 31, 2003: First Quarter. . . . . . . . . . . . . . . $1.75 $1.16 Second Quarter . . . . . . . . . . . . . . 1.80 1.23 Third Quarter. . . . . . . . . . . . . . . 1.80 1.35 Fourth Quarter . . . . . . . . . . . . . . 3.30 1.55 Year ended December 31, 2002: First Quarter. . . . . . . . . . . . . . . $1.95 $1.19 Second Quarter . . . . . . . . . . . . . . 1.45 1.25 Third Quarter. . . . . . . . . . . . . . . 1.40 1.15 Fourth Quarter . . . . . . . . . . . . . . 1.35 1.15
(b) HOLDERS As of March 31, 2004, there were approximately 900 holders of the Company's common stock, including approximately 400 holders of record, and 34 holders of the Company's convertible preferred stock. (c) DIVIDENDS No cash dividends have been paid on the Company's common stock, and the Company does not expect to pay cash dividends during the foreseeable future. The Company's convertible preferred stock does not accrue dividends of any kind. 19 STOCKHOLDER RIGHTS PLAN In March 1996, the board of directors of the Company declared a dividend of one right to purchase a fraction of a share of its Series A Junior Participating Preferred Stock, having rights, preferences, privileges and restrictions as designated, and under certain circumstances, other securities, for each outstanding share of the Company's common stock. The dividend was distributed to stockholders of record at the close of business on April 12, 1996. The Rights become exercisable upon the occurrence of certain defined events related to a possible change of control of the Company. The description and terms of the Rights are set forth in a Rights Agreement, dated as of March 22, 1996, as amended, between the Company and American Stock Transfer and Trust Company, as Rights Agent. The Rights Agreement may be amended by the Company's board of directors without the approval of the Rights holders, at any time prior to the Rights becoming exercisable. The Rights Agreement was amended in March 2000 to specify that the recapitalization transaction initiated in March 2000 would not cause the Rights to become exercisable. 20 ITEM 6. SELECTED FINANCIAL DATA -------------------------------- The selected financial data in the following table was derived from the audited consolidated financial statements of the Company. This data should be read in conjunction with such consolidated financial statements and notes thereto, and Management's Discussion and Analysis of Financial Condition and Results of Operations.
YEARS ENDED DECEMBER 31, -------------------------------------------------------- STATEMENT OF OPERATIONS DATA 2003 2002 2001 2000 1999 --------- ---------- ---------- ---------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA): Premium revenue, net $104,891 $ 83,043 $ 84,822 $ 97,251 $ 96,225 Health care services expense 73,194 57,937 58,692 68,568 69,528 Selling, general and administrative expense 28,684 24,540 25,391 31,203 35,072 Loss on impairment of assets (1) -- 334 -- 450 24,576 --------- ---------- ---------- ---------- --------- Operating income (loss) 3,013 232 739 (2,970) (32,951) Investment and other income 490 607 1,060 1,431 2,067 Interest expense (530) (232) (504) (4,913) (5,855) --------- ---------- ---------- ---------- --------- Income (loss) before income taxes, discontinued operations and extraordinary item 2,973 607 1,295 (6,452) (36,739) Income tax expense (benefit) (2) (4,840) (820) -- -- 10,934 --------- ---------- ---------- ---------- --------- Income (loss) before discontinued operations and extraordinary item 7,813 1,427 1,295 (6,452) (47,673) Discontinued operations: Loss from assets transferred under contractual arrangements (3) -- -- -- (2,500) (4,363) Extraordinary item: Gain on conversion of debt to convertible preferred stock (4) -- -- 11,251 -- -- --------- ---------- ---------- ---------- --------- Net income (loss) $ 7,813 $ 1,427 $ 12,546 $ (8,952) $(52,036) ========= ========== ========== ========== ========= Basic net income (loss) per share: Income (loss) before discontinued operations and extraordinary item $ 0.22 $ 0.04 $ 0.04 $ (1.36) $ (10.04) Loss from discontinued operations -- -- -- (0.53) (0.92) Extraordinary item -- -- 0.35 -- -- --------- ---------- ---------- ---------- --------- Net income (loss) per basic share $ 0.22 $ 0.04 $ 0.39 $ (1.89) $ (10.96) ========= ========== ========== ========== ========= Weighted average basic shares outstanding (5) 35,719 35,130 32,253 4,747 4,747 Diluted net income (loss) per share: Income (loss) before discontinued operations and extraordinary item $ 0.20 $ 0.04 $ 0.04 $ (1.36) $ (10.04) Loss from discontinued operations -- -- -- (0.53) (0.92) Extraordinary item -- -- 0.34 -- -- --------- ---------- ---------- ---------- --------- Net income (loss) per diluted share $ 0.20 $ 0.04 $ 0.38 $ (1.89) $ (10.96) ========= ========== ========== ========== ========= Weighted average diluted shares outstanding 40,244 35,638 33,009 4,747 4,747 BALANCE SHEET DATA AS OF DECEMBER 31 (IN THOUSANDS): Cash and short-term investments $ 28,199 $ 12,704 $ 15,453 $ 16,702 $ 6,281 Current assets 37,104 16,111 19,195 21,268 10,380 Total assets 71,238 34,114 29,325 33,095 28,577 Current liabilities 23,588 14,093 14,988 72,180 18,129 Long-term debt and capital lease obligations 22,537 2,997 -- 265 39,545 Other long-term liabilities 1,223 1,013 971 1,079 2,517 Stockholders' equity (deficit) 23,890 16,011 13,366 (40,429) (31,614)
See note explanations on the following page. 21 Note explanations to Selected Financial Data: (1) Represents reductions in the carrying value of notes receivable in 2002 and 2000, and goodwill in 1999, to their estimated realizable values. (2) The 2003 amount primarily represents a reduction in the valuation allowance on the Company's net deferred tax assets. The 2002 amount primarily represents a decrease in the accrual for estimated income tax liabilities related to certain transactions that occurred in prior years. The 1999 amount primarily represents a charge to establish a valuation allowance against net deferred tax assets. See Note 11 to the accompanying consolidated financial statements for more information on income taxes. (3) Represents reductions in the carrying value of the net assets related to certain dental practices to their estimated realizable value. (4) Effective January 31, 2001, the Company completed the conversion of $47.5 million of debt and $5.3 million of accrued interest into 30 million shares of convertible preferred stock, resulting in an extraordinary gain of $11.3 million, net of transaction expenses. (5) Includes the common share equivalents of the convertible preferred stock, because the holders of the convertible preferred stock participate in any dividends paid on the Company's common stock on an as-converted basis, and because the Company believes the convertible preferred stock is a participating security that is essentially equivalent to common stock, based on all the rights and preferences of both types of stock. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS -------------------------------------------------------------------------------- OF OPERATIONS ------------- SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements, as long as those statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed in the statements. The Company desires to take advantage of these safe harbor provisions. The information in the "Risk Factors" section of Item 1 of this Form 10-K should be read in conjunction with this Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A"). The statements contained in this MD&A concerning expected growth, the outcome of business strategies, future operating results and financial position, economic and market events and trends, future premium revenue, future health care expenses, the Company's ability to control health care, selling, general and administrative expenses, and all other statements that are not historical facts, are forward-looking statements. Words such as expects, projects, anticipates, intends, plans, believes, seeks or estimates, or variations of such words and similar expressions, are also intended to identify forward-looking statements. These forward-looking statements are subject to significant risks, uncertainties and contingencies, many of which are beyond the control of the Company. Actual results may differ materially from those projected in the forward-looking statements, which statements involve risks and uncertainties. All of the risks set forth in the "Risk Factors" section of this Form 10-K could negatively impact the earnings of the Company in the future. The Company's expectations for the future are based on current information and its evaluation of external influences. Changes in any one factor could materially impact the Company's expectations related to revenue, premium rates, benefit plans offered, membership enrollment, the amount of health care expenses incurred, and profitability, and therefore, affect the forward-looking statements which may be included in this report. In addition, past financial performance is not necessarily a reliable indicator of future performance. An investor should not use historical performance alone to anticipate future results or future period trends for the Company. CRITICAL ACCOUNTING POLICIES The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. Application of those accounting principles includes the use of estimates and assumptions that are made by management, and which the Company believes are reasonable based on the information available. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues and expenses in the accompanying consolidated financial statements. The Company believes the most critical accounting policies used to prepare the accompanying consolidated financial statements are the following: INVESTMENTS The Company has classified all of its investments as "available-for-sale." Accordingly, investments are carried at fair value, based on quoted market prices, and unrealized gains and losses, net of applicable income taxes, are reported in a separate caption of stockholders' equity. In the event there was an unrealized loss on an investment that the Company believed to be other than temporary, the loss would be reported in the statement of operations, instead of in a separate caption of stockholders' equity. As of December 31, 2003, there were no unrealized losses that the Company believed to be other than temporary. 22 ACCOUNTS RECEIVABLE Accounts receivable represent uncollected premiums related to coverage periods prior to the balance sheet date, and are stated at the estimated collectible amounts, net of an allowance for bad debts. The Company continuously monitors the timing and amount of its premium collections, and maintains a reserve for estimated bad debt losses. The amount of the reserve is based primarily on the Company's historical experience and any customer-specific collection issues that are identified. The Company believes its reserve for bad debt losses is adequate as of December 31, 2003. However, there can be no assurance that the bad debt losses ultimately incurred will not exceed the reserve for bad debts established by the Company. GOODWILL Goodwill as of December 31, 2003 consists of $3.2 million of goodwill related to the acquisition of Health Net Dental, Inc. ("HN Dental") and Health Net Vision, Inc. ("HN Vision") in October 2003, $5.3 million of goodwill related to the acquisition of Paramount Dental Plan, Inc. ("Paramount") in August 2002, and $3.9 million of goodwill related to the acquisition of First American Dental Benefits, Inc. ("First American") in 1996. See Note 2 to the accompanying consolidated financial statements for more information on the acquisitions of HN Dental, HN Vision and Paramount. In the case of each acquisition, goodwill represents the excess of the purchase price of the acquired company over the fair value of the net assets acquired, and in the case of the First American acquisition, the balance is net of accumulated amortization and an adjustment in 1999 to reduce the carrying value of the goodwill to its estimated realizable value. The Company estimated that the goodwill related to the First American acquisition had a useful life of 40 years from the date of acquisition, and amortized the goodwill over that period through December 31, 2001. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets," the Company ceased amortizing its goodwill effective January 1, 2002. SFAS No. 142 requires that all goodwill be evaluated for possible impairment as of January 1, 2002, on an annual basis thereafter, and any time an event that may have affected the value of the goodwill occurs. SFAS No. 142 also establishes a new method of testing for possible impairment. The Company has established October 1 as the date on which it conducts its annual evaluation of goodwill for possible impairment. In accordance with SFAS No. 142, the Company tested its goodwill for possible impairment by estimating the fair value of each of its reporting units that include goodwill, and comparing the fair value of each reporting unit to the book value of the net assets of each reporting unit. The fair value of each reporting unit was determined primarily by estimating the discounted future cash flows of the reporting unit, and by estimating the amount for which the reporting unit could be sold to a third party, based on a market multiple of earnings. The Company had no impairment of its goodwill as of January 1, 2002, or as of October 1, 2003, based on the method of testing for possible impairment established by SFAS No. 142. The estimates to which the results of the Company's test are the most sensitive are the amount of shared administrative expenses that are charged to each reporting unit, and the market multiple of earnings that is used to estimate the fair value of each reporting unit. The Company believes the estimates used in its test are reasonable and appropriate, but a significant change in either of these estimates could result in the indication of an impairment of goodwill. The Company is not aware of any events that have occurred since October 1, 2003 that may have affected the value of its goodwill. However, there can be no assurance that impairment will not occur in the future. INTANGIBLE ASSETS Intangible assets as of December 31, 2003 consist of customer relationships, provider networks, and other intangible assets with an aggregate net book value of $9.9 million, which were acquired in connection with the acquisitions of HN Dental and HN Vision in October 2003, Ameritas Managed Dental Plan, Inc. in March 2003, and Paramount in August 2002. See Note 2 to the accompanying consolidated financial statements for more information on these acquisitions. The amount of the purchase price that was allocated to each of the intangible assets was equal to the Company's estimate of the fair value of each asset. Each intangible asset is being amortized over its estimated useful life on a straight-line basis. CLAIMS PAYABLE AND CLAIMS INCURRED BUT NOT REPORTED The estimated liability for claims payable and claims incurred but not reported ("IBNR") is based primarily on the average historical lag time between the date of service and the date the related claim is paid by the Company, and 23 the recent trend in payment rates and the average number of incurred claims per covered individual. Since the liability for claims payable and claims incurred but not reported is an actuarial estimate, the amount of claims eventually paid for services provided prior to the balance sheet date could differ from the estimated liability. Any such differences are included in the consolidated statement of operations for the period in which the differences are identified. RECOGNITION OF PREMIUM REVENUE Premium revenue is recognized in the period during which dental or vision coverage is provided to the covered individuals. Payments received from customers in advance of the related period of coverage are reflected on the accompanying consolidated balance sheet as deferred premium revenue. INCOME TAXES The Company's accounting for income taxes is in accordance with SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of events that are recognized in the Company's financial statements in different periods than those in which the events are recognized in the Company's tax returns. The measurement of deferred tax liabilities and assets is based on current tax laws as of the balance sheet date. The Company records a valuation allowance related to deferred tax assets in the event that available evidence indicates that the future tax benefits related to deferred tax assets may not be realized. A valuation allowance is required when it is more likely than not that the deferred tax assets will not be realized. The Company's determination of whether a valuation allowance is required is subject to change based on future estimates of the recoverability of its net deferred tax assets. In 2003, the Company reduced the valuation allowance on its net deferred tax assets by $5.7 million, primarily due to a significant improvement in its reported operating results and its expected future operating results, compared to previous years. The Company's net deferred tax assets were fully reserved during the years ended December 31, 2002 and 2001, due to uncertainty about whether those net assets would be realized in the future. NET INCOME PER SHARE Net income per share is presented in accordance with SFAS No. 128, "Earnings Per Share." Basic earnings per share is based on the weighted average common shares outstanding, including the common shares into which the convertible preferred stock is convertible, but excluding the effect of other potentially dilutive securities. The number of basic common shares outstanding includes the common share equivalents of the convertible preferred stock, because the holders of the convertible preferred stock participate in any dividends paid on the Company's common stock on an as-converted basis, and because the Company believes the convertible preferred stock is a participating security that is essentially equivalent to common stock, based on all the rights and preferences of both types of stock. Diluted net income per share is based on the weighted-average common shares outstanding, including the effect of all potentially dilutive securities. During the three years ended December 31, 2003, the potentially dilutive securities of the Company that were outstanding consisted of stock options, convertible notes, and warrants. See Note 8 to the accompanying consolidated financial statements for information on convertible notes that were outstanding during 2003 and 2002. The calculation of diluted net income per share for 2003 includes the effect of all the outstanding convertible notes. Each of these convertible notes would have an anti-dilutive effect on net income per share in 2002, and accordingly, they are excluded from the calculation of diluted net income per share for this period. The calculation of diluted net income per share for 2003, 2002 and 2001 includes the effect of all outstanding stock options with an exercise price below the average market price of the Company's common stock during each period. The only warrants issued by the Company were canceled without being exercised effective January 31, 2001, as discussed in Note 9 to the accompanying consolidated financial statements. 24 SUMMARY OF RESULTS OF OPERATIONS The following table shows the Company's results of operations as a percentage of premium revenue, and is used in the year-to-year comparisons discussed below.
