10-K405/A 1 d86437ae10-k405a.txt AMENDMENT NO.1 TO FORM 10-K - FISCAL END 12/31/00 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K/A Amendment No. 1 [X] Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended December 31, 2000, or [ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from _______ to _______. Commission File No.: 001-13457 ORTHODONTIC CENTERS OF AMERICA, INC. ------------------------------------ (Exact name of registrant as specified in its charter) DELAWARE 72-1278948 -------------------------------------------------------------- ---------------------------------------------- (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 3850 N. Causeway Boulevard, Suite 1040 Metairie, Louisiana 70002 -------------------------------------------------------------- ---------------------------------------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (504) 834-4392 ---------------------------------------------- Securities registered pursuant to Section 12(b) of the Act: Title of Each Class Name of Each Exchange on Which Registered -------------------------------------------------------------- ---------------------------------------------- COMMON STOCK, $.01 PAR VALUE PER SHARE NEW YORK STOCK EXCHANGE
Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $.01 PAR VALUE PER SHARE -------------------------------------- (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark if 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 the 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 shares of the Registrant's Common Stock held by non-affiliates of the Registrant on March 30, 2001 was approximately $874.9 million, based upon the last reported sale price per share of the Registrant's Common Stock as reported on the New York Stock Exchange on March 30, 2001. As of March 30, 2001, there were approximately 49,148,109 outstanding shares of the Registrant's Common Stock. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's definitive Proxy Statement relating to the Annual Meeting of Stockholders of the Registrant to be held during 2001 are incorporated by reference into Part III of this Report. 2 EXPLANATORY NOTE: This amendment is being filed to insert information about our office space in Japan that was inadvertently omitted in "Item 2. Properties," to clarify the second paragraph of "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Overview," to correct certain percentages of net revenue represented by line items in our Consolidated Statements of Income and the pro forma operating profit and pro forma provision for income taxes for 1999 reported in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Results of Operations" and to correct basic net income per share for 2000 reported in "Item 8. Financial Statements and Supplementary Data -- Consolidated Statements of Income" and additional paid-in-capital at December 31, 2000 reported in "Item 8. Financial Statements and Supplementary Data -- Consolidated Statements of Shareholders' Equity." PART I ITEM 2. PROPERTIES We lease an average of between 2,200 and 2,500 square feet of office space for each of our affiliated orthodontic centers. The typical lease for office space is for a term of approximately five years, and generally provides for renewal options for additional years. The average rental payment is approximately $2,600 per month. As demand for orthodontic services has increased in a particular market, we have leased and developed new affiliated orthodontic centers in that market rather than expand its existing orthodontic centers, because the size of each affiliated orthodontic center, particularly those located in shopping malls, has been limited. We lease approximately 16,650 square feet of corporate office space, about 2,300 square feet of which is currently leased to another tenant, in Ponte Vedra Beach, Florida under a lease which expires in June 2010. We also maintain a corporate office in approximately 5,300 square feet of office space in Metairie, Louisiana under a lease which expires in October 2005. We maintain two corporate offices in Japan, in approximately 1,100 and 710 square feet of office space under leases expiring in April 2001 and September 2002, respectively. 2 3 PART II ITEM 6. SELECTED FINANCIAL AND OPERATING DATA In the table below, we provide you with our selected financial and operating data. We have prepared the statement of income and balance sheet data using our consolidated financial statements for the five years ended December 31, 2000. When you read this selected financial and operating data, it is important that you read along with it the historical financial statements and related notes included elsewhere in this Report, as well as the section of this Report captioned "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
YEAR ENDED DECEMBER 31, ---------------------------------------------------------- 1996 1997 1998 1999 2000 --------- --------- --------- --------- --------- STATEMENT OF INCOME DATA: (IN THOUSANDS, EXCEPT PER SHARE DATA) Net revenue ...................................... $ 71,273 $ 117,326 $ 171,298 $ 226,290 $ 268,836 --------- --------- --------- --------- --------- Direct expenses: Employee costs ................................. 19,895 33,429 46,878 61,224 78,051 Orthodontic supplies ........................... 5,428 8,789 13,287 17,136 21,274 Rent ........................................... 6,114 10,299 14,128 18,624 23,973 Marketing and advertising ...................... 6,644 9,855 15,491 16,874 22,001 --------- --------- --------- --------- --------- Total direct expenses ............................ 38,081 62,372 89,784 113,858 145,299 General and administrative ....................... 8,703 13,356 18,104 23,270 28,360 Depreciation and amortization .................... 2,814 5,640 9,124 12,238 15,175 --------- --------- --------- --------- --------- Operating profit ................................. 21,675 35,958 54,286 76,924 80,002 Interest (expense) income, net ................... 