YEARS ENDED DECEMBER 31, ------------------------------- 2003 2002 2001 -------- ---------- --------- Premium revenue, net 100.0% 100.0% 100.0% Health care services expense 69.8 69.8 69.2 Selling, general and administrative expense 27.3 29.9 29.9 -------- ---------- --------- Operating income 2.9 0.3 0.9 Investment and other income 0.4 0.7 1.2 Interest expense (0.5) (0.3) (0.6) -------- ---------- --------- Income before income taxes and extraordinary item 2.8 0.7 1.5 Income tax expense (benefit) (4.6) (1.0) -- -------- ---------- --------- Income before extraordinary item 7.4 1.7 1.5 Extraordinary item -- -- 13.3 -------- ---------- --------- Net income 7.4% 1.7% 14.8% ======== ========== =========
2003 COMPARED TO 2002 Premium revenue increased by $21.9 million, or 26.3%, from $83.0 million in 2002 to $104.9 million in 2003. The average membership for which the Company provided dental coverage increased by 214,000 members, or 34.7%, from approximately 616,000 members during 2002 to approximately 830,000 members during 2003. Average membership increased in 2003 by 78,000 members due to the acquisition of HN Dental in October 2003. The HN Dental acquisition added 468,000 members to the Company during the last two months of 2003, which resulted in an average increase of 78,000 members for the full year. The operations of HN Dental and HN Vision are included in the accompanying consolidated financial statements beginning on November 1, 2003. Average membership also increased in 2003 by 133,000 members due to the Paramount acquisition in August 2002. The Paramount acquisition added 200,000 members to the Company, which resulted in an average increase of 133,000 members in 2003, compared to 2002. The operations of Paramount are included in the accompanying consolidated financial statements beginning on September 1, 2002. Premium revenue increased by only 26.3% in 2003 even though average membership increased by 34.7%. This was primarily due to the Paramount acquisition, as the business acquired from Paramount consists largely of products that have significantly lower premium rates than the Company's pre-existing business. Substantially all of the Company's premium revenue was derived from dental benefit plans in 2003 and 2002. Premium revenue from vision benefit plans and other products was not material in 2003 or 2002. Health care services expense increased by $15.3 million, or 26.3%, from $57.9 million in 2002 to $73.2 million in 2003. Health care services expense as a percentage of premium revenue (the "loss ratio") was 69.8% in both 2003 and 2002. In 2003, the Company's mix of business shifted towards a higher proportion of HMO benefit plan designs, which was primarily due to the HN Dental, HN Vision and Paramount acquisitions. HMO benefit plan designs generally have lower loss ratios than PPO/indemnity benefit plan designs, and accordingly, this shift in the mix of business resulted in a slight decrease in the overall loss ratio. However, the effect of this shift was offset by a slight increase in the loss ratio on products with a PPO/indemnity plan design. Selling, general and administrative ("SG&A") expense increased by $3.8 million, or 15.3%, from $24.9 million in 2002 to $28.7 million in 2003. SG&A expense as a percentage of premium revenue decreased from 29.9% in 2002 to 27.3% in 2003. The increase in SG&A expense is primarily due to increases in salaries and benefits, broker commissions, premium taxes, and amortization of intangible assets, all of which are directly related to the acquisitions of HN Dental, HN Vision and Paramount. The decrease in SG&A expense as a percentage of premium revenue is primarily due economies of scale that resulted from the acquisitions of HN Dental, HN Vision and Paramount. 25 Investment and other income decreased by $0.1 million, from $0.6 million in 2002 to $0.5 million in 2003. This decrease is primarily due to a decrease in interest rates on short-term fixed-income investments during the past year. Interest expense increased by $0.3 million, from $0.2 million in 2002 to $0.5 million in 2003, primarily due to the borrowings made by the Company to finance the acquisition of HN Dental and HN Vision in October 2003 and the acquisition of Paramount in August 2002. See Notes 2 and 8 to the accompanying consolidated financial statements for information on outstanding debt. Income before income taxes increased by $2.4 million, from $0.6 million in 2002 to $3.0 million in 2003. Income before income taxes as a percentage of premium revenue increased from 0.7% in 2002 to 2.8% in 2003. This increase was primarily due to a decrease in SG&A expense as a percentage of premium revenue, which was primarily due to the acquisitions of HN Dental, HN Vision and Paramount, as discussed above. There was an income tax benefit of $4.8 million in 2003, which primarily represents a decrease in the valuation allowance on the Company's net deferred tax assets. The Company reduced the valuation allowance primarily due to a significant improvement in its reported operating results and its expected future operating results. There was an income tax benefit of $820,000 in 2002, which primarily represents a decrease in the Company's accrual for estimated income tax liabilities related to certain transactions that occurred in prior years. There was no other current income tax expense in 2002, due to temporary differences between income before income taxes for accounting purposes and taxable income for tax purposes, which resulted in a loss for tax purposes in 2002. See Note 11 to the accompanying consolidated financial statements for more information on income taxes. 2002 COMPARED TO 2001 Premium revenue decreased by $1.8 million, or 2.1%, from $84.8 million in 2001 to $83.0 million in 2002. The average membership for which the Company provided dental coverage was approximately 616,000 members during 2002, compared to 615,000 members during 2001. Average membership increased in 2002 by approximately 80,000 members due to the Paramount acquisition, but this increase was offset by the loss of a number of the Company's customers, and a net decrease in its enrollment within retained customers. The Paramount acquisition added approximately 240,000 members to the Company during the last four months of 2002, which resulted in an average increase of 80,000 members for the full year. The operations of Paramount are included in the accompanying consolidated financial statements beginning on September 1, 2002. The Company believes the net decrease in its enrollment within retained customers is primarily due to reduced employment levels within its customers due to general economic conditions, and to reduced enrollment in the Company's dental benefit plans due to significant increases in the cost of medical coverage, which may cause employers and employees to allocate less spending for the purchase of dental coverage, which is usually viewed as being more discretionary than medical coverage. Premium revenue decreased by 2.1% in 2002 even though average membership was approximately the same in both years. This was primarily due to the Paramount acquisition, as the business acquired from Paramount consists largely of products that have significantly lower premium rates than the Company's pre-existing business. Substantially all of the Company's premium revenue was derived from dental benefit plans in 2002 and 2001. Premium revenue from vision benefit plans and other products was not material in 2002 or 2001. Health care services expense decreased by $0.8 million, or 1.3%, from $58.7 million in 2001 to $57.9 million in 2002. The loss ratio increased slightly from 69.2% in 2001 to 69.8% in 2002. The business acquired from Paramount has a significantly lower loss ratio than the Company's pre-existing business, which is primarily due to the type of benefit plan designs sold by Paramount. The effect of the Paramount acquisition on the loss ratio was offset by increases in specialty referral services, supplemental payments, and discounted fee-for-service payments to dental HMO providers. The increase in the cost of specialty referral services was due to an increase in the utilization rate for those services in 2002. Supplemental payments are additional payments made to dentists who are compensated primarily through capitation payments, in connection with the delivery of certain dental procedures by those dentists. The increases in supplemental and discounted fee-for-service payments were partially due to high-cost arrangements with certain providers, which were started early in 2002, and which were terminated prior to the end of 2002. These arrangements resulted in an unusually large amount of supplemental payments and discounted fee-for-service payments in 2002. There was also a general increase in supplemental payments in 2002, which the Company believes is due to more comprehensive submission of claims information by the dentists in its HMO network. 26 SG&A expense decreased by $0.5 million, or 2.0%, from $25.4 million in 2001 to $24.9 million in 2002. SG&A expense as a percentage of premium revenue was 29.9% in both 2002 and 2001. The decrease in SG&A expense is primarily due to decreases in depreciation expense and furniture rent, and a $350,000 refund of maintenance fees from one of the Company's vendors, which were partially offset by a $250,000 expense in 2002 related to the settlement of stockholder litigation, as described in Note 12 to the accompanying consolidated financial statements, and a $334,000 loss on impairment of notes receivable in 2002. The decrease in depreciation expense is primarily due to the fact that a significant component of the Company's computer software became fully depreciated during 2002. The decrease in furniture rent was due to the purchase of the office furniture used in the Company's primary administrative office through a new capital lease during the second quarter of 2002. The related furniture was formerly leased under an operating lease with relatively expensive terms, compared to the new capital lease. The new capital lease caused an increase in depreciation expense, but this was more than offset by other decreases in depreciation, as noted above. The refund of maintenance fees was primarily due to the settlement of a dispute over the amount of equipment maintenance fees paid by the Company in several prior years. The impairment loss in 2002 is due to an increase in the reserve related to notes receivable, based on the Company's estimate of the net realizable value of the promissory notes. Investment and other income decreased by $0.5 million, from $1.1 million in 2001 to $0.6 million in 2002. This decrease is primarily due to realized gains on the sale of investments in 2001, a decrease in interest rates on short-term fixed-income investments, a decrease in interest income from notes receivable, due to the liquidation of a portion of the Company's notes receivable during 2001, and a decrease in the amount of investments held by the Company, compared to the prior year. The decrease in the Company's investments was primarily due to significant reductions in accrued expenses and claims payable and IBNR during both 2002 and 2001. By intentionally accelerating its payment of claims, the Company intends to enhance its image among dental providers. Interest expense decreased by $0.3 million, from $0.5 million in 2001 to $0.2 million in 2002, primarily due to the conversion of substantially all of the Company's debt into convertible preferred stock effective January 31, 2001, which eliminated nearly all of the Company's interest expense. Income before income taxes decreased by $0.7 million, from $1.3 million in 2001 to $0.6 million in 2002. Income before income taxes as a percentage of premium revenue decreased from 1.5% in 2001 to 0.7% in 2002. This decrease was primarily due to an increase in the loss ratio, which was partially offset by a decrease in SG&A expense as a percentage of premium revenue, both as discussed above. There was an income tax benefit of $820,000 in 2002, which primarily represents a decrease in the Company's accrual for estimated income tax liabilities related to certain transactions that occurred in prior years, as discussed in Note 11 to the accompanying consolidated financial statements. There was no current income tax expense in 2002, due to temporary differences between income before income taxes for accounting purposes and taxable income for tax purposes. Those temporary differences resulted in a loss for tax purposes in 2002. There was also no deferred income tax expense in 2002, due to the valuation allowance against the Company's net deferred tax assets, as discussed in Note 11 to the accompanying consolidated financial statements. LIQUIDITY AND CAPITAL RESOURCES The Company's net working capital increased from $2.0 million as of December 31, 2002 to $13.5 million as of December 31, 2003, primarily due to the Company's earnings during 2003, the acquisition of HN Dental and HN Vision in October 2003, and the issuance of $19.0 million of convertible notes in October 2003. Net income less net deferred income tax benefits, plus depreciation and amortization expense, added approximately $5.0 million of working capital during 2003. HN Dental and HN Vision had an aggregate of $3.0 million of working capital as of the acquisition date, which added $3.0 million to the Company's working capital. In addition, the Company borrowed $19.0 million in connection with the acquisition of HN Dental and HN Vision, and the total cost of the acquisition was $15.2 million, resulting in a $3.8 million addition to working capital. See Note 2 to the accompanying consolidated financial statements for more information on the acquisition of HN Dental and HN Vision, and the $19.0 million of convertible notes. The Company's total debt increased from $5.4 million as of December 31, 2002 to $22.9 million as of December 31, 2003, primarily due to $19.0 million of convertible notes issued in October 2003, in connection with the acquisition 27 of HN Dental and HN Vision, which was partially offset by $2.1 million of principal payments on debt and capital lease obligations during 2003. In October 2003, the Company acquired all of the outstanding capital stock of HN Dental, which is a California dental HMO, and certain PPO/indemnity dental business underwritten by Health Net Life Insurance Company ("HN Life"), which was formerly an affiliate of HN Dental, for $10.7 million in cash, and an agreement to provide private label dental HMO and PPO/indemnity products to be sold in the marketplace by subsidiaries of Health Net, Inc., the former parent company of HN Dental, for a period of at least five years following the transaction, subject to certain conditions. In October 2003, the Company also acquired all of the outstanding capital stock of HN Vision, which is a California vision HMO and an affiliate of HN Dental, and certain PPO/indemnity vision business underwritten by HN Life, for $4.5 million in cash. The combined revenue of the acquired businesses was approximately $61 million during the ten months ended October 31, 2003. The operations of HN Dental, HN Vision, and the related dental and vision PPO/indemnity business are included in the Company's consolidated financial statements beginning on November 1, 2003. The acquisition of HN Dental and HN Vision was financed through the issuance of $19.0 million of unsecured convertible promissory notes to certain of the Company's principal stockholders in October 2003. The proceeds from the convertible notes were used to finance the acquisitions, to satisfy the increase in the Company's regulatory net worth requirements related to the PPO/indemnity dental and vision business that was acquired, to provide working capital that may be required in connection with the integration of the acquired businesses into the Company's pre-existing operations, and for general corporate purposes. The convertible notes bear interest at 6.0% annually, and are convertible into the Company's common stock at the rate of $1.75 per share, at the option of the holder. There are no principal payments due under the convertible notes prior to January 31, 2010, then principal payments are due beginning on January 31, 2010, and each three months thereafter through July 31, 2013, pursuant to a ten-year amortization schedule, and the remaining balance is payable in full on October 31, 2013. The convertible notes are payable in full upon a change in control of the Company, at the holder's option. The Company has the option of redeeming the convertible notes for 229% of face value during the first seven years after the date of issuance, for 257% of face value during the eighth year after issuance, for 286% of face value during the ninth year after issuance, and for 323% of face value during the tenth year after issuance, provided that it redeems all the convertible notes held by each holder for which it redeems any of the notes. In March 2003, the Company acquired all of the outstanding capital stock of Ameritas Managed Dental Plan, Inc. ("Ameritas") for $1.0 million in cash, plus contingent monthly payments during the five years following the acquisition date. Based on the amount of premium revenue during the period from April 1, 2003 to December 31, 2003, from customers of Ameritas that existed as of March 31, 2003, the maximum aggregate amount of the contingent monthly payments would be approximately $1.5 million, if the Company retained all of the existing customers of Ameritas for five years after the acquisition date at the premium rates in effect during 2003. The operations of Ameritas are included in the Company's consolidated financial statements beginning on April 1, 2003. In August 2002, the Company acquired all of the outstanding capital stock of Paramount for approximately $6.7 million, consisting of $3.0 million in cash, a secured convertible note for $2,625,000, and 769,231 shares of the Company's common stock. The secured convertible note bears interest at 7.0% annually, and was originally payable in 36 equal monthly installments of principal and interest, beginning in October 2002. The terms of the note were amended in the fourth quarter of 2003, and the outstanding balance is now payable in monthly installments of interest only until a date to be specified by the holder of the convertible note at least 90 days in advance of such date, which must be no earlier than January 1, 2005, and no later than January 1, 2007. Effective on the date specified by the holder, the convertible note will be payable in 21 equal monthly installments of principal and interest. The outstanding balance under the secured convertible note is convertible into common stock of the Company at a conversion price of $1.625 per share. The convertible note is secured by the stock of the Company's dental HMO subsidiary in Florida. The operations of Paramount are included in the accompanying consolidated financial statements beginning on September 1, 2002. In August 2002, the Company borrowed $2.0 million from one of its principal stockholders, which was used to increase the Company's working capital, to provide for the payments due under certain capital leases entered into in June 2002, and to provide for the payments due under the settlement of the stockholder litigation discussed in Note 28 12 to the accompanying consolidated financial statements. The borrowing was made under an unsecured convertible note that bears interest at 7.0% annually, and was originally payable in equal monthly installments of principal and interest through August 2005. The terms of the note were amended during the second quarter of 2003, and the outstanding balance is now payable in monthly installments of interest only through May 2006, then in monthly installments of principal and interest from June 2006 through August 2008. The outstanding balance under the convertible note is convertible into common stock of the Company at a conversion price of $1.625 per share. Net cash provided by operating activities increased from $1.2 million during 2002 to $6.4 million in 2003, which was primarily due to increases in accrued expenses and claims payable and claims incurred but not reported ("IBNR") in 2003, compared to significant decreases in these liabilities in 2002, and an increase in net income, excluding the non-cash deferred income tax benefit in 2003. The increase in accrued expenses in 2003 was primarily due to an increase in accrued incentive compensation, which was related to the improvement in the Company's operating results in 2003. The decrease in accrued expenses in 2002 was primarily due to payments made to reduce accrued lease obligations related to equipment that was no longer used by the Company, and to reduce certain obligations related to discontinued operations that were disposed of prior to 2001. The increase in claims payable and claims IBNR in 2003 was primarily due to an increase in the number of members covered under PPO/indemnity benefit plan designs, which account for a majority of the total claims payable and claims IBNR liability. The decrease in claims payable and claims IBNR in 2002 was primarily due to intentional decreases in the processing time for payment of provider claims. Due in part to the recent decline in interest rates on investments, the Company adopted the practice of paying all provider claims as rapidly as possible, in order to enhance its image among dental providers. Net cash used by investing activities was $22.9 million in 2003, compared to $0.8 million of net cash provided in 2002. In 2003, there was $10.1 million of net cash used for acquisitions, and an $11.4 million net increase in investments. The increase in investments was due to the fact that the acquired entities had an aggregate of $5.9 million of cash as of the respective closing dates, and the fact that there was $6.4 million of cash provided by operating activities in 2003, as discussed above, all of which was used to purchase investments. Net cash provided by financing activities was $16.7 million in 2003, compared to $0.5 million of net cash used in 2002. The change was due to $19.0 million of borrowings in 2003, compared to $2.0 million of borrowings in 2002. CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS A summary of the Company's future commitments is as follows (in thousands):
PAYMENTS DUE IN ---------------------------------------- LESS THAN 1 TO 3 3 TO 5 MORE THAN ONE YEAR YEARS YEARS FIVE YEARS TOTAL --------- ------- -------- ---------- ------- CONTRACTUAL OBLIGATIONS: Long-term debt $ -- $ 2,659 $ 481 $ 19,000 $22,140 Capital lease obligations 313 364 33 -- 710 Other long-term liabilities -- 903 308 12 1,223 Operating lease commitments, net 2,098 5,778 1,226 -- 9,102 --------- ------- -------- ---------- ------- Total contractual obligations $ 2,411 $ 9,704 2,048 $ 19,012 $33,175 ========= ======= ======== ========== ======= OTHER COMMITMENTS: Contingent liability for dental office leases assigned to other entities $ 1,053 $ 891 14 -- $ 1,958 Contingent liability for subleased office space 183 9 -- -- 192 --------- ------- -------- ---------- ------- Total other commitments $ 1,236 $ 900 $ 14 $ -- $ 2,150 ========= ======= ======== ========== =======
29 If the entities to which the dental office leases have been assigned fail to make a significant amount of the lease payments, this could have a material adverse affect on the Company. See Note 10 to the accompanying consolidated financial statements for more information on other long-term liabilities, and see Note 12 for more information on operating lease commitments and contingent lease obligations. Several of the Company's subsidiaries are subject to state regulations that require them to maintain restricted deposits in the form of cash or investments. The Company had total restricted deposits of $2.9 million and $3.3 million as of December 31, 2003 and 2002, respectively. In addition, several of the Company's subsidiaries are subject to state regulations that require them to maintain minimum amounts of statutory capital and surplus, and that otherwise restrict the Company's access to the assets of its regulated subsidiaries. As a result of these regulatory restrictions, substantially all of the Company's consolidated stockholders' equity as of December 31, 2003, was not available for distribution to the Company's stockholders. The Company's primary source of funds is cash flows from operations and investment income. The Company believes that cash flows from operations and investment income will be adequate to meet the Company's cash requirements for at least the next twelve months, except for financing that may be required to complete potential acquisitions. The Company does not expect any significant changes in its cash requirements in the foreseeable future, except for any financing that may be required in connection with potential acquisitions. The Company believes it has adequate financial resources to continue its current operations for the foreseeable future, and that it will be able to meet its financial obligations from its existing financial resources and future cash flows from its operations. However, there can be no assurance that there will not be unforeseen events that could prevent the Company from doing so. RECENT ACCOUNTING PRONOUNCEMENTS See Note 1 to the accompanying consolidated financial statements for information on recent accounting pronouncements. IMPACT OF INFLATION The Company's operations are potentially impacted by inflation, which can affect premium rates, health care services expense, and selling, general and administrative expense. The Company expects that its earnings will be positively impacted by inflation in premium rates, because premium rates for dental benefit plans in general have been increasing due to inflation in recent years. The Company expects that its earnings will be negatively impacted by inflation in health care costs, because fees charged by dentists and other dental providers have been increasing due to inflation in recent years. The impact of inflation on the Company's health care services expense is mitigated in the short-term by the fact that approximately 32% of total health care services expense consists of capitation (fixed) payments to providers. In addition, most of the Company's selling, general and administrative expenses are impacted by general inflation in the economy. OFF-BALANCE SHEET ARRANGEMENTS The Company is not a party to off-balance sheet arrangements as defined by the Securities and Exchange Commission. However, from time to time the Company enters into certain types of contracts that contingently require the Company to indemnify parties against third party claims. The contracts primarily relate to: (i) certain asset purchase agreements, under which the Company may provide customary indemnification to the seller of the business being acquired; (ii) certain real estate leases, under which the Company may be required to indemnify property owners for environmental and other liabilities, and other claims arising from the Company's use of the applicable premises; and (iii) certain agreements with the Company's officers, directors, and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationship. The terms of such obligations vary by contract and in most instances a specific or maximum dollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot be reasonably estimated until a specific claim is asserted. Consequently, no liabilities have been recorded for these obligations on the Company's consolidated balance sheets for any of the periods presented. 30 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK --------------------------------------------------------------------------- The Company is subject to risk related to changes in short-term interest rates, due to its investments in interest-bearing securities. As of December 31, 2003, the Company's total investments were approximately $27.9 million. Therefore, a one percentage-point change in short-term interest rates would have a $279,000 impact on the Company's annual investment income. The Company is not subject to a material amount of risk related to changes in foreign currency exchange rates. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA --------------------------------------------------------- The Consolidated Financial Statements and the related Notes and Schedule thereto filed as part of this 2003 Annual Report on Form 10-K are listed on the accompanying Index to Financial Statements on page F-1. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT ACCOUNTANTS ON ACCOUNTING -------------------------------------------------------------------------------- AND FINANCIAL DISCLOSURES --------------------------- None. ITEM 9A. CONTROLS AND PROCEDURES ------------------------------------ EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES As of the end of period covered by this report, the Company completed an evaluation, under the supervision and with the participation of the Company's management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in alerting them, on a timely basis, to material information related to the Company required to be included in the Company's periodic filings with the Securities and Exchange Commission. During the period covered by this report, there have been no changes to the Company's internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------------------------------ The current directors and executive officers of the Company are as follows:
NAME AGE POSITION ------------------------ --- --------------------------------------------------------------- James E. Buncher 67 President, Chief Executive Officer and Director Stephen J. Baker 46 Executive Vice President and Chief Operating Officer Ronald I. Brendzel, JD 54 Senior Vice President, General Counsel, Secretary and Director Dennis L. Gates, CPA 48 Senior Vice President, Chief Financial Officer and Director Kenneth E. Keating 40 Vice President, Marketing and Chief Marketing Officer Michael J. Lauffenburger 43 Vice President, Chief Information Officer Steven J. Baileys, DDS 50 Chairman of the Board of Directors Neil R. Anderson 48 Director (1) Stephen J. Blewitt 44 Director (2) Leslie B. Daniels 56 Director (2)
(1) Member, Audit Committee. (2) Member, Compensation and Stock Option Committee, and Audit Committee. 31 All directors of the Company are elected annually. Officers of the Company serve at the pleasure of the board of directors. See Item 11. - Executive Compensation below for a description of severance agreements with certain executive officers. Mr. Buncher has been President and Chief Executive Officer, and a director of the Company, since March 2000. From July 1998 to February 2000, he was a private investor. Mr. Buncher was President and Chief Executive Officer of Community Dental Services, Inc., a corporation operating dental practices in California, from October 1997 until July 1998. Mr. Buncher was President of the Health Plans Group of Value Health, Inc., a national specialty managed care company, from September 1995 to September 1997. He served as Chairman, President and Chief Executive Officer of Community Care Network, Inc., a Value Health subsidiary, from August 1992 to September 1997, when Value Health was acquired by a third party and Mr. Buncher resigned his positions with that company. Mr. Buncher currently serves on the board of directors of Horizon Health Corporation and one other non-public health care company. Mr. Baker has been Executive Vice President and Chief Operating Officer since April 2001, when he joined the Company. Prior to joining the Company, he was a consultant to the senior management of the Company from September 2000 to March 2001. Mr. Baker was Vice President, Chief Operating Officer and Chief Information Officer for Novaeon, Inc., a national health and disability management company, from September 1999 to August 2000. He was an independent management consultant from September 1997 to August 1999. Mr. Baker was Vice President, Developing Businesses for Community Care Network, Inc., a group health and workers' compensation managed care company from January 1997 to August 1997. Mr. Brendzel has been Senior Vice President, General Counsel, Secretary since 1985 and a director of the Company since 1989. He joined the Company in 1978 and was Chief Financial Officer from April 1988 to May 1996. Mr. Brendzel is licensed to practice law in the state of California. Mr. Brendzel is the brother-in-law of Dr. Baileys. Mr. Gates has been Senior Vice President and Chief Financial Officer since November 1999, when he joined the Company, and has been a director of the Company since March 2000. From June 1995 to February 1999, he was Chief Financial Officer, then Treasurer, of Sheridan Healthcare, Inc., a physician practice management company. Mr. Keating has been Vice President, Marketing and Chief Marketing Officer since May 2001, and was Vice President, Sales and Marketing from February 2000 to May 2001. He was Western Regional Vice President of the Company from October 1997 to February 2000. He joined the Company in 1995 and was Vice President-Imprimis and Guards Office Operations for the Company from October 1995 until October 1997. Mr. Lauffenburger has been Chief Information Officer since November 2002. He served as Director, Information Services from January 2001, when he joined the Company, to November 2002. From November 1998 to January 2001, he was IS Manager, Year 2000, then Senior Project Manager, at Scripps Health. Mr. Lauffenburger was Senior Programmer, then Project Manager, then Director, Electronic Data Interchange of Community Care Network, Inc., from April 1991 to November 1998. Dr. Baileys has been Chairman of the Board of Directors since September 1995. He joined the Company in 1975 and served as President of the Company from 1981 to March 1997, and Chief Executive Officer from May 1995 to February 2000. Dr. Baileys is licensed to practice dentistry in the state of California currently practices dentistry full-time. Dr. Baileys is currently a director of SunLink Health Systems, Inc. Mr. Anderson has been President of Calver Fund, a healthcare investment and consulting firm, since 1988. He currently serves on the board of directors of a non-public health care company, and has been a director of several other private health care companies. Mr. Blewitt is a Senior Managing Director in the Bond & Corporate Finance Group of John Hancock Life Insurance Company and has been employed by John Hancock since 1982. Mr. Blewitt is also President of Hancock Mezzanine Advisors LLC, a subsidiary of John Hancock, and the managing member of the general partners of three related investment funds that invest primarily in mezzanine debt securities. Mr. Blewitt is currently a director of NSP Holdings, L.L.C. and Medical Resources, Inc. 32 Mr. Daniels was a founder of CAI Advisors & Co., an investment management firm, in 1989 and has been a principal of that entity and its related investment fund vehicles since then. Mr. Daniels is currently a director of Bioanalytical Systems, Inc. He was a past Chairman of Zenith Laboratories, Inc. and has been a director of several other public and private companies. ITEM 11. EXECUTIVE COMPENSATION ---------------------------------- The following table shows the compensation paid to the Company's Chief Executive Officer as of December 31, 2003, and the other four most highly compensated executive officers as of December 31, 2003 who received total compensation in excess of $100,000 during the year ended December 31, 2003 (the "Named Executive Officers"). The compensation disclosed is for the three years ended December 31, 2003.
LONG-TERM COMPENSATION AWARDS ANNUAL COMPENSATION ------------- ------------------------ OTHER COM- STOCK OPTIONS NAME PRINCIPAL POSITION YEAR SALARY BONUS PENSATION(1) GRANTED ------------------ ------------------------- ------ ------- ------- ------------ ------------- James E. Buncher President and Chief 2003 259,000 382,000 3,500 -- Executive Officer 2002 250,000 25,000 2,750 -- 2001 246,000 -- 928 100,000 Stephen J. Baker Executive Vice President 2003 250,000 176,000 -- 50,000 and Chief Operating 2002 220,000 20,000 -- -- Officer (2) 2001 152,000 -- -- 300,000 Dennis L. Gates Senior Vice President 2003 204,000 122,000 3,000 -- and Chief Financial 2002 204,000 15,000 2,750 20,000 Officer 2001 197,000 -- -- -- Ronald I. Brendzel Senior Vice President, 2003 191,000 106,000 3,500 -- General Counsel and 2002 191,000 15,000 2,738 207,500 Secretary 2001 193,000 -- -- -- Kenneth E. Keating Vice President, 2003 171,000 79,000 2,337 -- Marketing and Chief 2002 186,000 -- 2,319 2,500 Marketing Officer (3) 2001 180,000 -- 938 --
_________________________________ (1) Other compensation consists of matching contributions to the Company's 401(k) plan. (2) Mr. Baker joined the Company as Executive Vice President and Chief Operating Officer in April 2001. (3) Mr. Keating became Vice President, Marketing and Chief Marketing Officer in May 2001. He was Vice President, Sales and Marketing from February 2000 to May 2001. During 2002, the Company entered into a Severance Agreement with each of the Named Executive Officers, which continues until the officer's employment by the Company terminates for any reason. Pursuant to each of these agreements, either the Company or the officer can terminate the officer's employment with the Company at any time. In the event the Company terminates the officer's employment, or implements a substantial diminution of the officer's responsibilities, and as a result, the officer resigns, within one year and as a result of a "change in control" as defined below, the Company is obligated to pay the officer an amount equal to the officer's annual salary then in effect, plus an amount equal to the bonus earned by the officer during the last calendar year. A "change in control" is defined as the acquisition of the Company by another entity, a sale of substantially all of the assets of the Company, a merger of the Company with another entity, the acquisition by any person or group of persons of 50% or more of the combined voting power of the Company's then outstanding securities, or a change of 50% or more of the directors of the Company within a one-year period. During 2003, the Company implemented a Retention Bonus Plan with respect to each of the Named Executive Officers, which continues until the officer's employment by the Company terminates for any reason. The purpose of the Retention Bonus Plan is to provide an incentive for the senior management of the Company to remain employed 33 during a reasonable transition period in the event of the sale of the Company to a third party. In the event that more than 50% of the Company is sold to an entity that is not a current stockholder of the Company, each of the Named Executive Officers would receive a variable retention bonus that is based on the amount of proceeds from the sale transaction. The retention bonus amounts to be paid by the Company are the following amounts for each $1.00 per share of common stock that is realized in a sale transaction: $325,000 to Mr. Buncher, $250,000 to Mr. Baker, $150,000 to Mr. Gates, $150,000 to Mr. Brendzel, and $75,000 to Mr. Keating. Of the total amount of each officer's retention bonus, 25% would be paid at the closing of the transaction, provided the officer is still employed at that time, and 75% would be paid in monthly installments over the nine months following the closing of the transaction, provided the officer is still employed by the purchaser at the time each payment is due. Notwithstanding the previous sentence, the entire retention bonus would be paid in the event the purchaser reduces the officer's compensation rate or terminates the officer's employment. STOCK OPTION GRANTS DURING THE YEAR ENDED DECEMBER 31, 2003 Stock options granted to the Named Executive Officers during the year ended December 31, 2003 were as follows.
INDIVIDUAL STOCK OPTION GRANTS ------------------------------------------------------------------------------ POTENTIAL REALIZABLE VALUE NUMBER OF % OF TOTAL AT ASSUMED ANNUAL RATES SHARES OPTIONS OF STOCK PRICE APPRECIATION UNDERLYING GRANTED TO EXERCISE FOR OPTION TERM(3) OPTIONS EMPLOYEES PRICE PER EXPIRATION ---------------------------------- NAME GRANTED IN 2003 SHARE(1) DATE(2) 5% 10% ------------------ ---------------- -------------- ----------- ----------- ---------------- ---------------- James E. Buncher -- -- $ -- -- $ -- $ -- Stephen J. Baker 50,000 22.7% 1.60 Jul 2013 50,312 127,499 Dennis L. Gates -- -- -- -- -- -- Ronald I. Brendzel -- -- -- -- -- -- Kenneth E. Keating -- -- -- -- -- --
_________________________ (1) The exercise price per share of each of the options is equal to or greater than the market price of the Company's common stock on the date of the grant. Subject to the terms of each option agreement, the exercise price may be paid in cash or in shares of common stock owned by the option holder, or by a combination of the foregoing. (2) Each of the options becomes exercisable in three equal annual installments. The dates on which the options can be exercised may be accelerated in the event of a commencement of a tender offer for shares of the Company, the signing of an agreement for certain mergers or consolidations involving the Company, the sale of all or substantially all of the assets of the Company, a change of control, or certain other extraordinary corporate transactions. The options are subject to early termination in the event the option holder's employment is terminated. (3) There is no assurance that the actual stock appreciation over the term of the options will be at the assumed five percent (5%) or ten percent (10%) levels or at any other assumed level. Unless the market price of the common stock does in fact appreciate over the option term, the Named Executive Officers will realize no value from the option grants. STOCK OPTION EXERCISES AND YEAR-END STOCK OPTION VALUES There were no stock options exercised by any of the Named Executive Officers during the year ended December 31, 2003. Stock options held by the Named Executive Officers at December 31, 2003 are shown in the following table. There were no stock appreciation rights outstanding as of December 31, 2003.
STOCK OPTIONS EXERCISED NUMBER OF SECURITIES VALUE OF UNEXERCISED -------------------------- UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS SHARES OPTIONS AT FISCAL YEAR-END AT FISCAL YEAR-END ACQUIRED VALUE ------------------------------ ---------------------------- NAME ON EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE ------------------ ------------ ------------ --------------- ------------- ------------ -------------- James E. Buncher -- $ -- 666,667 33,333 $ 553,334 $ 21,666 Stephen J. Baker -- -- 200,000 150,000 121,667 73,333 Dennis L. Gates -- -- 381,667 13,333 322,750 8,000 Ronald I. Brendzel -- -- 189,167 138,333 144,834 85,666 Kenneth E. Keating -- -- 120,833 1,667 102,500 1,000
34 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ------------------------------------------------------------------------ AND RELATED STOCKHOLDER MATTERS ------------------------------- The following table shows the number of shares of common stock beneficially owned as of March 31, 2004, by each director, each Named Executive Officer, each entity that, to the Company's knowledge, beneficially owned 5% or more of the total outstanding convertible preferred stock and/or common stock of the Company, and all directors and Named Executive Officers as a group. The number of shares beneficially owned includes the number of shares of common stock into which the convertible preferred stock held by each person is convertible. To the Company's knowledge, the named person has sole voting and investment power with respect to all shares of common stock listed, except where indicated otherwise. The total number of shares of common stock outstanding as of March 31, 2004 was 5,770,590 and the total number of shares of preferred stock outstanding as of that date was 30,000,000, which is convertible into 30,000,000 shares of common stock. The following table includes the common share equivalents of the convertible preferred stock, because the Company believes the convertible preferred stock is essentially equivalent to common stock, based on all the rights and preferences of both types of stock. Each of the officers and directors may be contacted in care of the Company at 95 Enterprise, Suite 100, Aliso Viejo, California 92656-2605
NUMBER OF SHARES % OF TOTAL BENEFICIALLY SHARES OFFICER OR DIRECTOR OWNED(1) OUTSTANDING(2) ----------------------------------------------------------- ----------------- -------------- John Hancock Life Insurance Company (3) 17,857,143 46.2 CAI Capital Partners & Company II, Limited Partnership (4) 14,867,671 35.3 Leslie B. Daniels (5) 84,500 * Jack R. Anderson (6) 3,887,414 10.6 The Burton Partnerships (7) 3,471,542 9.4 Steven J. Baileys (8) 2,911,267 8.1 James E. Buncher (9) 914,667 2.5 Dennis L. Gates (10) 488,333 1.4 Ronald I. Brendzel (11) 422,340 1.2 Stephen J. Baker (12) 304,533 * Kenneth E. Keating (13) 127,667 * Neil R. Anderson 18,000 * Stephen J. Blewitt (3) -- * Other officers (6 persons) (14) 1,993,842 5.4 All directors, Named Executive Officers and other officers as a group (15 persons) 39,905,463 83.0 All principal stockholders in total 47,264,419 94.2
* Indicates less than one percent (1%) (1) Includes the number of shares of common stock into which the convertible preferred stock held by each person is convertible. Also includes shares issuable pursuant to stock options and convertible notes that are exercisable within 60 days of March 31, 2004. Some of the stockholders included in this table reside in states having community property laws under which the spouse of a stockholder in whose name securities are registered may be entitled to share in the management of their community property, which may include the right to vote or dispose of such shares. (2) For purposes of computing all the percentages shown, the total shares outstanding includes the shares of common stock into which all outstanding shares of convertible preferred stock are convertible. For purposes of computing the percentage for each individual, the total shares outstanding includes the shares issuable to that person pursuant to stock options and convertible notes that are exercisable within 60 days of March 31, 2004. For purposes of computing the percentages for all other officers as a group, and all directors and officers as a group, the total shares outstanding includes the shares issuable to the persons in each respective group pursuant to stock options and convertible notes that are exercisable within 60 days of March 31, 2004. For purposes of computing the percentages for all principal stockholders as a group, the total shares outstanding includes all the shares issuable pursuant to stock options and convertible notes that are included in the above table. (3) Mr. Blewitt is employed by John Hancock Life Insurance Company, which has beneficial ownership of 15,000,000 shares issuable upon conversion of shares of convertible preferred stock and 2,857,143 shares issuable upon conversion of convertible notes, all as to which Mr. Blewitt disclaims beneficial ownership. The address of Mr. Blewitt and John Hancock Life Insurance Company is John Hancock Place, P.O. Box 111, Boston, Massachusetts 02117. 35 (4) Includes 84,500 shares of common stock owned directly by Mr. Daniels, 2,780,786 shares issuable upon conversion of shares of convertible preferred stock and 2,260,198 shares issuable upon conversion of convertible notes owned by CAI Partners & Company II, Limited Partnership, and 5,649,293 shares issuable upon conversion of shares of convertible preferred stock and 4,092,894 shares issuable upon conversion of convertible notes owned by CAI Capital Partners & Company II, Limited Partnership (collectively "CAI"). Mr. Daniels is a principal of both entities. The address of CAI and Mr. Daniels is 540 Madison Avenue, 22nd Floor, New York, New York 10022. (5) Represents 84,500 shares of common stock owned directly by Mr. Daniels. Does not include 2,780,786 shares issuable upon conversion of shares of convertible preferred stock and 2,260,198 shares issuable upon conversion of convertible notes owned by CAI Partners & Company II, Limited Partnership, and 5,649,293 shares issuable upon conversion of shares of convertible preferred stock and 4,092,894 shares issuable upon conversion of convertible notes owned by CAI Capital Partners & Company II, Limited Partnership (collectively "CAI"). Mr. Daniels is a principal of both entities. The address of Mr. Daniels is 540 Madison Avenue, 22nd Floor, New York, New York 10022. (6) Includes 1,532,885 shares issuable upon conversion of shares of convertible preferred stock, 226,000 shares of common stock, and 946,799 shares issuable upon conversion of convertible notes, all owned by Mr. Anderson. Also includes 1,081,730 shares issuable upon conversion of shares of convertible preferred stock and 100,000 shares of common stock owned by Mr. Anderson's spouse as separate property, as to which Mr. Anderson disclaims beneficial ownership. The address of Mr. Anderson is 16475 Dallas Parkway, Suite 735, Addison, Texas 77001. (7) Includes 162,700 shares of common stock, 419,470 shares issuable upon conversion of shares of convertible preferred stock, and 285,714 shares issuable upon conversion of convertible notes, all owned by the Burton Partnership, Limited Partnership ("BPLP"), and 488,100 shares of common stock, 1,258,415 shares issuable upon conversion of shares of convertible preferred stock, and 857,143 shares issuable upon conversion of convertible notes, all owned by the Burton Partnership (QP), Limited Partnership ("QP"). Mr. Donald W. Burton is a principal of both entities. The address of BPLP, QP and Mr. Burton is P.O. Box 4643, Jackson, Wyoming 83001. (8) Includes 645,000 shares of common stock held by Dr. Baileys directly, 912,500 shares issuable upon conversion of shares of convertible preferred stock held by the Baileys Family Trust and affiliated trusts for the benefit of various relatives of Dr. Baileys, 700,767 shares of common stock owned by the Baileys Family Trust, 303,000 shares of common stock held in various trusts for relatives of Dr. Baileys, as to all of which Dr. Baileys is trustee and for which Dr. Baileys has sole power to vote the securities, 150,000 shares of common stock held by the Alvin and Geraldine Baileys Foundation, for which Dr. Baileys is an officer and director and for which Dr. Baileys has shared power to vote the securities, and options to purchase 200,000 shares of common stock. Dr. Baileys disclaims beneficial ownership of any of the shares in the trusts or the foundation referenced above. (9) Includes 48,000 shares of common stock, 200,000 shares issuable upon conversion of shares of convertible preferred stock, and options to purchase 666,667 shares of common stock. (10) Includes 100,000 shares issuable upon conversion of shares of convertible preferred stock, and options to purchase 388,333 shares of common stock. (11) Includes 130,673 shares of common stock, 100,000 shares issuable upon conversion of shares of convertible preferred stock, and options to purchase 191,667 shares of common stock. (12) Includes 21,200 shares of common stock and options to purchase 283,333 shares of common stock. (13) Includes 6,000 shares of common stock and options to purchase 121,667 shares of common stock. (14) Includes 724,557 shares of common stock, 985,618 shares issuable upon conversion of a convertible note, and options to purchase 283,667 shares of common stock. 36 The following is a summary of the Company's equity compensation plans as of December 31, 2003:
SHARES OF WEIGHTED NUMBER STOCK TO BE AVERAGE OF SHARES ISSUED UPON EXERCISE AVAILABLE EXERCISE OF PRICE OF FOR ISSUANCE OUTSTANDING OUTSTANDING UNDER STOCK STOCK OPTIONS STOCK OPTIONS OPTION PLAN ------------- -------------- ------------ Equity compensation plans approved by stockholders 2,940,334 $ 1.17 1,059,666 Equity compensation plans not approved by stockholders -- -- -- ------------- -------------- ------------ Total 2,940,334 $ 1.17 1,059,666 ============= ============== ============
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ------------------------------------------------------------- CERTAIN AGREEMENTS As of January 31, 2001, in connection with the completion of a recapitalization transaction, the Company and certain stockholders, including CAI Partners and Company II, L.P., CAI Capital Partners and Company II, L.P., Jack R. Anderson, John Hancock Life Insurance Company and the Baileys Family Trust (collectively, the "Investors"), entered into an Agreement Among Stockholders which, among other things, provides that the Investors will vote their shares of capital stock of the Company to maintain the size of the board of directors of the Company at seven (7) members and also contains provisions requiring the Investors to sell their shares of capital stock in the Company under certain conditions applicable to an acquisition of all outstanding shares of capital stock of the Company by a third party. In addition, as of January 31, 2001, the Company entered into a Registration Rights Agreement with the Investors, under which it granted certain registration rights to the Investors with respect to all shares of common stock owned by the Investors and into which the convertible preferred stock owned by the Investors is convertible. See Note 9 to the accompanying consolidated financial statements for more information on the recapitalization transaction. CONSULTING SERVICES The Company paid $10,000, $153,000 and $200,000 of consulting fees to the chairman of its board of directors during the years ended December 31, 2003, 2002 and 2001, respectively. This consulting arrangement terminated effective January 31, 2003. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES ------------------------------------------------ The Company's principal accountant is Deloitte & Touche LLP ("Deloitte"). The aggregate fees billed by Deloitte, the member firms of Deloitte Touche Tohmatsu, and their respective affiliates, for professional services rendered for the years ended December 31, 2003 and 2002 are as shown below.