1,935 1,143 280 (2,204) (3,731) --------- --------- --------- --------- --------- Income before income taxes ....................... 23,610 37,101 54,566 74,720 76,271 Provision for income taxes ....................... 9,208 14,469 20,753 28,206 28,549 --------- --------- --------- --------- --------- Income before cumulative effect of changes in accounting principles ............ 14,402 22,632 33,813 46,514 47,772 Cumulative effect of changes in benefit accounting principles, net of income tax benefit (1)(2)... -- -- -- (678) (50,576) --------- --------- --------- --------- --------- Net income (loss) ................................ $ 14,402 $ 22,632 $ 33,813 $ 45,836 $ (2,854) ========= ========= ========= ========= ========= Net income per share before cumulative effect of changes in accounting principles (3) ........ $ .33 $ .50 $ .70 $ .96 $ .96 Cumulative effect of changes in accounting principles, net of income tax benefit, per share(1)(2) .................................... -- -- -- (.02) (1.02) --------- --------- --------- --------- --------- Net income (loss) per share (3) .................. $ .33 $ .50 $ .70 $ .94 $ (.06) ========= ========= ========= ========= ========= Weighted average shares outstanding (3) .......... 43,708 45,414 48,502 48,643 49,845 Pro forma net income for change in accounting principle adopted effective January 1, 2000 (2)(4) ........................ $ 8,288 $ 12,013 $ 22,276 $ 32,326 N/A Pro forma net income per share for change in accounting principle adopted effective January 1, 2000 (2)(4) ........................ $ .19 $ .26 $ .46 $ .66 N/A
YEAR ENDED DECEMBER 31, ------------------------------------------------------------- 1996 1997 1998 1999 2000 --------- --------- --------- --------- --------- OPERATING DATA: (IN THOUSANDS, EXCEPT PERCENTAGE AND PER SHARE DATA) Number of orthodontic centers (5) ..................... 247 360 469 537 592 Comparable orthodontic center net revenue growth (6) ......................................... 22.2% 20.0% 19.2% 20.1% 22.6%(7) Total case starts ..................................... 44,910 70,611 95,377 126,307 160,639
3 4
AS OF DECEMBER 31, ---------------------------------------------------- 1996 1997 1998 1999 2000 -------- -------- -------- -------- -------- BALANCE SHEET DATA: (IN THOUSANDS) Cash and cash equivalents ................... $ 11,827 $ 9,865 $ 1,601 $ 5,822 $ 4,690 Working capital ............................. 40,219 68,243 59,634 102,276 39,573 Total assets(8) ............................. 142,460 224,805 292,472 362,816 367,947 Total debt .................................. 3,397 10,393 31,332 58,793 61,001 Total equity ................................ 114,887 190,740 231,159 278,527 287,196
-------------- (1) See Note 2 to our Consolidated Financial Statements included elsewhere in this Report for information regarding the cumulative effect of a change in accounting principle effective January 1, 1999 related to Statement of Position 98-5, "Reporting on the Costs of Start-Up Activities." (2) See Note 2 to our Consolidated Financial Statements included elsewhere in this Report for information regarding the cumulative effect of a change in accounting principle effective January 1, 2000 related to revenue recognition and Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). (3) These amounts represent the full dilutive effect of the exercise of common equivalent shares (stock options) outstanding during the year. See Note 6 to our Consolidated Financial Statements included elsewhere in this Report. (4) Pro forma amounts were calculated assuming our change in revenue recognition effective January 1, 2000 pursuant to SAB 101 had been in effect for all periods presented. (5) These amounts are presented as of the end of the period. (6) These amounts represent the growth in net revenue in the indicated period relative to the comparable prior-year period by orthodontic centers that were affiliated with us throughout each of the two periods being compared. There were 53 of these comparable orthodontic centers in 1995, 75 in 1996, 130 in 1997, 227 in 1998, 332 in 1999, and 469 in 2000. The amount of that growth has been significantly affected by the number of newly-opened orthodontic centers included in the computation, because newly-opened orthodontic centers have experienced significant growth during their first 26 months of operations. The average term of a patient contract is about 26 months. Our affiliated orthodontic centers have typically reached maturity as patients are added during the first 26 months of operations. (7) This amount represents the growth in net revenue in 2000 for orthodontic centers open throughout 1999 and 2000, compared to pro forma net revenue for these centers in 1999, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Revenue Recognition." (8) To conform to the balance sheet presentation as of December 31, 2000, amounts reported as of December 31, 1996, 1997, 1998 and 1999 as patient prepayments (previously reported as a liability) have been reclassified as a reduction of service fees receivable. 4 5 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Dr. Gasper Lazzara, Jr. and Bartholomew F. Palmisano, Sr. established our business in 1985. At December 31, 2000, we provided integrated business services to 592 orthodontic centers with 395 affiliated orthodontists throughout the United States and in Japan, Mexico and Puerto Rico. During 2000, our net revenue increased 18.8% to $268.8 million, from $226.3 million in 1999. Our net income before the cumulative effect of a change in accounting principle increased 2.5% during 2000 to $47.7 million, which excluded the effects of a $50.6 million charge, net of tax benefit, taken in 2000 to reflect the cumulative effect of a change in accounting principle related to revenue recognition, from $46.5 million in 1999, which excluded the effects of a $678,000 charge, net of tax benefit, taken in 1999 to reflect the cumulative effect of a change in accounting principle related to start-up activities. During 2000, our affiliated orthodontists initiated treatment of about 160,639 patients, an increase of 27.2% from about 126,307 patients during 1999, representing initial new patient contract balances of $494.1 million for 2000, an increase of 33.9% from $369.1 million for 1999. As of December 31, 2000, our affiliated orthodontists were treating a total of about 343,373 patients, an increase of 28.1% from about 267,965 patients at December 31, 1999. The following table provides information about the growth in the number of our affiliated orthodontic centers for the periods shown:
YEAR ENDED DECEMBER 31, ------------------------------------------------------- 1996 1997 1998 1999 2000 -------- -------- -------- -------- -------- Number of centers at beginning of period ......... 145 247 360 469 537 Number of centers developed during period ........ 53 58 54 36 18 Number of centers acquired during period ......... 68 78 66 32 45 Number of centers consolidated during period ..... (19) (23) (11) -- (8) -------- -------- -------- -------- -------- Number of centers at end of period ............... 247 360 469 537 592 ======== ======== ======== ======== ========
Of the 592 orthodontic centers at December 31, 2000, 306 were developed by us and 361 were existing orthodontic practices whose assets we acquired, of which 75 were consolidated into another orthodontic center. We expect that future growth in the number of our affiliated orthodontic centers will come from both developing orthodontic centers with existing and newly recruited orthodontists and acquiring the assets of, and affiliating with, existing orthodontic practices. Generally, when we develop a new orthodontic center, all patients treated at the orthodontic center are new patients and, in the first several months after commencing operations, the orthodontic center is open only for a limited number of days each month as new patients are added. Our affiliated orthodontic centers have generally become increasingly more productive and profitable as more new patients are added and existing patients return for monthly follow-up visits. After 26 months of operations, an orthodontic center's growth in patient base has typically begun to stabilize as the initial patients complete treatment. At that point, an orthodontic center can increase the number of patients treated by improving the efficiency of its clinical staff, increasing patient treatment intervals and adding operating days or orthodontists. Our affiliated orthodontic centers may also increase revenue by implementing periodic price increases. Established practices with which we have affiliated have typically increased their revenue by applying our operating strategies and systems, including increased advertising and efficient patient scheduling. AGREEMENTS WITH AFFILIATED ORTHODONTISTS We provide a wide range of services to our affiliated orthodontists under either a service agreement or a consulting agreement. The specific form of the agreement is based upon the dental regulatory provisions of the particular state in which an orthodontic center is located. The service agreement is used in the majority of states, with some minor variations from state to state. The consulting agreement, also with some variations from state to state, is used in 5 6 states with particularly stringent laws relating to the practice of dentistry. We enter into a separate service or consulting agreement with each affiliated orthodontic practice owner. If an affiliated orthodontist operates his or her practice through a professional corporation or association or other similar entity, that entity is a party to the agreement, as well as the affiliated orthodontist. Under the service agreement, we provide our affiliated orthodontists with a comprehensive range of business services in exchange for monthly service fees, which are described in "--Revenue Recognition" below. The types of services we provide to affiliated orthodontists under the consulting agreements are generally similar to the services we provide under the service agreements. However, rather than being based on a percentage of patient contract balances, the service fees paid to us by the affiliated orthodontists under the consulting agreements are a combination of, depending on the service being performed, "cost-plus" types of fees, flat monthly fees and hourly fees. Among other differences from the service agreements, some consulting agreements have shorter terms than the service agreements, some do not give us a right to purchase the orthodontist's interest in the practice assets following termination, no matter the reason, and some require more limited non-competition agreements from the affiliated orthodontist after termination of the consulting agreement than do most of the service agreements. In addition, the consulting agreements emphasize that the affiliated orthodontist has ultimate control and authority over his or her practice's business management, including such matters as advertising, hiring and termination of staff and the purchase of equipment and supplies. During 2000, net revenue that was attributable to service agreements totaled $256.7 million, or 95.5% of net revenue, and net revenue that was attributable to consulting agreements totaled $12.1 million, or 4.5% of net revenue. During 1999, net revenue that was attributable to service agreements totaled 95.7% of net revenue, and net revenue that was attributable to consulting agreements totaled 4.3% of net revenue. During 1998, net revenue that was attributable to service agreements totaled 95.3% of net revenue, and net revenue that was attributable to consulting agreements totaled 4.7% of net revenue. During 2000, the operating margin, or operating profit as a percentage of net revenue, for net revenue attributable to service agreements was comparable to that for net revenue attributable to consulting agreements, with an operating margin for net revenue attributable to service agreements of 29.8% and an operating margin for net revenue attributable to