2003 2002 -------- -------- Audit fees $309,500 $232,000 Audit related fees, which consist of fees for the audit of the Company's 401(k) plan 15,000 14,600 Tax services 22,500 20,000 -------- -------- Total fees $347,000 $266,600 ======== ========
The Audit Committee must approve in advance any significant audit or non-audit engagement or relationship between the Company and its independent public accountants. As a result, the Audit Committee pre-approved the provision of audit related services and tax services provided by Deloitte as described above. The 37 Audit Committee has determined that the provision of certain non-audit services by Deloitte is compatible with maintaining Deloitte's independence. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K -------------------------------------------------------------------------- (a) FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, AND EXHIBITS The consolidated financial statements and financial statement schedule of SafeGuard Health Enterprises, Inc. filed as part of this 2003 Annual Report on Form 10-K are listed in the accompanying Index to Financial Statements on Page F-1. An "Exhibit Index" is included in this 2003 Annual Report on Form 10-K beginning on Page E-1. All Exhibits are either attached hereto or are on file with the Securities and Exchange Commission. (b) REPORTS ON FORM 8-K The Company filed a Current Report on Form 8-K/A on January 13, 2004, which amended the Current Report on Form 8-K filed on November 7, 2003, which reported the completion of the acquisition of HN Dental, HN Vision and the related dental and vision PPO/indemnity business effective October 31, 2003. The report on Form 8-K/A included the financial information required under Item 7 of Form 8-K. 38 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. SAFEGUARD HEALTH ENTERPRISES, INC. By: /s/ James E. Buncher Date: April 12, 2004 ----------------------- -------------------- James E. Buncher President, Chief Executive Officer and Director (Principal Executive Officer) By: /s/ Dennis L. Gates Date: April 12, 2004 ----------------------- -------------------- Dennis L. Gates Senior Vice President, Chief Financial Officer and Director (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, the following persons have signed this report below on behalf of the registrant and in the capacities and on the dates indicated. By: /s/ James E. Buncher Date: April 12, 2004 ----------------------- -------------------- James E. Buncher President, Chief Executive Officer and Director By: /s/ Steven J. Baileys Date: April 12, 2004 ------------------------ -------------------- Steven J. Baileys Chairman of the Board of Directors By: /s/ Ronald I. Brendzel Date: April 12, 2004 ------------------------- -------------------- Ronald I. Brendzel Senior Vice President, General Counsel, Secretary and Director By: /s/ Dennis L. Gates Date: April 12, 2004 ---------------------- -------------------- Dennis L. Gates Senior Vice President, Chief Financial Officer and Director By: /s/ Neil R. Anderson Date: April 12, 2004 ----------------------- -------------------- Neil R. Anderson Director By: /s/ Stephen J. Blewitt Date: April 12, 2004 ------------------------- -------------------- Stephen J. Blewitt Director By: /s/ Leslie B. Daniels Date: April 12, 2004 ------------------------ -------------------- Leslie B. Daniels Director 39
EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION ------- ---------------------------------------------------------------------------------------------------- 2.1 Plans of Acquisition (5) 3.1 Articles of Incorporation (3) 3.1.1 Amended and Restated Certificate of Incorporation (11) 3.1.2 Amended and Restated Certificate of Incorporation (15) 3.1.3 Amended and Restated Certificate of Incorporation (17) 3.1.4 Certificate of Designation of Preferred Stock (11) 3.1.5 2002 Certificate of Designation of Preferred Stock 3.1.6 Amendment to Restated Certificate of Incorporation (22) 3.2 Amended and Restated Bylaws (19) 10.1 1984 Stock Option Plan (2) 10.2 Stock Option Plan Amendment (1) 10.3 Stock Option Plan Amendment (3) 10.4 Stock Option Plan Amendment (4) 10.5 2000 Stock Option Plan Amendment (12) 10.5.1 Amended and Restated Stock Option Plan (17) 10.5.2 2003 Stock Option Plan Amendment (22) 10.6 Form of Employment Agreement between the Company and the Named Executive Officers (12) 10.7 Form of Rights Agreement, dated as of March 22, 1996, between the Company and American StockTransfer and Trust Company, as Rights Agent (5) 10.8 Default Forbearance Agreement and Irrevocable Power of Attorney (6) 10.9 First Waiver and Amendment to Note Purchase Agreement (7) 10.10 Amended and Restated Loan and Security Agreement (7) 10.11 Debenture and Note Purchase Agreement (8) 10.12 Stockholder Agreement (8) 10.13 First Amendment to Debenture and Note Purchase Agreement (9) 10.14 Second Amendment to Debenture and Note Purchase Agreement (9) 10.15 Term Sheet Agreement dated as of March 1, 2000 (10) 10.16 Loan Document and Purchase Agreement (11) 10.17 Agreement among Stockholders and the Company (11) 10.18 Registration Rights Agreement between certain Stockholders and the Company (11) 10.19 Consulting Agreement between the Company and Steven J. Baileys (12) 10.20 Asset Purchase Agreement between the Company and Total Dental Administrators Health Plan, Inc. (13) 10.21 Administrative Services Agreement between the Company and Total Dental Administrators Health Plan, Inc. (13) 10.22 Stock Purchase Agreement between the Company and Total Dental Administrators, Inc. (13) 10.23 Promissory Note and Security Interest given by Total Dental Administrators, Inc. to the Company (13) 10.24 Administrative Services Agreement between the Company and Total Dental Administrators, Inc. (13) 10.25 Stock Purchase Agreement between the Company and Dental Source of Missouri and Kansas, Inc. (13) 10.26 First Amendment to Stock Purchase Agreement between the Company and Dental Source of Missouri and Kansas, Inc. (13) 10.27 Administrative Services Agreement between the Company and Dental Source of Missouri and Kansas, Inc. (13) 10.28 Amended and Restated 401(k) Plan (13) 10.29 First Amendment to Amended and Restated 401(k) Plan (13) 10.30 Stock Purchase Agreement dated as of April 24, 2002 by and between the Company and Nicholas M. Kavouklis (14) 10.31 First Amendment to Stock Purchase Agreement dated as of June 17, 2002 between the Company and Nicholas M. Kavouklis (16) 10.32 Secured Convertible Promissory Note dated as of August 30, 2002 issued by the Company to Nicholas M. Kavouklis in connection with Exhibit 10.31 above (16) E-1 10.33 Registration Rights Agreement dated as of August 30, 2002 between the Company and Nicholas M. Kavouklis in connection with Exhibit 10.31 above (16) 10.34 Employment Agreement dated as of August 30, 2002 between the Company and Nicholas M. Kavouklis (16) 10.35 Lease Agreement dated as of August 30, 2002 between the Company and an affiliate of Nicholas M. Kavouklis (16) 10.36 Pledge Agreement dated as of August 30, 2002 between the Company and Nicholas M. Kavouklis in connection with Exhibit 10.31 above (16) 10.37 Guarantee Agreement dated as of August 30, 2002 between the Company and an affiliate of Nicholas M. Kavouklis in connection with Exhibit 10.35 above (16) 10.38 Stipulation and Settlement dated as of September 17, 2002 of stockholder class action lawsuit filed against the Company in 1999 (17) 10.39 Order Preliminarily Approving Settlement, providing for notice to the class, and scheduling final approval of settlement dated as of September 19, 2002 (17) 10.40 Convertible Promissory Note dated as of August 8, 2002 issued by the Company to Jack R. Anderson (18) 10.41 Registration Rights Agreement dated as of August 8, 2002 between the Company and Jack R. Anderson (18) 10.42 Stock Purchase Agreement dated as of January 15, 2003 between a subsidiary of the Company and Ameritas Life Insurance Company for the purchase of Ameritas Managed Dental Plan, Inc. (20) 10.43 Purchase and Sale Agreement dated as of April 7, 2003 between the Company and Health Net, Inc. relating to the sale of Health Net Dental, Inc. (21) 10.44 Network Access Agreement dated as of April 7, 2003 between the Company and Health Net, Inc. (21) 10.45 Assumption and Indemnity Reinsurance Agreement dated as of April 7, 2003 between the Company and a subsidiary of Health Net, Inc. (21) 10.46 Strategic Relationship Agreement dated as of April 7, 2003 between the Company and Health Net, Inc. (21) 10.47 Amendment to Promissory Note dated as of May 6, 2003 between the Company and Jack R. Anderson (22) 10.48 Purchase and Sale Agreement dated as of June 30, 2003, between the Company and Health Net, Inc. relating to the sale of Health Net Vision, Inc. (23) 10.49 Assumption and Indemnity Reinsurance Agreement dated as of June 30, 2003 between the Company and a subsidiary of Health Net, Inc. (23) 10.50 Network Access Agreement dated as of June 30, 2003 between the Company and Health Net, Inc. (23) 10.51 Administrative Services Agreement dated as of June 30, 2003 between the Company and Health Net, Inc. (23) 10.54 Amendment to Purchase and Sale Agreement dated as of October 31, 2003 between the Company and Health Net, Inc. relating to the sale of Health Net Dental, Inc. (24) 10.55 Amendment to Assumption and Indemnity Reinsurance Agreement dated as of October 31, 2003 between the Company and Health Net, Inc. relating to the sale of Health Net Dental, Inc. (24) 10.56 Amendment to Purchase and Sale Agreement dated as of October 31, 2003 between the Company and Health Net, Inc. relating to the sale of Health Net Vision, Inc. (24) 10.57 Amendment to Assumption and Indemnity Reinsurance Agreement dated as of October 31, 2003 between the Company and Health Net, Inc. relating to the sale of Health Net Vision, Inc. (24) 10.58 Form of 6% Promissory Note used by the Company in connection with the financing of the acquisition of Health Net Dental, Inc., and Health Net Vision, Inc. (24) 10.59 Amended Credit Agreement and Termination of Registration Rights Agreement dated as of December 3, 2003 between the Company and Nicholas M. Kavouklis 10.60 Amended and Restated Promissory Note dated as of December 3, 2003 between the Company and Nicholas M. Kavouklis 21.1 Subsidiaries of the Company 23.1 Independent Auditors' Consent 31.1 Certification of Chief Executive Officer 31.2 Certification of Chief Financial Officer 32 Certification Pursuant to 18 U.S.C. Section 1350
_________________________________________ (1) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Registration Statement on Form S- 1 filed as of September 12, 1983 (File No. 2-86472). (2) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Registration Statement on Form S-1 filed as of July 3, 1984 (File No. 2-92013). E-2 (3) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Annual Report of Form 10-K for the year ended December 31, 1989. (4) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Annual Report of Form 10-K for the year ended December 31, 1992. (5) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of September 27, 1996. (6) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. (7) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of June 4, 1999. (8) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of June 30, 1999. (9) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of October 5, 1999. (10) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of March 16, 2000. (11) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of March 6, 2001. (12) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 2000. (13) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 2001. (14) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of April 24, 2002. (15) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Registration Statement on Form S-8 filed as of August 30, 2002 (File No. 33-2226). (16) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of August 30, 2002. (17) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of September 19, 2002. (18) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. (19) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 2002. (20) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of February 14, 2003. (21) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of April 25, 2003. (22) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2003. (23) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of June 30, 2003. (24) Incorporated by reference herein and disclosed and filed as an exhibit to the Company's Current Report on Form 8-K dated as of November 1, 2003. E-3
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 2003 PAGE ----------- Independent Auditors' Report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . F-2 Financial Statements: Consolidated Balance Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . F-3 Consolidated Statements of Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . F-4 Consolidated Statements of Stockholders' Equity (Deficit) and Other Comprehensive Income F-5 Consolidated Statements of Cash Flows. . . . . . . . . . . . . . . . . . . . . . . . . . F-6 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . F-8 to F-33 Financial Statement Schedule: Schedule II - Valuation and Qualifying Accounts. . . . . . . . . . . . . . . . . . . . . F-34
F-1 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of SafeGuard Health Enterprises, Inc.: We have audited the accompanying consolidated balance sheets of SafeGuard Health Enterprises, Inc. and subsidiaries (the "Company") as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders' equity (deficit) and other comprehensive income, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the consolidated financial statement schedule for the years ended December 31, 2003, 2002 and 2001, included in the Index at Item 15(a)(2). These consolidated financial statements and consolidated financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the consolidated financial statements and consolidated financial statement schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of SafeGuard Health Enterprises, Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets as a result of adopting Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002. DELOITTE & TOUCHE LLP Costa Mesa, California March 26, 2004 F-2
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2003 AND 2002 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) 2003 2002 --------- --------- ASSETS Current assets: Cash and cash equivalents $ 3,201 $ 3,036 Investments available-for-sale, at fair value 24,998 9,668 Accounts receivable, net of allowances of $544 in 2003 and $325 in 2002 5,486 2,554 Deferred tax assets, net of valuation allowance of $212 in 2003 1,871 -- Other current assets 1,548 853 --------- --------- Total current assets 37,104 16,111 Property and equipment, net of accumulated depreciation and amortization 4,823 3,532 Restricted investments available-for-sale, at fair value 2,932 3,254 Goodwill 12,365 8,590 Intangible assets, net of accumulated amortization 9,862 2,013 Deferred tax assets, net of valuation allowance of $388 in 2003 3,432 -- Other assets 720 614 --------- --------- Total assets $ 71,238 $ 34,114 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,716 $ 1,661 Accrued expenses 7,919 3,526 Current portion of long-term debt and capital lease obligations 313 2,430 Claims payable and claims incurred but not reported 10,109 4,690 Deferred premium revenue 3,531 1,786 --------- --------- Total current liabilities 23,588 14,093 Long-term debt and capital lease obligations 22,537 2,997 Other long-term liabilities 1,223 1,013 Commitments and contingencies (Note 12) Stockholders' equity: Convertible preferred stock and additional paid-in capital - $0.01 par value; 31,000,000 shares authorized; 30,000,000 shares issued and outstanding in 2003 and 2002; liquidation preference of $30 million 41,250 41,250 Common stock and additional paid-in capital - $0.01 par value; 54,000,000 shares authorized; 8,970,000 shares and 8,900,000 shares issued in 2003 and 2002, respectively; 5,753,000 shares and 5,683,000 shares outstanding in 2003 and 2002, respectively 22,766 22,662 Retained earnings (accumulated deficit) (22,357) (30,170) Accumulated other comprehensive income 57 95 Treasury stock - at cost; 3,217,000 shares in 2003 and 2002 (17,826) (17,826) --------- --------- Total stockholders' equity 23,890 16,011 --------- --------- Total liabilities and stockholders' equity $ 71,238 $ 34,114 ========= ========= See accompanying Notes to Consolidated Financial Statements.
F-3
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001 (IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2002 2001 --------- -------- -------- Premium revenue, net $104,891 $83,043 $84,822 Health care services expense 73,194 57,937 58,692 Selling, general and administrative expense 28,684 24,874 25,391 --------- -------- -------- Operating income 3,013 232 739 Investment and other income 490 607 1,060 Interest expense on debt that was converted to equity in 2001 -- -- (402) Other interest expense (530) (232) (102) --------- -------- -------- Income before income taxes and extraordinary item 2,973 607 1,295 Income tax benefit (4,840) (820) -- --------- -------- -------- Income before extraordinary item 7,813 1,427 1,295 Extraordinary item: Gain on conversion of debt to convertible preferred stock -- -- 11,251 --------- -------- -------- Net income $ 7,813 $ 1,427 $12,546 ========= ======== ======== Basic net income per share: Income before extraordinary item $ 0.22 $ 0.04 $ 0.04 Extraordinary item -- -- 0.35 --------- -------- -------- Net income $ 0.22 $ 0.04 $ 0.39 ========= ======== ======== Weighted average basic shares outstanding 35,719 35,130 32,253 Diluted net income per share: Income before extraordinary item $ 0.20 $ 0.04 $ 0.04 Extraordinary item -- -- 0.34 --------- -------- -------- Net income $ 0.20 $ 0.04 $ 0.38 ========= ======== ======== Weighted average diluted shares outstanding 40,244 35,638 33,009 See accompanying Notes to Consolidated Financial Statements.