consulting agreements of 29.3%. During 1999, the operating margin for net revenue attributable to service agreements was 34.3% and the operating margin for net revenue attributable to consulting agreements was 26.6%, due to the addition of new orthodontic centers affiliated under consulting agreements that were not operating at full capacity. During 1998, the operating margin for net revenue attributable to service agreements was 32.7% and the operating margin for net revenue attributable to consulting agreements was 12.0%, due to the addition of new orthodontic centers affiliated under consulting agreements that were not operating at full capacity. The change in operating margin from 1999 to 2000 was primarily due to the effect on net revenue for 2000 from our change in net revenue recognition policy effective January 1, 2000. See "--Results of Operations" below. REVENUE RECOGNITION Effective January 1, 2000, we changed our net revenue recognition pursuant to Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). SAB 101 summarizes certain of the Securities and Exchange Commission staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. Effective January 1, 2000, we recognize net revenue based on a straight-line allocation of patient contract revenue over the terms of the patient contracts (which average about 26 months), minus the portion of that straight-line allocation retained or to be retained by our affiliated orthodontists. Amounts retained or to be retained by an affiliated orthodontist are estimated using the percentage of practice operating profits that may be retained by the orthodontist under his or her service agreement. Amounts retained or that may be retained by an affiliated orthodontist equal the orthodontist's proportionate share of the straight-line allocation of patient contract revenue that is collected during the relevant period and the orthodontist's proportionate share of patient receivables representing any remaining portion of that allocation, minus any operating losses, depreciation, interest on outstanding loans, bad debt or other expenses that we have incurred but for which we have not been reimbursed by the orthodontist. These unreimbursed expenses reduce amounts retained by an affiliated orthodontist only up to the amounts that would otherwise be retained by the orthodontist. Any remaining unreimbursed expenses would reduce amounts retained or to be retained by the orthodontist in subsequent periods. The cumulative effect of this change in accounting principle was about $50.6 million, net of income tax, which is reflected in our results of operations for 2000. The cumulative effect of the change was also reflected in a reduction in service fee receivables, net of allowance for uncollectible amounts, to $35.4 million as of December 31, 2000 from $87.6 million as of December 31, 1999. The pro forma net income amounts presented in "Item 6. Selected Financial and Operating Data" and in our consolidated statement of operations were calculated assuming that the change in accounting principle pursuant to SAB 101 was effective throughout all periods presented. For periods prior to January 1, 2000, we recognized net revenue consistent with the proportion of services that we provide our affiliated orthodontists during the term of a patient's course of treatment and the general terms of our service agreements with affiliated orthodontists. We believe that at least 24% of the services we and our employees, including orthodontic assistants and other center staff, provide our affiliated orthodontists, including staffing, supplies and inventory, computer and management information systems, scheduling, billing and accounting services, relate to the first month of the term of our affiliated orthodontists' patient contracts. Our service agreements generally provide for monthly service fees based upon the result of approximately 24% of each new patient contract 6 7 balance during the first month of the term of the patient contract, plus the balance of the patient contract balance allocated equally over the remaining term of the patient contract (which averages 26 months), minus amounts retained by the affiliated orthodontist. The amounts retained by an affiliated orthodontist are based on a percentage of the operating profit of the orthodontist's practice on a cash basis, generally cash collections minus expenses during the period. Amounts retained by an affiliated orthodontist who operates a newly developed orthodontic center are typically reduced by operating losses on a cash basis because of start-up expenses. For periods prior to January 1, 2000, we recognized net revenue attributable to an affiliated orthodontist's share of these operating losses in the period during which the operating losses were incurred, with such net revenue totaling about $4.0 million during 1999 and $4.7 million during 1998. EXPENSES Operating expenses of our affiliated orthodontic centers are our expenses and are recognized as incurred. Employee costs consist of wages, salaries and benefits paid to all of our employees, including orthodontic assistants, business staff and management personnel. General and administrative expenses consist of provision for losses on receivables, professional service fees, maintenance and utility costs, office supply expense, telephone expense, taxes, license fees, printing expense and shipping expense. EMERGING ISSUES TASK FORCE ISSUE NO. 97-2 We do not have a controlling financial interest in our affiliated orthodontists' practices. In accordance with guidance in Emerging Issues Task Force No. 97-2, we do not consolidate the patient revenue and other operations and accounts of our affiliated orthodontists within our financial statements. 7 8 RESULTS OF OPERATIONS The following table provides information about the percentage of net revenue represented by some of the items in our consolidated statements of income. Information for 2000 includes the effect of the change in revenue recognition we adopted effective January 1, 2000.
YEAR ENDED DECEMBER 31, ----------------------------------------- 1998 1999 2000 -------- -------- -------- Net revenue ...................................... 100.0% 100.0% 100.0% Direct expenses: Employee costs ................................. 27.4 27.1 29.0 Orthodontic supplies ........................... 7.8 7.6 7.9 Rent ........................................... 8.2 8.2 8.9 Marketing and advertising ...................... 9.0 7.5 8.2 -------- -------- -------- Total direct expenses .................. 52.4 50.4 54.0 General and administrative ....................... 10.6 10.3 10.6 Depreciation and amortization .................... 5.3 5.4 5.6 -------- -------- -------- Operating profit ................................. 31.7 33.9 29.8 Interest (income) expense ........................ (0.2) 1.0 1.4 -------- -------- -------- Income before income taxes ....................... 31.9 32.9 28.4 Provision for income taxes ....................... 12.2 12.5 10.6 -------- -------- -------- Income before cumulative effect of changes in accounting principles ....................... 19.7 20.4 17.8 -------- -------- -------- Cumulative effect of changes in accounting principles, net of income tax benefit ........... -- 0.2 (18.8) -------- -------- -------- Net income (loss)................................. 19.7% 20.4% (1.0)% ======== ======== ========
2000 COMPARED TO 1999 NET REVENUE Net revenue increased $42.5 million, or 18.8%, to $268.8 million for 2000 from $226.3 million for 1999. We attribute $28.8 million of this increase to the growth in net revenue of orthodontic centers open throughout both periods and $13.7 million of this increase to orthodontic centers opened since January 1, 1999. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, net revenue increased $63.2 million, or 30.7%, to $268.8 million for 2000 from $205.6 million for 1999. The number of patient contracts increased to about 343,370 at December 31, 2000 from about 267,965 at December 31, 1999. EMPLOYEE COSTS Employee costs increased $16.9 million, or 27.6%, to $78.1 million for 2000 from $61.2 million for 1999. As a percentage of net revenue, employee costs increased to 29.0% for 2000 from 27.1% for 1999, due to the effect on net revenue for 2000 from our change in net revenue recognition policy effective January 1, 2000 pursuant to SAB 101, which offset capacity efficiencies achieved through general changes to patient treatment schedules by our affiliated orthodontists which resulted in fewer treatments per patient contract and lower employee costs per patient. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, employee costs decreased as a percentage of net revenue to 29.0% for 2000 from 29.8% for 1999, due to capacity efficiencies achieved through general changes to patient treatment schedules by our affiliated orthodontists which resulted in fewer treatments per patient contract and lower employee costs per patient. As a result of developments in orthodontic technology, a patient may be seen every six to eight weeks, rather than the traditional four weeks, without compromising quality of care. Consistent with industry trends, our affiliated orthodontists have begun increasing the intervals between patient treatments. During 2000, patients in our affiliated orthodontic centers averaged 43.6 days between office visits, compared to an average of 39.3 days during 1999. This increase in patient treatment interval reduces the number of office visits during the term of a patient's treatment, which continues to average about 26 months, and results in lower employee costs per patient. The increased interval does not, however, reduce the amount of treatment fees per patient. Therefore, the increased interval reduces the employee costs incurred with respect to an individual patient relative to the patient's treatment fee. ORTHODONTIC SUPPLIES Orthodontic supplies expense increased $4.1 million, or 24.0%, to $21.2 million for 2000 from $17.1 million for 1999. As a percentage of net revenue, orthodontic supplies expense increased to 7.9% for 2000 from 7.6% for 1999, due to the effect on net revenue for 2000 from our change in revenue recognition effective January 1, 8 9 2000 pursuant to SAB 101, which offset cost improvements attained through bulk purchasing and our proprietary inventory control and ordering system. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, orthodontic supplies expense, as a percentage of net revenue, decreased to 7.9% for 2000 from 8.3% for 1999. RENT Rent expense increased $5.4 million, or 29.0%, to $24.0 million for 2000 from $18.6 million for 1999. We attribute the increase in this expense to orthodontic centers affiliated, opened or relocated after 1999. As a percentage of net revenue, rent expense increased to 8.9% for 2000 from 8.2% for 1999. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, rent expense decreased slightly as a percentage of net revenue to 8.9% for 2000 from 9.1% for 1999. MARKETING AND ADVERTISING Marketing and advertising expense increased $5.1 million, or 30.2%, to $22.0 million for 2000 from $16.9 million for 1999. The increase in this expense resulted primarily from increases in marketing and advertising related to growth in net revenue for existing orthodontic centers as well as marketing and advertising for orthodontic centers added after 1999. As a percentage of net revenue, marketing and advertising expense increased to 8.2% for 2000 from 7.5% for 1999, due to the effect on net revenue for 2000 from our change in net revenue recognition effective January 1, 2000 pursuant to SAB 101. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, marketing and advertising expense, as a percentage of net revenue, remained constant at 8.2% for 2000 and 1999. GENERAL AND ADMINISTRATIVE General and administrative expense increased $5.1 million, or 21.8%, to $28.4 million for 2000 from $23.3 million for 1999. The increase in general and administrative expense resulted primarily from the addition of orthodontic centers and increases in our affiliated orthodontists' patient base after 1999. As a percentage of net revenue, general and administrative expense increased to 10.6% for 2000 from 10.3% for 1999 due to the effect on net revenue for 2000 from our change in revenue recognition policy effective January 1, 2000 pursuant to SAB 101. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, general and administrative expense decreased as a percentage of net revenue to 10.6% for 2000 from 11.7% for 1999. DEPRECIATION AND AMORTIZATION Depreciation and amortization expense increased $2.9 million, or 23.9%, to $15.2 million for 2000 from $12.2 million for 1999. The increase in this expense is a result of the fixed assets acquired and service agreements entered into for orthodontic centers developed, acquired or relocated after 1999. As a percentage of net revenue, depreciation and amortization expense increased to 5.6% for 2000 from 5.4% for 1999. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, depreciation and amortization expense decreased as a percentage of net revenue to 5.6% for 2000 from 6.0% for 1999. OPERATING PROFIT Operating profit increased $3.1 million, or 4.0%, to $80.0 million for 2000 from $76.9 million for 1999. As a percentage of net revenue, operating profit decreased to 29.8% for 2000 from 33.9% for 1999 as a result of the factors discussed above. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, operating profit increased $25.6 million, or 47.0%, to $80.0 million for 2000 from $55.4 million for 1999, and increased as a percentage of net revenue to 29.8% for 2000 from 27.0% for 1999, as a result of the factors discussed above. INTEREST Net interest expense increased $1.5 million, or 69.3%, to $3.7 million for 2000 from $2.2 million for 1999. As a percentage of net revenue, net interest expense increased to 1.4% for 2000 from 1.0% for 1999. The increase in this expense resulted from an increase since 1999 in the average balance of borrowings under our $100 million revolving line of credit associated with expansion in new and existing markets and an increase in the average interest rate charged for those borrowings. The increase in net interest expense as a percentage of revenue was also due to the effect on net revenue for 2000 from our change in net revenue recognition effective January 1, 2000 pursuant to SAB 101. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, net interest expense increased as a percentage of net revenue to 1.4% for 2000 from 1.2% for 1999, due to an increase since 1999 in the average balance of borrowings under our $100 million revolving line of credit associated with expansion in new and existing markets and an increase in the average interest rate charged for those borrowings. 9 10 PROVISION FOR INCOME TAXES Provision for income taxes increased $343,000, or 1.2%, to $28.6 million for 2000 from $28.2 million for 1999. Our effective income tax rate was 37.8% for 2000 and 1999. Our change in accounting principle pursuant to SAB 101 effective January 1, 2000 resulted in deferred tax assets of $41.1 million, because we have not received approval from taxing authorities to change our tax accounting method of recognizing revenue. We cannot assure you that we will receive any such approval. Failure to obtain this approval could have an adverse effect on our cash flow from operating activities. We have provided no valuation allowance for deferred tax assets. We believe that the deferred tax assets at December 31, 2000 are realizable through carrybacks and future reversals of existing taxable temporary differences. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, provision for income taxes increased $8.6 million, or 43.0%, to $28.6 million for 2000 from $20.0 million for 1999. CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE During 2000, we recorded a cumulative effect of a change in accounting principle of $50.6 million, net of an income tax benefit of $30.6 million, with respect to our change in revenue recognition effective as of January 1, 2000 pursuant to SAB 101. During 1999, we recorded a cumulative effect of a change in accounting principle of $678,000, net of an income tax benefit of $410,000, with respect to our adoption in 1999 of Statement of Position 98-5, "Reporting on the Costs of Start-Up Activities." NET INCOME (LOSS) Net income (loss) decreased $48.6 million, or 106.2%, to a net loss of $2.8 million for 2000 from net income of $45.8 million for 1999, primarily due to the cumulative effect of our change in accounting principle during 2000 pursuant to SAB 101. As a percentage of net revenue, the net loss for 2000 was (1.0)%, as compared to 20.4% for net income for 1999, as a result of the factors discussed above. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, net income, excluding the cumulative effects of changes in accounting principles, increased $14.7 million, or 44.5%, to $47.7 million for 2000 from $33.0 million for 1999, and increased as a percentage of net revenue to 17.9% for 2000 from 16.1% for 1999, as a result of the factors discussed above. 