F-4
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) AND OTHER COMPREHENSIVE INCOME YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001 (IN THOUSANDS) ACCUMU- NUMBER OF SHARES PREFERRED COMMON RETAINED LATED ----------------------------- STOCK AND STOCK AND EARNINGS OTHER COMMON ADDITIONAL ADDITIONAL (ACCUMU- COMPRE- ------------------ PAID-IN PAID-IN LATED HENSIVE TREASURY PREFERRED ISSUED TREASURY CAPITAL CAPITAL DEFICIT) INCOME STOCK TOTAL --------- ------- --------- ----------- ------------ ---------- --------- ---------- --------- Balance, January 1, 2001 -- 8,022 (3,275) 21,829 (44,254) 119 (18,123) (40,429) Net income -- -- -- -- -- 12,546 -- -- 12,546 Other comprehensive income: Net unrealized losses on investments available- (56) (56) for-sale --------- Total comprehensive income 12,490 Issuance of preferred 30,000 -- -- 41,250 -- -- -- -- 41,250 stock Cancellation of stock -- -- -- -- (320) 320 -- -- -- warrants (1) Repurchase of common stock -- -- (10) -- -- -- -- (10) (10) Reissuance of treasury stock in contribution to -- -- 18 -- -- (59) -- 81 22 retirement plan Exercise of stock options -- 43 -- -- 43 -- -- -- 43 --------- ------- --------- ----------- ------------ ---------- --------- ---------- --------- Balance, December 31, 2001 30,000 8,065 (3,267) 41,250 21,552 (31,447) 63 (18,052) 13,366 Net income -- -- -- -- -- 1,427 -- -- 1,427 Other comprehensive income: Net unrealized gains on investments available- 32 32 for-sale --------- Total comprehensive income 1,459 Issuance of common stock -- 786 -- -- 1,061 -- -- -- 1,061 Reissuance of treasury stock in contribution to -- -- 50 -- -- (150) -- 226 76 retirement plan Exercise of stock options -- 49 -- -- 49 -- -- -- 49 --------- ------- --------- ----------- ------------ ---------- --------- ---------- --------- Balance, December 31, 2002 30,000 8,900 (3,217) 41,250 22,662 (30,170) 95 (17,826) 16,011 Net income -- -- -- -- -- 7,813 -- -- 7,813 Other comprehensive income: Net unrealized losses on investments available- (38) (38) for-sale --------- Total comprehensive income 7,775 Issuance of common stock -- 70 -- -- 104 -- -- -- 104 --------- ------- --------- ----------- ------------ ---------- --------- ---------- --------- Balance, December 31, 2003 30,000 8,970 (3,217) $ 41,250 $ 22,766 $ (22,357) $ 57 $ (17,826) $ 23,890 ========= ======= ========= =========== ============ ========== ========= ========== ========= (1) These warrants were canceled without being exercised as of January 31, 2001, in connection with the conversion of the Senior Notes Payable to convertible preferred stock, as discussed in Note 9. See accompanying Notes to Consolidated Financial Statements.
F-5
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001 (IN THOUSANDS) 2003 2002 2001 --------- -------- --------- Cash flows from operating activities: Net income $ 7,813 $ 1,427 $ 12,546 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Gain on conversion of debt to convertible preferred stock -- -- (11,251) Deferred income tax benefit (4,887) -- -- Loss on impairment of assets -- 334 -- Bad debt expense 476 220 245 Depreciation and amortization 2,110 1,474 1,862 Gain or loss on sale or disposal of assets (19) (16) (276) Contribution to retirement plan in the form of common stock, at fair value 118 87 51 Changes in operating assets and liabilities, net of effects of acquisitions: Accounts receivable (479) 103 (306) Other current assets 203 241 685 Other assets (196) 69 58 Accounts payable (61) (653) (144) Accrued expenses 1,126 (1,271) (2,063) Claims payable and claims incurred but not reported 632 (1,440) (1,649) Deferred premium revenue (421) 607 (469) --------- -------- --------- Net cash provided by (used in) operating activities 6,415 1,182 (711) Cash flows from investing activities: Purchases of investments available-for-sale (24,610) (3,448) (15,599) Proceeds from sale/maturity of investments available-for-sale 13,177 7,334 16,878 Cash paid for acquisitions of businesses, net of cash acquired (10,028) (2,708) -- Purchases of property and equipment (1,436) (444) (1,109) Additions to intangible assets (125) -- -- Payments received on notes receivable 114 14 1,320 Proceeds from sale of subsidiary -- 77 -- --------- -------- --------- Net cash (used in) provided by investing activities (22,908) 825 1,490 Cash flows from financing activities: Borrowings on long-term debt 19,000 2,000 -- Increase in accrued interest that was converted to equity in 2001 -- -- 321 Payments on debt and capital lease obligations (2,089) (1,663) (235) Decrease in bank overdrafts (463) (896) (674) Repurchase of common stock -- -- (10) Exercise of stock options -- 49 43 Increase (decrease) in other long-term liabilities 210 42 (108) --------- -------- --------- Net cash provided by (used in) financing activities 16,658 (468) (663) --------- -------- --------- Net increase in cash and cash equivalents 165 1,539 116 Cash and cash equivalents at beginning of year 3,036 1,497 1,381 --------- -------- --------- Cash and cash equivalents at end of year $ 3,201 $ 3,036 $ 1,497 ========= ======== ========= (Continued on next page)
F-6
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001 (IN THOUSANDS) 2003 2002 2001 --------- -------- ------- Supplementary information: Cash paid during the year for interest $ 342 $ 207 $ 315 Cash paid during the year for income taxes 125 18 -- Supplementary disclosure of non-cash activities: Debt converted into convertible preferred stock $ -- $ -- $41,250 Purchases of property and equipment through capital leases 447 1,836 -- Liabilities assumed in acquisitions of businesses: Fair value of assets acquired, excluding cash $ 16,700 $ 2,670 $ -- Goodwill related to transactions 4,191 4,670 -- Less - Secured convertible note issued to seller -- (2,625) -- Less - Common stock issued in transaction -- (1,040) -- Less - Cash paid in transactions, net of cash acquired (10,028) (2,708) -- --------- -------- ------- Liabilities assumed in acquisitions of businesses $ 10,863 $ 967 $ -- ========= ======== ======= See accompanying Notes to Consolidated Financial Statements.
F-7 SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1.ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES ------------------------------------------------------------ SafeGuard Health Enterprises, Inc., a Delaware corporation (the "Company"), provides a wide range of dental benefit plans, vision benefit plans, and other related products. The Company's operations are primarily in California, Florida and Texas, but it also operates in several other states. The Company conducts its operations through several subsidiaries, one of which is an insurance company that is licensed in several states, and several of which are licensed as dental or vision health maintenance organization ("HMO") plans in the states in which they operate. The Company provides dental benefits, vision benefits or other related products to approximately 1.5 million individuals. The Company has been providing dental benefit plans in California since the Company was organized in 1974. Over 90% of the Company's total premium revenue is derived from providing dental benefit plans. Under the dental HMO plan designs provided by the Company, a majority of the total health care services expense consists of capitation payments to dental service providers, which are fixed monthly payments for each covered individual. These capitation arrangements limit the amount of risk assumed by the Company. Under the dental preferred provider organization ("PPO")/indemnity plan designs provided by the Company, all health care services expense consists of claims that are paid each time a covered individual receives dental services. Under this type of plan design, the Company assumes all of the utilization risk. Capitation payments comprised 32%, 33% and 37% of the Company's total health care services expense during the years ended December 31, 2003, 2002 and 2001, respectively. BASIS OF PRESENTATION The consolidated financial statements include all the accounts of the Company and its subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation. The Company's consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America. BUSINESS SEGMENT INFORMATION Management views certain geographic areas as separate operating segments, and therefore, measures the Company's operating results separately for each of those geographic areas. The Company provides essentially the same services in all of the geographic areas in which it operates. For financial reporting purposes, all the Company's operating segments are aggregated into one reporting segment, which provides dental benefit plans and other related products to employers, individuals and other purchasers. CASH AND CASH EQUIVALENTS Investments with an original maturity of three months or less are included in cash equivalents. RESTRICTED DEPOSITS AND MINIMUM NET WORTH REQUIREMENTS Several of the Company's subsidiaries are subject to state regulations that require them to maintain restricted deposits in the form of cash or investments. The Company had total restricted deposits of $2.9 million and $3.3 million as of December 31, 2003 and 2002, respectively. In addition, several of the Company's subsidiaries are subject to state regulations that require them to maintain minimum amounts of statutory capital and surplus, and that otherwise restrict the Company's access to the assets of its regulated subsidiaries. As a result of these regulatory restrictions, substantially all of the Company's consolidated stockholders' equity as of December 31, 2003, was not available for distribution to the Company's stockholders. INVESTMENTS In accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," the Company has classified its investments as "available-for-sale." F-8 Investments classified as available-for-sale are carried at fair value, based on quoted market prices, and unrealized gains and losses, net of applicable income taxes, are reported in stockholders' equity under the caption "Accumulated other comprehensive income." In the event there was an unrealized loss on an investment that the Company believed to be other than temporary, the loss would be reported in the statement of income, instead of in a separate caption of stockholders' equity. As of December 31, 2003, there were no unrealized losses that the Company believed to be other than temporary. FAIR VALUE OF FINANCIAL INSTRUMENTS The accompanying consolidated balance sheets include the following financial instruments as of December 31, 2003: cash and cash equivalents, investments, accounts receivable, accounts payable, accrued expenses, short-term and long-term debt, and other long-term liabilities. All of these financial instruments, except for long-term debt and other long-term liabilities, are current assets or current liabilities. The Company expects to realize the current assets, and to pay the current liabilities, within a short period of time. Therefore, the carrying amount of these financial instruments approximates fair value. Long-term debt and other long-term liabilities are stated at the estimated amount of the future payments, which approximates fair value. PROPERTY AND EQUIPMENT Property and equipment is recorded at cost. Depreciation and amortization are calculated using the straight-line method over the estimated useful lives of the assets. Depreciation of leasehold improvements is calculated based on the shorter of the estimated useful lives of the assets, or the length of the related lease. The Company uses the following useful lives to record depreciation expense: leasehold improvements - 4 to 10 years; computer hardware and software - 3 to 4 years; and furniture, fixtures and other office equipment - 4 to 7 years. The cost of maintenance and repairs is expensed as incurred, while significant improvements that add functionality to an asset or extend the estimated useful life of an asset are capitalized. Upon the sale or other retirement of assets, the cost of any such assets and the related accumulated depreciation are removed from the books and any resulting gain or loss is recognized. GOODWILL Goodwill as of December 31, 2003 is related to the following acquisitions:
Health Net Dental, Inc. ("HN Dental") and Health Net Vision, Inc. ("HN Vision") - October 2003 $ 3,181 Paramount Dental Plan, Inc. ("Paramount") - August 2002 5,264 First American Dental Benefits, Inc. ("First American") - October 1996 3,920 ------- Total $12,365 =======
See Note 2 for more information on the HN Dental, HN Vision, and Paramount acquisitions. In the case of each acquisition, goodwill represents the excess of the purchase price of the acquired company over the fair value of the net assets acquired, and in the case of the First American acquisition, the balance is net of accumulated amortization and an adjustment in 1999 to reduce the carrying value of the goodwill to its estimated realizable value. The Company estimated that the goodwill related to the First American acquisition had a useful life of 40 years from the date of acquisition, and amortized the goodwill over that period through December 31, 2001. See Recently Adopted Accounting Principles below in Note 1 for information on the Company's adoption of SFAS No. 142, "Goodwill and Other Intangible Assets," which changed the accounting for goodwill effective January 1, 2002. INTANGIBLE ASSETS Intangible assets as of December 31, 2003 consist of customer relationships, provider networks and other intangible assets with an aggregate net book value of $9.9 million, all of which are related to the acquisitions of HN Dental, HN Vision, Ameritas Managed Dental Plan, Inc. ("Ameritas") and Paramount, which are discussed in Note 2. The amount of the purchase price in each acquisition that was allocated to the intangible assets was equal to the Company's estimate of the fair value of each intangible asset. Each intangible asset is being amortized over its estimated useful life on a straight-line basis. F-9 LONG-LIVED ASSETS In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," long-lived assets are reviewed for events or changes in circumstances that indicate that their carrying values may not be recoverable. The Company's principal long-lived assets as of December 31, 2003 are property and equipment and intangible assets. The Company is not aware of any events or circumstances that may have impaired the fair value of these long-lived assets. RECOGNITION OF PREMIUM REVENUE AND COMMISSION EXPENSE Premium revenue is recognized in the period during which dental or vision coverage is provided to the covered individuals. Payments received from customers in advance of the related period of coverage are reflected on the accompanying consolidated balance sheets as deferred premium revenue. In connection with its acquisition of new customers, the Company pays broker and consultant commissions, which are generally based on a percentage of premium revenue collected. The Company also pays internal sales commissions, some of which are based on a percentage of premium revenue collected, and some of which consist of a one-time payment at the beginning of a customer contract. Commissions that are based on a percentage of premium revenue collected are recognized as expenses in the period in which the related premium revenue is recognized. Commissions that consist of a one-time payment at the beginning of a customer contract are recognized as expenses at the beginning of the related customer contract. As stated in SFAS No. 60, "Accounting and Reporting by Insurance Companies," commissions related to insurance contracts should be capitalized and charged to expense over the term of the customer contract, in proportion to premium revenue recognized. In the case of the PPO/indemnity insurance policies issued by the Company, the customers have the ability to cancel the policy at any time with 30 days advance written notice. Because of this ability, one-time commissions paid at the beginning of a customer contract are charged to expense at the beginning of the related customer contract. RECOGNITION OF HEALTH CARE SERVICES EXPENSE Capitation payments to providers are recognized as expense in the period in which the providers are obligated to deliver the related health care services. Other payments for health care services are recognized as expense in the period in which the services are delivered. The estimated liability for claims payable and claims incurred but not reported is based primarily on the average historical lag time between the date of service and the date the related claim is paid by the Company, and the recent trend in payment rates and the average number of incurred claims per covered individual. Since the liability for claims payable and claims incurred but not reported is an actuarial estimate, the amount of claims eventually paid for services provided prior to the balance sheet date could differ from the estimated liability. Any such differences are included in the consolidated statements of income for the period in which the differences are identified. ADMINISTRATIVE SERVICES ARRANGEMENTS The Company processed approximately $5.2 million, $2.6 million, and $3.2 million of dental and vision claims under administrative services only ("ASO") agreements during the years ended December 31, 2003, 2002 and 2001, respectively. The revenue recognized by the Company from ASO agreements consists only of the ASO fees received from its clients, and the claims processed by the Company under ASO agreements are not included in the accompanying consolidated statements of income. STOCK-BASED COMPENSATION SFAS No. 123, "Accounting for Stock-Based Compensation," provides a choice of two different methods of accounting for stock options granted to employees. SFAS No. 123 encourages, but does not require, entities to recognize compensation expense equal to the fair value of employee stock options granted. Under this method of accounting, the fair value of a stock option is measured at the grant date, and compensation expense is recognized over the period during which the stock option becomes exercisable. Alternatively, an entity may choose to use the accounting method described in Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees." Under APB No. 25, no compensation expense is generally recognized as long as the exercise F-10 price of each stock option is at least equal to the market price of the underlying stock at the time of the grant. If an entity chooses to use the accounting method described in APB No. 25, SFAS No. 123 requires that the pro forma effect of using the fair value method of accounting on its net income be disclosed in a note to the financial statements. The Company has chosen to use the accounting method described in APB No. 25. All stock options granted by the Company have an exercise price equal to the market value of the Company's common stock on the date of grant, and accordingly, there is no employee compensation expense related to stock options reflected in the accompanying consolidated statements of income. The weighted average fair value of stock options granted by the Company was $0.90, $0.75, and $1.13 per share during the years ended December 31, 2003, 2002 and 2001, respectively. Stock options granted generally become exercisable in equal annual installments over a three-year period after the date of grant. The following table shows the pro forma effect of using the fair value method of accounting for stock options, as described by SFAS No. 123, on the Company's net income and net income per share (in thousands, except per share amounts):
YEARS ENDED DECEMBER 31, ---------------------------------- 2003 2002 2001 ---------- ----------- --------- Net income, as reported $ 7,813 $ 1,427 $ 12,546 Less - Employee compensation expense based on the fair value method of accounting for stock options (416) (856) (833) ---------- ----------- --------- Pro forma net income $ 7,397 $ 571 $ 11,713 ========== =========== ========= Basic net income per share, as reported $ 0.22 $ 0.04 $ 0.39 Pro forma basic net income per share 0.21 0.02 0.36 Diluted net income per share, as reported $ 0.20 $ 0.04 $ 0.38 Pro forma diluted net income per share 0.19 0.02 0.35
SFAS No. 123 requires a publicly traded entity to estimate the fair value of stock-based compensation by using an option-pricing model that takes into account certain facts and assumptions. The facts and assumptions that must be taken into account are the exercise price, the expected life of the option, the current stock price, the expected volatility of the stock price, the expected dividends on the stock, and the risk-free interest rate. The option-pricing models commonly used were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the stock options granted by the Company. The Company estimated the fair value of each stock option as of the date of grant by using the Black-Scholes option-pricing model. The facts and assumptions used to determine the fair value of stock options granted were: an average expected life of four years; expected volatility of 75% in 2003, 82% in 2002, and 160% in 2001; no expected dividends; and a risk-free interest rate of approximately 2.2% in 2003, 2.0% in 2002, and 3.8% in 2001. The assumptions regarding the expected life of the options and the expected volatility of the stock price are subjective, and these assumptions have a significant effect on the estimated fair value amounts. INCOME TAXES The Company's accounting for income taxes is in accordance with SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of events that are recognized in the Company's consolidated financial statements in different periods than those in which the events are recognized in the Company's tax returns. The measurement of deferred tax liabilities and assets is based on current tax laws as of the balance sheet date. The Company records a valuation allowance related to deferred tax assets in the event that available evidence indicates that the future tax benefits related to the deferred tax assets may not be realized. A valuation allowance is required when it is more likely than not that the deferred tax assets will not be realized. F-11 RELATED PARTY TRANSACTIONS See Notes 2 and 8 for information on $19.0 million of unsecured convertible promissory notes that were issued to certain of the Company's principal stockholders in October 2003 in connection with the Company's acquisition of HN Dental and HN Vision effective October 31, 2003. See Notes 2 and 8 for information on a secured convertible promissory note payable to a member of the Company's senior management, the outstanding balance of which was $1.6 million as of December 31, 2003. The convertible note was issued in September 2002 in connection with the acquisition of Paramount, and the former owner of Paramount is currently a member of the Company's senior management. See Note 8 for information on an unsecured convertible promissory note payable to one of the Company's principal stockholders, the outstanding balance of which was $1.5 million as of December 31, 2003. The note was issued in August 2002 to obtain working capital for various purposes. The Company paid $10,000, $153,000 and $200,000 of consulting fees to the chairman of its board of directors during the years ended December 31, 2003, 2002 and 2001, respectively. ADVERTISING Advertising expense was $148,000, $185,000, and $110,000 for the years ended December 31, 2003, 2002 and 2001, respectively. USE OF ESTIMATES IN FINANCIAL STATEMENTS The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported amounts of revenues and expenses. Actual results could differ from those estimates. NET INCOME PER SHARE Net income per share is presented in accordance with SFAS No. 128, "Earnings Per Share." Basic net income per share is based on the weighted average common shares outstanding, including the common shares into which the convertible preferred stock is convertible, but excluding the effect of other potentially dilutive securities. The number of basic common shares outstanding includes the common share equivalents of the convertible preferred stock, because the holders of the convertible preferred stock participate in any dividends paid on the Company's common stock on an as-converted basis, and because the Company believes the convertible preferred stock is a participating security that is essentially equivalent to common stock, based on all the rights and preferences of both types of stock. Diluted net income per share is based on the weighted average common shares outstanding, including the effect of all potentially dilutive securities. During the three years ended December 31, 2003, the potentially dilutive securities of the Company that were outstanding consisted of convertible notes, stock options, and warrants. See Note 8 for information on convertible notes that were outstanding during 2003 and 2002. The calculation of diluted net income per share for 2003 includes the effect of all the outstanding convertible notes. Each of these convertible notes would have an anti-dilutive effect on net income per share in 2002, and accordingly, they are excluded from the calculation of diluted net income per share for this period. The calculation of diluted net income per share for 2003, 2002 and 2001 includes the effect of all outstanding stock options with an exercise price below the average market price of the Company's common stock during each period. The only warrants issued by the Company were canceled without being exercised effective January 31, 2001, as discussed in Note 9. F-12 The differences between weighted average basic shares outstanding and weighted average diluted shares outstanding in each of the three years ended December 31, 2003, are as follows (in thousands):