1999 COMPARED TO 1998 NET REVENUE Net revenue increased $55.0 million, or 32.1%, to $226.3 million for 1999 from $171.3 million for 1998. We attribute $31.0 million of this increase to the growth in net revenue of orthodontic centers open throughout 1998 and 1999, and $24.0 million of this increase to orthodontic centers opened since January 1, 1998. The number of patient contracts increased to about 268,000 at December 31, 1999 from about 195,000 at December 31, 1998. EMPLOYEE COSTS Employee costs increased $14.3 million, or 30.6%, to $61.2 million for 1999 from $46.9 million for 1998. As a percentage of net revenue, however, employee costs decreased to 27.1% for 1999 from 27.4% for 1998. The percentage decrease primarily reflects efficiencies achieved through a general change to longer patient treatment intervals by our affiliated orthodontists, which resulted in fewer treatments per patient contract and lower employee costs per patient. As a result of developments in orthodontic technology, a patient may be seen every six to eight weeks, rather than the traditional four weeks, without compromising quality of care. Consistent with industry trends, our affiliated orthodontists have begun increasing the intervals between patient treatments. During 1999, patients in our affiliated orthodontic centers averaged 39.3 days between office visits, compared to an average of 36.6 days during 1998. This increase in patient treatment interval reduces the number of office visits during the term of a patient's treatment, which continues to average about 26 months, and results in lower employee costs per patient. The increased interval does not, however, reduce the amount of treatment fees per patient. Therefore, the increased interval reduces the employee costs incurred with respect to an individual patient relative to the patient's treatment fee. ORTHODONTIC SUPPLIES Orthodontic supplies expense increased $3.8 million, or 29.0%, to $17.1 million for 1999 from $13.3 million for 1998. As a percentage of net revenue, however, orthodontic supplies expense decreased to 7.6% for 1999 from 7.8% for 1998. Cost improvements attained through bulk purchasing were partially offset by increased expense associated with an increased percentage of new patient treatment days, which require greater orthodontic supplies per patient, associated with the opening of additional orthodontic centers. 10 11 RENT Rent expense increased $4.5 million, or 31.8%, to $18.6 million for 1999 from $14.1 million for 1998. We attribute the increase in this expense to orthodontic centers affiliated, opened or relocated after 1998. As a percentage of net revenue, however, rent remained constant at 8.2% for 1998 and 1999. MARKETING AND ADVERTISING Marketing and advertising expense increased $1.4 million, or 8.9%, to $16.9 million for 1999 from $15.5 million for 1998. The increase in this expense resulted primarily from increases in marketing and advertising related to growth in net revenue for existing orthodontic centers as well as marketing and advertising for orthodontic centers added after 1998. As a percentage of net revenue, however, marketing and advertising expense decreased to 7.5% for 1999 from 9.0% for 1998. We attribute the decrease in this expense as a percentage of net revenue to changes in our marketing department designed to eliminate costs not related to the purchase of media advertisements. GENERAL AND ADMINISTRATIVE General and administrative expense increased $5.2 million, or 28.5%, to $23.3 million for 1999 from $18.1 million for 1998. The increase in general and administrative expense resulted primarily from the addition of orthodontic centers after 1998. As a percentage of net revenue, however, general and administrative expense decreased to 10.3% for 1999 from 10.6% for 1998. General and administrative expense decreased as a percentage of net revenue as a result of lower average start-up costs for orthodontic centers developed after 1998. DEPRECIATION AND AMORTIZATION Depreciation and amortization expense increased $3.1 million, or 34.1%, to $12.2 million for 1999 from $9.1 million for 1998. As a percentage of net revenue, depreciation and amortization expense increased to 5.4% for 1999 from 5.3% for 1998. The increase in this expense is a result of the fixed assets acquired and service agreements entered into for orthodontic centers developed, acquired or relocated after 1998. OPERATING PROFIT Operating profit increased $22.6 million, or 41.7%, to $76.9 million for 1999 from $54.3 million for 1998. As a percentage of net revenue, operating profit increased to 33.9% for 1999 from 31.7% for 1998 as a result of the factors discussed above. INTEREST We incurred net interest expense of $2.2 million for 1999, compared to net interest income of $280,000 for 1998. The increase in net interest expense resulted from the interest incurred on borrowings under our $100.0 million revolving line of credit associated with expansion in new and existing markets. PROVISION FOR INCOME TAXES Provision for income taxes increased $7.4 million, or 35.9%, to $28.2 million for 1999 from $20.8 million for 1998. Our effective income tax rate was 37.8% for 1999 and 1998. CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE During 1999, we recorded a cumulative effect of a change in accounting principle of $678,000, net of an income tax benefit of $410,000, with respect to our adoption in 1999 of Statement of Position 98-5, "Reporting on the Costs of Start-Up Activities." 11 12 NET INCOME Net income increased $12.0 million, or 35.6%, to $45.8 million for 1999 from $33.8 million for 1998. As a percentage of net revenue, net income increased to 20.4% for 1999 from 19.7% for 1998 as a result of the factors discussed above. QUARTERLY OPERATING RESULTS The following table provides information about our unaudited quarterly operating results for 1999 and 2000. We believe that the following information includes all of the adjustments considered necessary for a fair presentation of our consolidated financial position and our consolidated results of operations for these periods in accordance with generally accepted accounting principles. Results of operations for any particular quarter are not necessarily indicative of results of operations for a full year or predictive of future periods.