2003 2002 2001 ------ ------ ------ Weighted average basic shares outstanding 35,719 35,130 32,253 Effect of convertible notes 3,806 -- -- Effect of dilutive stock options 719 508 756 ------ ------ ------ Weighted average diluted shares outstanding 40,244 35,638 33,009 ====== ====== ======
For purposes of computing the net income per diluted share of common stock, the Company's net income was adjusted as follows (in thousands):
2003 2002 2001 ------ ------ ------- Net income, as reported $7,813 $1,427 $12,546 Interest expense on convertible notes, net of tax effect 272 -- -- ------ ------ ------- Adjusted Net Income $8,085 $1,427 $12,546 ====== ====== =======
RECENTLY ADOPTED ACCOUNTING PRINCIPLES Effective January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 requires that goodwill and other intangible assets with indefinite useful lives not be amortized. SFAS No. 142 also requires that all goodwill be evaluated for possible impairment as of January 1, 2002, on an annual basis thereafter, and any time an event that may have affected the value of the goodwill occurs. SFAS No. 142 also establishes a new method of testing goodwill for possible impairment. The adoption of SFAS No. 142 had no significant effect on the Company's consolidated financial statements. See Notes 5 and 6 for more information. In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," and APB No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual, and Infrequently Occurring Events and Transactions." SFAS No. 144 establishes accounting and reporting standards for the impairment or disposal of long-lived assets, and for reporting the results of discontinued operations. The Company adopted SFAS No. 144 effective January 1, 2002. The adoption of SFAS No. 144 had no significant effect on the Company's consolidated financial statements. In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 145 updates, clarifies, and simplifies existing accounting pronouncements. SFAS No. 145 is generally effective for financial statements issued after May 15, 2002. The adoption of SFAS No. 145 had no significant effect on the Company's consolidated financial statements. In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 requires that a liability for the cost of an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 also requires that the liability be initially measured and recorded at fair value. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 had no significant effect on the Company's consolidated financial statements. In October 2002, the Emerging Issues Task Force ("EITF") of the FASB issued EITF 02-17, which addresses issues raised in the interpretation of SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets," and the identification and valuation of intangible assets. EITF 02-17 provides guidance on determining when, as a result of a business combination, a customer-related intangible asset exists that should be separately valued from goodwill. EITF No. 02-17 is effective for business combinations consummated and goodwill impairment tests performed after October 25, 2002. The adoption of EITF 02-17 had no significant effect on the Company's consolidated financial statements. F-13 In November 2002, the FASB issued FASB Interpretation ("FIN") No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN No. 45 is an interpretation of FASB Statements No. 5, 57, and 107, and a rescission of FIN No. 34, "Disclosure of Indirect Guarantees of Indebtedness of Others." FIN No. 45 requires that a guarantor recognize a liability for the fair value of certain types of guarantees, at the time the guarantee is initially made. It also elaborates on the financial statement disclosures to be made by a guarantor about its obligations under certain types of guarantees. The initial recognition and measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements for periods ending after December 15, 2002. The adoption of FIN No. 45 had no significant effect on the Company's consolidated financial statements. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," which is an amendment of SFAS No. 123, "Accounting for Stock-Based Compensation." SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. It also requires prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. SFAS No. 148 is effective for fiscal years ending after December 15, 2002. The adoption of SFAS No. 148 had no significant effect on the Company's consolidated financial statements. In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities," an interpretation of Accounting Research Bulletin No. 51. FIN No. 46 requires that variable interest entities be consolidated by the investing company if the investing company is obligated to absorb a majority of the losses incurred by the variable interest entity, or is entitled to receive a majority of the profits earned by the entity, or both. The consolidation requirements of FIN No. 46 are effective for all periods with respect variable interest entities that are created after January 31, 2003. The consolidation requirements with respect to variable interest entities created prior to February 1, 2003 are effective for periods beginning after June 15, 2003. The adoption of FIN No. 46 had no significant effect on the Company's consolidated financial statements. In December 2003, the FASB issued FIN No. 46R, which revised the implementation date for FIN No. 46 with respect to variable interest entities created prior to January 31, 2003, among other things. The adoption of FIN No. 46R had no significant effect on the Company's consolidated financial statements. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 is effective for contracts and hedging relationships entered into or modified after June 30, 2003. The adoption of SFAS No. 149 had no significant effect on the Company's consolidated financial statements. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Instruments with Characteristics of Both Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments that have characteristics of both debt and equity, and requires an issuer to classify certain instruments as liabilities in its balance sheet. SFAS No. 150 is effective for financial instruments created or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 had no significant effect on the Company's consolidated financial statements. In November 2003, the FASB issued FASB Staff Position No. 150-3 ("FSP 150-3"), which deferred the effective dates for applying certain provisions of SFAS No. 150 related to mandatorily redeemable financial instruments. The adoption of FSP 150-3 had no significant effect on the Company's consolidated financial statements. RECLASSIFICATION Certain amounts in the financial statements for prior years have been reclassified to conform to the current year presentation. NOTE 2. ACQUISITIONS ---------------------- HEALTH NET DENTAL, INC. AND HEALTH NET VISION, INC. Effective October 31, 2003, the Company acquired all of the outstanding capital stock of HN Dental, which is a California dental HMO, and certain PPO/indemnity dental business underwritten by Health Net Life Insurance F-14 Company ("HN Life"), which was formerly an affiliate of HN Dental, for $10.7 million in cash, and an agreement to provide private label dental HMO and PPO/indemnity products to be sold in the marketplace by subsidiaries of Health Net, Inc., the former parent company of HN Dental, for a period of at least five years following the transaction, subject to certain conditions. Effective October 31, 2003, the Company also acquired all of the outstanding capital stock of HN Vision, which is a California vision HMO and a former affiliate of HN Dental, and certain PPO/indemnity vision business underwritten by HN Life, for $4.5 million in cash. The combined revenue of the acquired businesses was approximately $61 million during the ten months ended October 31, 2003. The operations of HN Dental, HN Vision, and the related dental and vision PPO/indemnity business are included in the Company's consolidated financial statements beginning on November 1, 2003. The dental and vision PPO/indemnity business referred to above was transferred to the Company through two Assumption and Indemnity Reinsurance Agreements with HN Life (the "Agreements"). In connection with the Agreements, the Company assumed an estimated amount of claims payable and claims incurred but not reported, and certain other assets and liabilities, in exchange for a cash payment from HN Life. Also in connection with the Agreements, the Company and HN Life agreed to adjust the cash payment approximately six months after the effective date of the Agreements, based on subsequent payment of claims, subsequent collection of receivables, and other information that becomes available to the parties during the six months after the effective date. The business purpose of these acquisitions was to increase the Company's market penetration in California, which is one of the Company's primary geographic markets, and to gain vision benefit products that are internally administered by the Company. As a result of the acquisitions, the number of individuals in California for which the Company provides dental benefits increased from approximately 350,000 members to approximately 800,000 members, and the number of individuals in California for which the Company provides vision benefits increased from approximately 20,000 members to approximately 150,000 members. The acquisitions were financed through the issuance of $19.0 million of unsecured convertible promissory notes to certain of the Company's principal stockholders in October 2003. The proceeds from the convertible notes were used to finance the acquisitions, to satisfy the increase in the Company's regulatory net worth requirements related to the PPO/indemnity dental and vision business that was acquired, which is estimated to be $3.8 million, to provide working capital that may be required in connection with the integration of the acquired businesses into the Company's pre-existing operations, and other purposes. The convertible notes bear interest at 6.0% annually, and are convertible into the Company's common stock at the rate of $1.75 per share, at the option of the holder. There are no principal payments due under the convertible notes prior to January 31, 2010, then principal payments are due beginning on January 31, 2010, and each three months thereafter through July 31, 2013, pursuant to a ten-year amortization schedule, and the remaining balance is payable in full on October 31, 2013. The convertible notes are payable in full upon a change in control of the Company, at the holder's option. The Company has the option of redeeming the convertible notes for 229% of face value during the first seven years after the date of issuance, for 257% of face value during the eighth year after issuance, for 286% of face value during the ninth year after issuance, and for 323% of face value during the tenth year after issuance, provided that it redeems all the convertible notes held by each holder for which it redeems any of the notes. F-15 The aggregate cost of the acquisitions was allocated among the assets acquired as follows (in thousands):
Cost of acquisitions: Cash purchase price, including estimated post-closing adjustments $15,158 Transaction expenses incurred by the Company 68 -------- Total cost $15,226 ======== Fair value of net assets acquired (liabilities assumed): Cash and cash equivalents $ 5,672 Investments, including restricted investments 3,147 Accounts receivable 2,864 Property and equipment 795 Goodwill 4,191 Intangible assets 7,768 Other assets 1,110 Accounts payable (537) Accrued expenses (3,121) Claims payable and claims incurred but not reported (4,755) Deferred premium revenue (1,908) -------- Net assets acquired $15,226 ========
The intangible assets acquired consist of the following (in thousands):
WEIGHTED AVERAGE AMOUNT AMORTIZATION ALLOCATED PERIOD ---------- ------------ Customer relationships $ 5,237 6.2 years Provider networks 2,230 20.0 years Other intangible assets 301 11.7 years ---------- Total $ 7,768 10.4 years ==========
The Company plans to make an election under Section 338 of the Internal Revenue Code to treat the acquisition of HN Dental as an asset purchase for tax purposes. Assuming this election is made, the Company estimates that approximately $8.9 million of goodwill and intangible assets related to the HN Dental and HN Vision acquisitions will be amortized over 15 years on a straight-line basis for income tax purposes. AMERITAS MANAGED DENTAL PLAN, INC. Effective March 31, 2003, the Company acquired all of the outstanding capital stock of Ameritas for $1.0 million in cash, including a post-closing adjustment, plus contingent monthly payments during the five years following the acquisition date. Each contingent monthly payment is equal to 10% of the actual premium revenue during the month from customers of Ameritas that existed as of March 31, 2003. As of December 31, 2003, the Company has accrued a total of $301,000 of contingent purchase price, which has been added to the cost of the acquisition for accounting purposes. This amount represents contingent monthly payments related to the period from the acquisition date through December 31, 2003, plus the estimated contingent monthly payments related to the remaining portion of annual customer contracts that are in force as of January 1, 2004. The Company intends to accrue additional portions of the contingent purchase price in the future, if and when the payment of such amounts becomes probable, based on the renewal of existing customer contracts. Based on the amount of premium revenue during the period from April 1, 2003 to December 31, 2003, from customers of Ameritas that existed as of March 31, 2003, the maximum aggregate amount of the contingent monthly payments would be approximately $1.5 million, if the Company retained all of the existing customers of Ameritas for five years after the acquisition date at the premium rates in effect during 2003. The operations of Ameritas are included in the Company's consolidated financial statements beginning on April 1, 2003. Ameritas was a dental benefits company located in California and was merged into the Company's California dental HMO subsidiary effective March 31, 2003. The business purpose of the acquisition was to increase the Company's F-16 market penetration in California, which is one of the Company's primary geographic markets. As a result of the acquisition, the number of individuals in California for which the Company provides dental benefits increased from approximately 300,000 members to approximately 330,000 members. The cost of the acquisition was allocated among the assets acquired as follows (in thousands):
Cost of acquisition: Cash purchase price, net of post-closing adjustments $1,034 Contingent purchase price accrued as of December 31, 2003 301 ------- Total cost $1,335 ======= Fair value of net assets acquired (liabilities assumed): Cash and cash equivalents $ 276 Investments 465 Intangible assets 810 Other assets 150 Deferred premium revenue (258) Other current liabilities (108) ------- Total cost of acquisition $1,335 =======
The intangible assets acquired consist of the following (in thousands):
WEIGHTED AVERAGE AMOUNT AMORTIZATION ALLOCATED PERIOD ---------- ------------ Customer relationships $ 635 9.5 years Other intangible assets 175 10.8 years ---------- Total $ 810 9.8 years ==========
The Company estimates that approximately $0.1 million of the intangible assets related to the acquisition of Ameritas will be amortized over 15 years on a straight-line basis for income tax purposes. PARAMOUNT DENTAL PLAN, INC. Effective August 30, 2002, the Company acquired all of the outstanding capital stock of Paramount for approximately $6.7 million, consisting of $3.0 million in cash, a secured convertible note for $2,625,000, and 769,231 shares of the Company's common stock. Paramount was a dental benefits company located in Florida, and was merged into the Company's Florida dental HMO subsidiary effective August 30, 2002. The secured convertible note bears interest at 7.0% annually, and was originally payable in 36 equal monthly installments of principal and interest, beginning in October 2002. The terms of the note were amended in the fourth quarter of 2003, and the outstanding balance is now payable in monthly installments of interest only until a date to be specified by the holder of the convertible note at least 90 days in advance of such date, which must be no earlier than January 1, 2005, and no later than January 1, 2007. Effective on the date specified by the holder, the convertible note will be payable in 21 equal monthly installments of principal and interest. The outstanding balance under the secured convertible note is convertible into common stock of the Company at a conversion price of $1.625 per share. The convertible note is secured by the stock of the Company's dental HMO subsidiary in Florida. The operations of Paramount are included in the accompanying consolidated financial statements beginning on September 1, 2002. The business purpose of the acquisition was to increase the Company's market penetration in Florida, which is one of the Company's primary geographic markets. The acquisition increased the number of members in Florida for which the Company provides dental benefits from approximately 50,000 members to approximately 275,000 members. In connection with this transaction, the Company entered into a three-year employment agreement with the seller of Paramount, who is currently employed as president of the Company's operations in Florida. Also in connection with this transaction, the Company entered into a three-year office lease agreement with the seller of Paramount, the term F-17 of which started in November 2002, related to the office space that is currently used as the Company's primary sales and administrative office in Florida. The cost of the acquisition was allocated among the assets acquired as follows (in thousands):
Cost of acquisition: Cash portion of purchase price $3,000 Secured convertible note issued to seller 2,625 Common stock issued to seller 1,040 ------- Purchase price paid to seller 6,665 Transaction expenses incurred by the Company 164 ------- Total cost $6,829 ======= Fair value of net assets acquired (liabilities assumed): Cash and cash equivalents $ 456 Restricted investment 50 Property and equipment 121 Goodwill 4,670 Intangible assets 2,270 Other assets 229 Accounts payable and accrued expenses (386) Claims payable and claims incurred but not reported (225) Deferred premium revenue (356) ------- Net assets acquired $6,829 =======
The value indicated above for the Company's common stock issued in the acquisition is based on 769,231 shares of common stock issued, and a market value of $1.35 per share. The market value of $1.35 per share is the average closing price of the Company's common stock during the period from five business days prior to execution of the Stock Purchase Agreement to five business days after execution of the agreement. The Stock Purchase Agreement was executed on April 24, 2002. The intangible assets acquired consist of the following (in thousands):
WEIGHTED AVERAGE AMOUNT AMORTIZATION ALLOCATED PERIOD ---------- ------------ Customer relationships $ 1,926 4.5 years Other intangible assets 344 10.1 years ---------- Total $ 2,270 5.3 years ==========
None of the goodwill or intangible assets related to the acquisition of Paramount will be amortized for income tax purposes. F-18 PRO FORMA RESULTS OF OPERATIONS Following is certain unaudited pro forma statement of income information, which reflects adjustments to the Company's historical financial statements as if the acquisitions of HN Dental, HN Vision, and Paramount had been completed as of the beginning of each period presented (in thousands):
YEARS ENDED DECEMBER 31, ---------------------------- 2003 2002 ------------ -------------- (unaudited) Premium revenue, net $ 150,629 $ 139,521 Operating income (loss) 3,222 (3,461) Net income (loss) 7,281 (3,171) Basic net income (loss) per share $ 0.20 $ (0.09) Diluted net income (loss) per share 0.17 (0.09)
The above unaudited pro forma statement of income information is not intended to indicate the results that would have occurred if the acquisitions had actually been completed on the dates indicated, or the results that may occur in any future period. The above pro forma information does not reflect the pro forma effect of the acquisition of Ameritas, because such pro forma effect is not significant. NOTE 3. INVESTMENTS --------------------- Gross realized gains on sales of investments were $1,000, $2,000, and $101,000 for the years ended December 31, 2003, 2002, and 2001, respectively. There were no gross realized losses on sales of investments during the three years ended December 31, 2003. The historical cost of specific securities sold is used to compute the gain or loss on the sale of investments. At December 31, 2003, the Company had net unrealized gains of $57,000, which is included in stockholders' equity under the caption "Accumulated other comprehensive income." The Company's investments as of December 31, 2003 are summarized below (in thousands):
COST/ ESTIMATED AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE ---------- ----------- ------------ ---------- Classified as available-for-sale: U.S. government securities $ 5,842 $ 55 $ -- $ 5,897 U.S. government agency securities 6,238 2 (1) 6,239 Corporate bonds and commercial paper 3,109 3 -- 3,112 Other marketable debt securities 12,684 -- (2) 12,682 ---------- ----------- ------------ ---------- Total available-for-sale $ 27,873 $ 60 $ (3) $ 27,930 ========== =========== ============ ==========
The maturity dates of the Company's investments as of December 31, 2003 are summarized below (in thousands):
COST/ ESTIMATED AMORTIZED FAIR COST VALUE ---------- ---------- Classified as available-for-sale: Due in 2004 $ 23,121 $ 23,126 Due in 2005 1,544 1,581 Due in 2006 and thereafter 3,208 3,223 ---------- ---------- Total available-for-sale $ 27,873 $ 27,930 ========== ==========
F-19 The Company's investments as of December 31, 2002 are summarized below (in thousands):
COST/ ESTIMATED AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE ---------- ----------- ----------- ---------- Classified as available-for-sale: U.S. government and its agencies $ 2,303 $ 87 $ -- $ 2,390 State and municipal obligations 255 8 -- 263 Other marketable debt securities 10,269 -- -- 10,269 ---------- ----------- ----------- ---------- Total available-for-sale $ 12,827 $ 95 $ -- $ 12,922 ========== =========== =========== ==========
NOTE 4. PROPERTY AND EQUIPMENT ---------------------------------- The Company's property and equipment consists of the following (in thousands):
DECEMBER 31, ------------------- 2003 2002 -------- --------- Leasehold improvements $ 950 $ 842 Furniture and office equipment 1,871 1,504 Computer hardware and software 9,957 7,767 -------- --------- Total, at cost 12,778 10,113 Less - accumulated depreciation and amortization (7,955) (6,581) -------- --------- Total, net of accumulated depreciation and amortization $ 4,823 $ 3,532 ======== =========
Property and equipment that was acquired through capital leases with an outstanding balance as of the balance sheet date consists of the following, which is included above (in thousands):
DECEMBER 31, ------------------ 2003 2002 ------- --------- Furniture and office equipment $1,135 $ 950 Computer hardware and software 250 1,250 ------- --------- Total cost of property acquired through capital leases 1,385 2,200 Less - accumulated depreciation and amortization (297) (344) ------- --------- Total, net of accumulated depreciation and amortization $1,088 $ 1,856 ======= =========
NOTE 5. GOODWILL ----------------- Changes in the carrying amount of goodwill were as follows (in thousands):
YEARS ENDED DECEMBER 31, ---------------------------- 2003 2002 ------------- ------------- Balance at beginning of year $ 8,590 $ 3,920 Goodwill acquired (see Note 2) 4,191 4,670 Adjustments to goodwill (see Note 11) (416) -- ------------- ------------- Balance at end of year $ 12,365 $ 8,590 ============= =============
F-20 In accordance with SFAS No. 142, the Company ceased amortizing its goodwill effective January 1, 2002. The Company recorded $113,000 of amortization expense related to goodwill during the year ended December 31, 2001. The Company's adjusted results of operations for the year ended December 31, 2001, which are adjusted to assume the non-amortization provision of SFAS No. 142 was applied as of January 1, 2001, are as follows (in thousands):
Income before extraordinary item, as reported $ 1,295 Add back - Goodwill amortization 113 ------- Income before extraordinary item, as adjusted $ 1,408 ======= Net income, as reported $12,546 Add back - Goodwill amortization 113 ------- Net income, as adjusted $12,659 =======
None of the Company's reported net income per share amounts for the year ended December 31, 2001 would change as a result of the above adjustment for goodwill amortization expense, due to the relatively small amount of this adjustment. SFAS No. 142 requires that all goodwill be evaluated for possible impairment as of January 1, 2002, on an annual basis thereafter, and any time an event that may have affected the value of the goodwill occurs. SFAS No. 142 also establishes a new method of testing for possible impairment. The Company has established October 1 as the date on which it conducts its annual evaluation of goodwill for possible impairment. In accordance with SFAS No. 142, the Company tested its goodwill for possible impairment by estimating the fair value of each of its reporting units that include goodwill, and comparing the fair value of each reporting unit to the book value of the net assets of each reporting unit. For purposes of this test, the Company has three reporting units, which are its operations in California, Florida and Texas. As of December 31, 2003, the Company has goodwill in each of the three reporting units. The fair value of each reporting unit was determined primarily by estimating the discounted future cash flows of the reporting unit, and estimating the amount for which the reporting unit could be sold to a third party, based on a market multiple of earnings. The Company had no impairment of its goodwill as of January 1, 2002, or as of October 1, 2003, based on the method of testing for possible impairment established by SFAS No. 142. The Company is not aware of any events that have occurred since October 1, 2003, that may have resulted in impairment of the value of its goodwill. NOTE 6. INTANGIBLE ASSETS ---------------------------- The Company's intangible assets consist of the following (in thousands):
DECEMBER 31, ------------------- 2003 2002 -------- --------- Customer relationships $ 7,798 $ 1,926 Provider networks 2,461 -- Other intangible assets 589 344 -------- --------- Total, at cost 10,848 2,270 Less - accumulated amortization (986) (257) -------- --------- Total, net of accumulated amortization $ 9,862 $ 2,013 ======== =========
F-21 Amortization expense related to intangible assets was $729,000 and $257,000 during the years ended December 31, 2003 and 2002, respectively. As of December 31, 2003, the Company expects future amortization expense related to intangible assets to be as follows (in thousands): 2004 $1,909 2005 1,580 2006 1,188 2007 904 2008 755 Thereafter 3,526 NOTE 7. CLAIMS PAYABLE AND CLAIMS INCURRED BUT NOT REPORTED ("IBNR") ---------------------------------------------------------------------- The Company is responsible for paying claims submitted by dental and vision providers for services provided to patients who have purchased dental or vision coverage from the Company. The liability for claims payable and claims IBNR is an estimate of the claims related to services delivered prior to the balance sheet date, which have not yet been paid by the Company as of the balance sheet date. The estimate of claims payable and claims IBNR is based primarily on the average historical lag time between the date of service and the date the related claim is paid by the Company, the recent trend in payment rates, and the recent trend in the average number of incurred claims per covered individual. Since the liability for claims payable and claims IBNR is an actuarial estimate, the amount of claims eventually paid for services provided prior to the balance sheet date could differ from the estimated liability. Any such differences are included in the consolidated statement of income for the period in which the differences are identified. A summary of the activity in the liability for claims payable and claims IBNR during the two years ended December 31, 2003 is shown below (in thousands):
CLAIMS LIABILITY BY TYPEOF COVERAGE --------------------------------------------- VISION HMO DENTAL PPO/ DENTAL AND PPO/ INDEMNITY HMO INDEMNITY TOTAL --------------- ------------- ------------- --------- Balance at January 1, 2002 $ 4,252 $ 1,653 $ -- $ 5,905 Incurred claims related to: Current year - 2002 23,133 10,566 -- 33,669 Prior years (594) (206) -- (800) Balance assumed in acquisition -- 225 -- 225 Paid claims related to: Current year - 2002 (20,092) (8,928) -- (29,020) Prior years (3,658) (1,447) -- (5,105) Balance assumed in acquisition -- (214) -- (214) --------------- ------------- ------------- --------- Balance at December 31, 2002 3,041 1,649 -- 4,690 Incurred claims related to: Current year - 2003 28,134 14,492 716 43,342 Prior years (378) (371) -- (749) Balance assumed in acquisitions 2,344 1,945 466 4,755 Paid claims related to: Current year - 2003 (22,608) (11,798) (297) (34,703) Prior years (2,663) (1,278) -- (3,941) Balance assumed in acquisition (1,621) (1,360) (304) (3,285) --------------- ------------- ------------- --------- Balance at December 31, 2003 $ 6,249 $ 3,279 $ 581 $ 10,109 =============== ============= ============= =========
F-22 The liability for claims payable and claims IBNR is adjusted each year to reflect any differences between claims actually paid and previous estimates of the liability. During each of the years ended December 31, 2003 and 2002, the aggregate adjustments to the liability to reflect these differences, which are reflected in the above table, were not material. NOTE 8. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS ----------------------------------------------------------- Long-term debt and capital lease obligations consisted of the following (in thousands):
DECEMBER 31, ------------------- 2003 2002 -------- --------- Unsecured convertible promissory notes - October 2003 $19,000 $ -- Secured convertible promissory note - September 2002 1,602 2,427 Unsecured convertible promissory note - August 2002 1,538 1,798 Capital lease obligations 710 1,202 -------- --------- Total debt 22,850 5,427 Less - short-term portion (313) (2,430) -------- --------- Long-term debt and capital lease obligations $22,537 $ 2,997 ======== =========
See Note 2 for descriptions of the unsecured convertible promissory notes issued in October 2003 in connection with the acquisition of HN Dental and HN Vision, and the secured convertible promissory note issued in September 2002 in connection with the acquisition of Paramount. None of the outstanding convertible notes include any financial covenants or similar restrictions. In August 2002, the Company borrowed $2.0 million from one of its principal stockholders under an unsecured convertible promissory note. The note bears interest at 7.0% annually, and was originally payable in equal monthly installments of principal and interest through August 2005. The terms of the note were amended during the second quarter of 2003, and the outstanding balance is now payable in monthly installments of interest only through May 2006, then in monthly installments of principal and interest from June 2006 through August 2008. The outstanding balance under the unsecured convertible note is convertible into common stock of the Company at a conversion price of $1.625 per share. The Company has several capital leases outstanding, which are related to the purchase of certain office and computer equipment. Annual maturities of long-term debt and future minimum lease payments under capital lease obligations were as follows, as of December 31, 2003 (in thousands):
CAPITAL LESS - AMOUNT LONG-TERM LEASE REPRESENTING DEBT OBLIGATIONS INTEREST TOTAL ---------- ------------ --------------- ------- Payable in 2004 $ -- $ 372 $ (59) $ 313 Payable in 2005 886 169 (35) 1,020 Payable in 2006 1,092 166 (22) 1,236 Payable in 2007 681 98 (12) 767 Payable in 2008 481 35 (2) 514 Payable thereafter 19,000 -- -- 19,000 ---------- ------------ --------------- ------- Total balance at December 31, 2003 $ 22,140 $ 840 $ (130) $22,850 ========== ============ =============== =======
NOTE 9. CONVERSION OF DEBT TO CONVERTIBLE PREFERRED STOCK ---------------------------------------------------------- On March 1, 2000, the Company entered into a recapitalization agreement with an investor group (the "Investors"), the Company's revolving credit facility lender (the "Bank"), and the holder of certain senior notes payable issued by F-23 the Company (the "Senior Note Holder"). Pursuant to this agreement, the Investors loaned $8.0 million to the Company in the form of an investor senior loan, due April 30, 2001. In addition, the Investors, the Bank, and the Senior Note Holder agreed to convert the $8.0 million investor senior loan, the outstanding balance of $7.0 million under the revolving credit facility plus accrued interest, and the $32.5 million of senior notes payable plus accrued interest, to convertible preferred stock, subject to regulatory and stockholder approval. Effective as of January 31, 2001, the Company completed the conversion of the investor senior loan ($8.0 million), the outstanding balance under the revolving credit facility ($7.0 million), the senior notes payable ($32.5 million), and the accrued interest on the revolving credit facility and the senior notes payable ($5.3 million) into 30 million shares of convertible preferred stock. The estimated value of the convertible preferred stock was $1.375 per share as of January 31, 2001, which is based on the closing price of the Company's common stock on January 31, 2001, which was $1.375 per share, and the fact that each share of convertible preferred stock is convertible into one share of common stock. The number of shares of convertible preferred stock, the estimated value per share, and the conversion ratio indicated above have all been adjusted to reflect an exchange of the Company's outstanding shares of convertible preferred stock that was completed in May 2002. See Note 13 for more information on this exchange. Based on the estimated value of the convertible preferred stock as of January 31, 2001, the debt conversion resulted in an extraordinary gain of $11.3 million, which is net of approximately $350,000 of transaction costs. There was no income tax effect related to the conversion, due to the Company's net operating loss carryforwards for tax purposes, as discussed in Note 11. See Note 13 for a description of the convertible preferred stock. As a result of the debt conversion, the ownership interest of the previously existing common stockholders of the Company was reduced to approximately 14% of the common stock interests of the Company. The holders of the convertible preferred stock issued to the Investors in the debt conversion (Series A convertible preferred stock) have the right to elect four members of the Company's board of directors, voting as a separate class, which constitutes a majority of the board of directors, which has a total of seven members. In addition, the holders of the convertible preferred stock issued to the Bank and the Senior Note Holder in the debt conversion (Series B, C and D convertible preferred stock) have the right to elect one member of the Company's board of directors, voting as a separate class. The holders of the Company's common stock have the right to elect the remaining two members of the Company's board of directors, voting as a separate class. In 1999, in connection with a previous restructuring of the senior notes payable, the Company issued warrants to purchase 382,000 shares of its common stock for $4.51 per share to the Senior Note Holder. The Company estimated that the fair value of these warrants was $320,000, based on an option-pricing model. Accordingly, this amount was charged to interest expense and credited to additional paid-in capital during 1999. The warrants were canceled without being exercised, in connection with the conversion of the senior notes payable into convertible preferred stock effective January 31, 2001. Accordingly, the estimated fair value of the warrants, which was $320,000, was debited to additional paid-in capital and credited to retained earnings during 2001. NOTE 10. OTHER LONG-TERM LIABILITIES ---------------------------------------- Other long-term liabilities consist primarily of deferred rent related to an office lease with monthly payments that increase over the term of the lease, an accrued lease obligation related to a dental office sold by the Company in 1998 (see Note 12), deferred compensation payments to a former employee of a dental HMO company acquired by the Company in 1996, and certain other liabilities. Annual maturities of other long-term liabilities as of December 31, 2003 are as follows (in thousands): 2005 $280 2006 312 2007 311 2008 208 Thereafter 112 ------ Total other long-term liabilities $1,223 ====== F-24 NOTE 11. INCOME TAXES ------------------------ The Company's federal and state income tax expense (benefit) is as follows (in thousands):
YEARS ENDED DECEMBER 31, --------------------------------- 2003 2002 2001 ---------- ---------- --------- Currently payable: Federal $ 64 $ (120) $ -- State (17) (700) -- Deferred: Federal 860 -- -- State (22) -- -- Decrease in valuation allowance (5,725) -- -- ---------- ---------- --------- Total income tax expense (benefit) $ (4,840) $ (820) $ -- ========== ========== =========
The Company's taxable income for federal income tax purposes in 2003 was completely offset by net operating loss carryforwards from previous years, but the Company recognized a current federal income tax expense in 2003 due to the alternative minimum tax. The State of California suspended the use of net operating loss carryforwards to offset current taxable income in 2003 for all corporations, and accordingly, the Company recognized a current state income tax expense for 2003, which was more than offset by a decrease in the Company's accrual for estimated income tax liabilities related to certain transactions that occurred in prior years. The Company incurred net losses for federal and state income tax purposes during the years ended December 31, 2002 and 2001, primarily due to temporary differences that reduced the Company's income for tax purposes, and the fact that the Company's gain on the conversion of debt to equity in 2001 (see Note 9) was not taxable. The income tax benefit in 2002 primarily represents a decrease in the Company's accrual for estimated income tax liabilities related to certain transactions that occurred in prior years. In the fourth quarter of 2003, the Company reduced the valuation allowance on its net deferred tax assets by $5.7 million, based on its determination that this amount of the net deferred tax assets is more likely than not to be realized, primarily due to a significant improvement in the Company's reported operating results and its expected future operating results. Accordingly, the Company recognized deferred federal income tax expense and a deferred state income tax benefit in 2003. The Company's net deferred tax assets were fully reserved during the years ended December 31, 2002 and 2001, as the Company believed at that time that it was more likely than not that the net deferred tax assets would not be realized. Accordingly, the Company's deferred income tax expense in both of these years was completely offset by adjustments to decrease the valuation allowance against its net deferred tax assets. A reconciliation of the expected federal income tax expense (benefit) based on the statutory rate to the actual income tax expense (benefit) is as follows (in thousands):
YEARS ENDED DECEMBER 31, ------------------------------------------------------------ 2003 2002 2001 ------------------ -------------------- ------------------ AMOUNT % AMOUNT % AMOUNT % -------- -------- ---------- -------- --------- ------- Expected federal income tax expense $ 1,011 34.0% $ 206 34.0% $ 4,266 34.0% State income tax expense, net of effect on federal income tax 123 4.1 23 3.7 -- -- Amortization of goodwill -- -- -- -- 35 0.3 Other items (49) (1.6) 132 21.8 855 6.8 Decrease in income tax accrual (200) (6.7) (820) (135.1) -- -- Expiration of net operating loss carryforwards due to change of control -- -- -- -- 6,774 54.0 Change in valuation allowance (5,725) (192.6) (361) (59.5) (11,930) (95.1) -------- -------- ---------- -------- --------- ------- Actual income tax expense (benefit) $(4,840) (162.8)% $ (820) (135.1)% $ -- --% ======== ======== ========== ======== ========= =======
F-25 Deferred tax assets and liabilities are related to the following items (in thousands):
DECEMBER 31, ------------------ 2003 2002 ------- --------- Deferred tax assets: Net operating loss carryforward $2,612 $ 3,690 Depreciation and amortization 960 1,498 Accrued expenses 1,720 948 Capital loss carryforward 600 610 Other items 547 166 ------- --------- Total deferred tax assets 6,439 6,912 Deferred tax liabilities: State income taxes 253 321 Prepaid expenses 184 -- Other items 99 266 ------- --------- Total deferred tax liabilities 536 587 ------- --------- Net deferred tax assets 5,903 6,325 Valuation allowance (600) (6,325) ------- --------- Net deferred tax assets after valuation allowance $5,303 $ -- ======= =========
As noted above, the Company reduced the valuation allowance on its net deferred tax assets by $5.7 million in 2003. The Company evaluated all the available positive and negative evidence regarding whether it was more likely than not that the Company would realize the value of its net deferred tax assets in the future. As a result of this evaluation, the Company concluded that it is more likely than not that the Company will realize its net deferred tax assets. In reaching this conclusion, significant weight was given to the significant improvement in the Company's operating results, including its operating results for the two months ended December 31, 2003, during which time the Company's results included the operations of HN Dental and HN Vision. The remaining valuation allowance of $0.6 million as of December 31, 2003, is related to a deferred tax asset that represents an unused capital loss carryforward. The Company retained the valuation allowance on this deferred tax asset because the Company can only use the capital loss carryforward by offsetting it against capital gains, and there are no capital gains expected in the foreseeable future. Due to the conversion of outstanding debt into convertible preferred stock, as described in Note 9, there was a "change of control" of the Company for purposes of Internal Revenue Code Section 382, effective January 31, 2001. As a result, effective January 31, 2001, the amount of pre-existing net operating loss carryforwards that can be used to offset current taxable income on the Company's federal income tax return is limited to approximately $350,000 per year. As of December 31, 2003, the Company had net operating loss carryforwards for federal and state tax purposes of approximately $6.7 million and $5.2 million, respectively, which are net of the amounts that will expire unused due to the change of control limitation. The federal and state net operating loss carryforwards will begin to expire in 2020 and 2012, respectively. In 2003, as a result of the decrease in the valuation allowance on the Company's net deferred tax assets, the Company reduced the goodwill related to the acquisition of HN Dental and HN Vision in October 2003 by $1,010,000, and increased the goodwill related to the acquisition of Paramount in August 2002 by $594,000, to recognize the deferred tax assets and liabilities that were acquired in these transactions. See Note 5 for more information on goodwill. NOTE 12. COMMITMENTS AND CONTINGENCIES ------------------------------------------ LEASE COMMITMENTS The Company leases administrative office space and office equipment under a number of operating leases. Rent expense was $2,632,000, $2,960,000, and $3,465,000 in 2003, 2002, and 2001, respectively. The Company has subleased certain of its office space to unrelated third parties, which office space is subject to lease agreements for F-26 which the Company remains contingently liable in the event the sublessees fail to make the lease payments. Future minimum rental payments required under non-cancelable operating leases are as follows, net of payments the Company expects to receive pursuant to subleases (in thousands):
TOTAL EXPECTED NET LEASE SUBLEASE LEASE OBLIGATION PAYMENTS OBLIGATION ----------- ---------- ----------- 2004 $ 2,281 $ (183) $ 2,098 2005 2,093 (9) 2,084 2006 1,853 -- 1,853 2007 1,841 -- 1,841 2008 1,226 -- 1,226 Thereafter -- -- -- ----------- ---------- ----------- Total minimum payments $ 9,294 $ (192) $ 9,102 =========== ========== ===========
LITIGATION The Company is subject to various claims and legal actions arising in the ordinary course of business. The Company believes all pending claims either are covered by liability insurance maintained by the Company or by providers in the Company's network, or will not have a material adverse effect on the Company's consolidated financial position or results of operations. In December 1999, a stockholder lawsuit against the Company was filed, which alleged that the Company and certain of its officers, who were then in office, violated certain securities laws by issuing alleged false and misleading statements concerning the Company's publicly reported revenues and earnings during a specified class period. During 2002 the Company settled the lawsuit for a payment of $1.25 million to the plaintiffs, without an admission of liability. The settlement was approved by the District Court in September 2002, and the lawsuit has been dismissed with prejudice. The Company's insurer paid $1.0 million of the cost of the settlement, and the Company recorded a $250,000 expense during 2002, which is included in selling, general and administrative expenses in the accompanying consolidated statement of income. CONTINGENT LEASE OBLIGATIONS The Company sold all of its general dental practices and orthodontic practices in 1996, 1997 and 1998. The office lease agreements related to all of the practices sold by the Company either have been assigned to the respective purchasers of the practices, or have expired. In the case of the assigned leases, the Company is secondarily liable for the lease payments in the event the purchasers of those practices fail to make the payments. As of December 31, 2003, the total of the minimum annual payments under these leases was approximately $1.1 million, and the aggregate contingent liability of the Company related to these leases was approximately $2.0 million over the terms of the lease agreements, which expire at various dates through 2009. In the event the parties to which these lease agreements have been assigned defaulted on the leases, the aggregate contingent liability of approximately $2.0 million could be mitigated by the Company by subleasing the related office space to other parties, although there can be no assurance it would be able to do so. The aggregate contingent lease obligation of $2.0 million excludes $350,000 of estimated lease obligations that have been accrued as of December 31, 2003, due to the failure by one of the entities to make the lease payments under a lease that was assigned to that entity by the Company. This estimated lease obligation is included in the accompanying consolidated balance sheet under the caption "Accrued expenses." The Company has not been notified of any other defaults under these leases that would have a material effect on the Company's consolidated financial position. GUARANTEES AND INDEMNITIES As discussed above, the Company has contingent lease obligations under which it is secondarily liable for the lease payments under dental office leases that have been assigned to third parties. In the event those third parties fail to F-27 make the lease payments, the Company could be obligated to make the lease payments itself. The Company has purchased a letter of credit for $250,000 in connection with a certain customer agreement. In the event the Company fails to meet its financial obligations to the customer, the customer would be able to use the letter of credit to satisfy the Company's obligations, in which case the Company would be obligated to repay the issuer of the letter of credit. The Company also indemnifies its directors and officers to the maximum extent permitted by Delaware law. In addition, the Company makes indemnities to its customers in connection with the sale of dental and vision benefit plans in the ordinary course of business. The maximum amount of potential future payments under all of the preceding guarantees and indemnities cannot be determined. The Company has recorded no liabilities related to these guarantees and indemnities in the accompanying consolidated balance sheets, except as described above under "Contingent Lease Obligations." EMPLOYMENT AGREEMENT COMMITMENTS The Company has an employment agreement with one of its senior officers, which expires on August 30, 2005, and has severance agreements with certain other officers of the Company, which continue for as long as each officer remains employed by the Company. In the event there is a change in control of the Company, each officer with a severance agreement would receive a severance payment under certain circumstances, which is equal to that officer's annual salary then in effect, plus the amount of the bonus, if any, earned by the officer for the previous calendar year. The maximum aggregate commitment under the employment agreement and the severance agreements is approximately $3.2 million as of December 31, 2003. None of the future commitments under the employment agreement or the severance agreements are accrued as of December 31, 2003, as these commitments are all related to services to be performed by the officers subsequent to 2003. RETENTION BONUS PLAN In January 2003, the Company implemented a Retention Bonus Plan (the "Plan") with respect to certain senior executives of the Company. The purpose of the Plan is to provide an incentive for the senior management of the Company to remain employed during a reasonable transition period in the event of the sale of the Company to a third party. In the event that more than 50% of the Company is sold to an entity that is not otherwise a current stockholder of the Company, each eligible officer would receive a variable retention bonus that is based on the amount of proceeds from the sale transaction, subject to the officer remaining an employee of the Company for a specified period of time. The aggregate amount of retention bonuses paid by the Company under the Plan would be approximately $1.3 million for each $1.00 of proceeds per share of common stock realized by the Company's stockholders in a sale of the Company. EMPLOYEE RETIREMENT PLAN The Company maintains a retirement plan under Section 401(k) of the Internal Revenue Code (the "Plan"). Under the Plan, employees are permitted to make contributions to a retirement account through payroll deductions from pre-tax earnings. Employees are fully vested in contributions made from payroll deductions. In addition, the Company may, at its discretion, make additional contributions to the Plan. The Company made $118,000, $87,000 and $51,000 of matching contributions to the Plan for the years ended December 31, 2003, 2002 and 2001, respectively, in the form of 73,000 shares, 66,000 shares and 33,000 shares of its common stock, respectively. Of the total of 73,000 shares of common stock related to 2003, 55,000 shares were contributed in 2003, and an additional 18,000 shares were contributed in 2004, the value of which is included in accrued expenses as of December 31, 2003. Employees become vested in the matching contributions at the rate of 20% per year during the first five years of employment with the Company, with employees receiving credit for past years of service. There are no restrictions on the ability of employees to liquidate the Company's common stock that is credited to their account, except for vesting requirements. PROFESSIONAL LIABILITY INSURANCE The Company maintains professional liability insurance that covers losses on a claims-made basis. The Company's professional liability insurance policy provides $5 million of coverage and has an aggregate deductible of $250,000. F-28 GOVERNMENT REGULATION The dental benefits industry is subject to extensive state and local laws, rules and regulations. Several of the Company's operating subsidiaries are subject to various requirements imposed by state laws and regulations related to the operation of a dental or vision HMO plan or an insurance company, including the maintenance of a minimum amount of net worth and compliance with numerous other financial requirements. In addition, regulations applicable to dental or vision benefit plans could be changed in the future. There can be no assurance that the Company will be able to meet all applicable regulatory requirements in the future. During the years ended December 31, 2003, 2002 and 2001, certain of the Company's subsidiaries were not in compliance with regulatory requirements that limit the amount of the subsidiary's administrative expenses as a percentage of its premium revenue. The Company has discussed this noncompliance with the applicable regulatory agencies, and those agencies have taken no action with respect to this noncompliance. The Company believes these instances of noncompliance with regulatory requirements will have no significant effect on its consolidated financial statements. HEALTH INSURANCE PORTABILITY AND ACCOUNTABILITY ACT OF 1996 ("HIPAA") HIPAA imposes various responsibilities on the Company, including but not limited to, the issuance of privacy notices to members of the Company's benefit plans, the security and privacy of individually identifiable health information, the use of unique identifiers for all of the contractual relationships the Company has with members, providers and group and individual contract holders, the adoption of standardized electronic transaction code sets, and prevention of unauthorized use or disclosure of personal data maintained by the Company. The Company has developed policies and procedures to comply with these requirements and has provided privacy notices as required by HIPAA and the Gramm-Leach-Bliley Act. CONCENTRATIONS OF CREDIT RISK Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of bank deposits, investments and accounts receivable. As of December 31, 2003, the Company had bank deposits that were approximately $7.0 million in excess of the amounts insured by the Federal Deposit Insurance Corporation. The Company's investments consist entirely of high-quality marketable securities. NOTE 13. CAPITAL STOCK ------------------------- CONVERTIBLE PREFERRED STOCK The convertible preferred stock does not accrue dividends of any kind, but participates in any dividends paid on the Company's common stock on an as-converted basis. Each share of convertible preferred stock is convertible into one share of common stock at the option of the holder. The convertible preferred stock entitles the holder to one vote for each share of common stock into which the preferred stock is convertible, with respect to all matters voted on by the common stockholders of the Company, except for the election of directors. The holders of the convertible preferred stock have the right to elect a total of five members of the board of directors, and the holders of the common stock have the right to elect the remaining two directors. In the aggregate, the convertible preferred stock has a $30 million liquidation preference over the Company's common stock. Prior to May 2002, there were 300,000 shares of convertible preferred stock issued and outstanding. Each share had a par value of $100 and a liquidation preference of $100, and was convertible into 100 shares of the Company's common stock. In May 2002, each outstanding share of convertible preferred stock was exchanged for 100 new shares of convertible preferred stock. Each new share of convertible preferred stock has a par value of $1.00 and a liquidation preference of $1.00, and is convertible into one share of the Company's common stock. All other rights and preferences of the convertible preferred stock remained the same. All references to the convertible preferred stock in the accompanying consolidated financial statements reflect the effects of this exchange on a retroactive basis. F-29 TREASURY STOCK AND STOCK REPURCHASES As of December 31, 2003 and 2002, the Company had 3,216,978 shares of treasury stock, which were acquired by the Company for an aggregate of $17.8 million. In December 2000, the board of directors of the Company authorized management to repurchase up to 500,000 shares of the Company's outstanding common stock, of which 10,000 shares had been repurchased as of December 31, 2003. PENDING REVERSE STOCK SPLIT In November 2003 the Company's board of directors approved a reverse stock split and certain related transactions, pursuant to which: (i) each 1,500 shares of the Company's outstanding common stock would be converted into one share of new common stock; (ii) the Company would pay cash for fractional shares that result from the reverse stock split at the rate of $2.25 per share of existing common stock; (iii) the Company would acquire all the shares of its common stock that are held by the Company's 401(k) retirement plan (approximately 172,000 shares) for a price of $2.25 per share of existing common stock; (iv) each outstanding option to purchase 1,500 shares of common stock would be converted into an option to purchase one share of new common stock, at an exercise price per share that is equal to 1,500 times the existing exercise price per share; and (v) the Company would pay cash equal to the excess, if any, of $2.25 per existing share over the existing exercise price per share, for the fractional options that result from the reverse split. The purpose of the reverse stock split is to reduce the number of the Company's stockholders below 300, after which the Company intends to de-register its common stock with the United States Securities and Exchange Commission and cease being a publicly traded company. The Company estimates the aggregate cost of the reverse stock split and related transactions to be approximately $1.2 million, including the cost of acquiring shares of stock and fractional stock options and transaction expenses. The reverse stock split and related transactions are currently pending stockholder approval. STOCKHOLDER RIGHTS PLAN In March 1996, the board of directors of the Company declared a dividend of one right to purchase a fraction of a share of its Series A Junior Participating Preferred Stock, having rights, preferences, privileges and restrictions as designated, and under certain circumstances, other securities, for each outstanding share of the Company's common stock (the "Rights"). The dividend was distributed to stockholders of record at the close of business on April 12, 1996. The Rights become exercisable upon the occurrence of certain defined events related to a possible change of control of the Company. The description and terms of the Rights are set forth in a Rights Agreement, dated as of March 22, 1996, as amended, between the Company and American Stock Transfer and Trust Company, as Rights Agent. The Rights Agreement may be amended by the Company's board of directors without the approval of the Rights holders, at any time prior to the Rights becoming exercisable. The Rights Agreement was amended in March 2000 to specify that the recapitalization transaction initiated in March 2000 would not cause the Rights to become exercisable. STOCK OPTION PLAN The Company has a stock option plan (the "Plan") that authorizes the granting of both incentive and non-qualified stock options to purchase an aggregate of 4,000,000 shares of common stock. Either incentive or non-qualified stock options may be granted to executive officers and other employees of the Company. Only non-qualified stock options may be granted to non-employee directors of the Company. Under the Plan, the exercise price of any stock option granted must be at least equal to the market value of the Company's common stock on the date the option is granted. The Compensation and Stock Option Committee of the board of directors of the Company administers the Plan. F-30 The following is a summary of stock options outstanding as of December 31, 2003:
TOTAL STOCK OPTIONS OUTSTANDING STOCK OPTIONS EXERCISABLE -------------------------------------------- ----------------------------- RANGE OF WEIGHTED WEIGHTED WEIGHTED EXERCISE NUMBER AVERAGE AVERAGE NUMBER AVERAGE PRICES OF SHARES REMAINING LIFE EXERCISE PRICE OF SHARES EXERCISE PRICE ---------------- ----------- -------------- --------------- ------------ --------------- $ 1.00 - 1.46 2,642,334 6.9 years $ 1.09 2,130,228 $ 1.06 1.50 - 2.00 290,000 8.7 years 1.58 80,004 1.50 9.00 - 15.75 8,000 3.5 years 10.64 8,000 10.64 ----------- ------------ Total 2,940,334 7.1 years $ 1.17 2,218,232 $ 1.11 =========== ============
The following is a summary of activity in stock options:
YEARS ENDED DECEMBER 31, ------------------------------------- 2003 2002 2001 ----------- ----------- ----------- Outstanding at beginning of year 2,725,834 2,614,500 2,216,300 Stock options granted 220,000 404,500 805,000 Stock options exercised -- (48,332) (43,332) Stock options canceled (5,500) (244,834) (363,468) ----------- ----------- ----------- Outstanding at end of year 2,940,334 2,725,834 2,614,500 =========== =========== =========== Exercisable at end of year 2,218,232 1,319,142 616,107 Available to issue 1,059,666 874,166 385,500 Weighted average exercise price of options granted $ 1.59 $ 1.24 $ 1.26 Weighted average exercise price of options exercised -- 1.00 1.00 Weighted average exercise price of options canceled 10.91 1.16 3.81 Weighted average exercise price of options outstanding 1.17 1.15 1.14 Weighted average exercise price of options exercisable 1.11 1.15 1.23
NOTE 14. INVESTMENT AND OTHER INCOME ----------------------------------------- Investment and other income consists of the following (in thousands):
YEARS ENDED DECEMBER 31, ------------------------------- 2003 2002 2001 --------- --------- --------- Investment income, including realized gains $ 226 $ 318 $ 1,046 Other income, net 264 289 14 --------- --------- --------- Total investment and other income $ 490 $ 607 $ 1,060 ========= ========= =========
F-31 NOTE 15. UNAUDITED SELECTED QUARTERLY INFORMATION ---------------------------------------------------- QUARTERLY RESULTS OF OPERATIONS Unaudited quarterly results of operations for the years ended December 31, 2003 and 2002 are shown below (in thousands, except per share data). This information was derived from the Company's unaudited interim financial statements, which were prepared on the same basis as the accompanying consolidated financial statements for the years ended December 31, 2003 and 2002, and include all necessary adjustments, which consist only of normal recurring adjustments. The unaudited quarterly results should be read in conjunction with the accompanying audited consolidated financial statements.
YEAR ENDED DECEMBER 31, 2003 ------------------------------------------- FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER --------- --------- --------- ---------- Premium revenue, net $ 21,912 $ 23,129 $ 23,009 $ 36,841 Health care services expense 15,093 15,947 16,118 26,036 Selling, general and administrative expense 6,354 6,565 6,243 9,522 --------- --------- --------- ---------- Operating income 465 617 648 1,283 Investment and other income 79 79 73 259 Interest expense (100) (86) (76) (268) --------- --------- --------- ---------- Income before income taxes 444 610 645 1,274 Income tax expense -- 60 81 (4,981) --------- --------- --------- ---------- Net income $ 444 $ 550 $ 564 $ 6,255 ========= ========= ========= ========== Basic net income per share $ 0.01 $ 0.02 $ 0.02 $ 0.18 Weighted average basic shares outstanding 35,693 35,711 35,729 35,741 Diluted net income per share $ 0.01 $ 0.02 $ 0.02 $ 0.14 Weighted average diluted shares outstanding 35,989 36,366 36,421 46,228
FOURTH QUARTER ADJUSTMENTS IN 2003 During the fourth quarter of 2003, the Company recorded a $5.0 million income tax benefit, which primarily represents a decrease in the valuation allowance for the Company's net deferred tax assets and a decrease in the Company's accrual for estimated income tax liabilities related to certain transactions that occurred in prior years, as discussed in Note 11. F-32
YEAR ENDED DECEMBER 31, 2002 -------------------------------------------- FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER --------- --------- ---------- ---------- Premium revenue, net $ 20,688 $ 20,174 $ 20,682 $ 21,499 Health care services expense 14,550 14,676 14,546 14,165 Selling, general and administrative expense 5,839 5,777 6,040 6,884 Loss on impairment of assets -- -- -- 334 --------- --------- ---------- ---------- Operating income (loss) 299 (279) 96 116 Investment and other income 116 103 92 296 Interest expense (7) (24) (84) (117) --------- --------- ---------- ---------- Income (loss) before income taxes 408 (200) 104 295 Income tax expense -- -- -- (820) --------- --------- ---------- ---------- Net income (loss) $ 408 $ (200) $ 104 $ 1,115 ========= ========= ========== ========== Basic net income (loss) per share $ 0.01 $ (0.01) $ 0.00 $ 0.03 Weighted average basic shares outstanding 34,812 34,857 35,161 35,677 Diluted net income (loss) per share $ 0.01 $ (0.01) $ 0.00 $ 0.03 Weighted average diluted shares outstanding 35,568 34,857 35,526 36,010
FOURTH QUARTER ADJUSTMENTS IN 2002 During the fourth quarter of 2002, the Company recorded an $820,000 income tax benefit, which primarily represents a decrease in the Company's accrual for estimated income tax liabilities related to certain transactions that occurred in prior years, as discussed in Note 11. During the fourth quarter of 2002, the Company also increased the bad debt reserve on its notes receivable by $334,000 to reduce the carrying value of those notes to their estimated realizable values. F-33
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001 (IN THOUSANDS) BALANCE AT CHARGED TO CHARGED TO BALANCE AT BEGINNING COSTS AND OTHER END OF YEAR EXPENSES ACCOUNTS WRITE-OFFS OF YEAR ----------- ----------- ----------- ------------ ----------- YEAR ENDED DECEMBER 31, 2001: Allowance for doubtful accounts: Accounts receivable $ 868 $ 245 $ -- $ (605) $ 508 Long-term notes receivable $ 2,806 $ -- $ -- $ (2,339) $ 467 YEAR ENDED DECEMBER 31, 2002: Allowance for doubtful accounts: Accounts receivable $ 508 $ 220 $ -- $ (403) $ 325 Long-term notes receivable $ 467 $ 334 $ -- $ -- $ 801 YEAR ENDED DECEMBER 31, 2003: Allowance for doubtful accounts: Accounts receivable $ 325 $ 476 $ -- $ (257) $ 544 Long-term notes receivable $ 801 $ -- $ -- $ (21) $ 780
F-34