QUARTERS ENDED 1999 2000 ------------------------------------------- ---------------------------------------------------- MAR. 31 JUNE 30 SEPT. 30 DEC. 31 MAR. 31(1) JUNE 30(1) SEPT. 30(1) DEC. 31 ------- ------- -------- ------- ---------- ---------- ---------- ------- (IN THOUSANDS) Net revenue ............. $49,048 $55,401 $ 59,770 $62,071 $59,282 $65,842 $69,724 $73,988 Operating profit ................ 16,666 18,923 20,094 21,241 16,821 19,897 19,752 23,532
---------- (1) Amounts for the three months ended March 31, June 30 and September 30, 2000 have been restated from amounts previously reported to reflect our change in revenue recognition pursuant to SAB 101 effective as of January 1, 2000. SEASONALITY Our affiliated orthodontic centers have experienced their highest volume of new cases in the summer and other periods when schools are not typically in session. During these periods, children have a greater opportunity to visit an orthodontist to commence treatment. Consequently, our affiliated orthodontic centers have experienced higher revenue during the first and third quarters of the year as a result of increased patient starts. During the Thanksgiving and Christmas seasons, our affiliated orthodontic centers have experienced reduced volume and fourth quarter revenue for our affiliated orthodontic centers has been generally lower as compared to other periods. Seasonality in recent periods has been mitigated by the impact of additional orthodontic centers. LIQUIDITY AND CAPITAL RESOURCES Our development and acquisition costs, capital expenditures and working capital needs have been, and we expect will continue to be, financed through a combination of cash flow from operations, bank borrowings and the issuance of notes and shares of our common stock. We intend to continue to lease, rather than purchase, facilities for our affiliated orthodontic centers, to maximize our available capital. Our net cash provided by operations for 2000 was $39.6 million, an increase of 69.8% from $23.3 million for 1999, which represented an increase of 5.4% from $22.1 million for 1998. Due to a change of income tax payment methods, cash paid for income taxes during 1999 exceeded the 1999 provision by $7.0 million. Our working capital at December 31, 2000 was $39.6 million, a decrease of 61.3% from $102.3 million at December 31, 1999, including cash and cash equivalents of $4.7 million at December 31, 2000, compared to $5.8 million at December 31, 1999, primarily due to a decrease in service fees receivable, net of uncollectible amounts, to $35.4 million at December 31, 2000 from $87.6 million at December 31, 1999, as a result of the cumulative effect of our change in accounting principle effective January 1, 2000 pursuant to SAB 101. 12 13 Our net cash used in investing activities for 2000 was $48.5 million, a decrease of 12.6% from $43.1 million for 1999, which represented a decrease of 0.2% from $43.2 million for 1998. Our capital expenditures consist primarily of the costs associated with the development of additional orthodontic centers. The average cost of developing a new orthodontic center in the United States is about $255,000, including the cost of equipment, leasehold improvements, working capital and start-up losses associated with the initial operations of the orthodontic center. These costs are shared by us and the particular affiliated orthodontist. We assist our affiliated orthodontists in obtaining financing for their share of these costs by providing a guaranty of loans from our primary lender. In some cases, we bear an affiliated orthodontist's share of these costs until we are reimbursed by the orthodontist. At December 31, 2000, the outstanding balance of these amounts that we guaranteed was about $2.9 million, compared to about $5.0 million at December 31, 1999. We also intend to continue to make advances of about $40,000 to newly-affiliated orthodontists during the first year of an orthodontic center's operations, which advances bear no interest and typically are repaid during the second year of the orthodontic center's operations. We intend to fund these advances and any continued financing through a combination of bank borrowings, cash from operations and our net proceeds from this offering. During 2000, we entered into agreements to acquire the assets of, and affiliate with, 71 affiliated orthodontists operating in existing orthodontic practices at 55 locations, and made payments to orthodontists or orthodontic entities with which we affiliated in earlier periods, with a total acquisition cost of about $34.2 million, consisting of an aggregate principal amount of $1.3 million of promissory notes issued by us, an aggregate of 227,000 shares of our common stock and about $28.2 million of cash. At December 31, 2000, outstanding indebtedness under promissory notes we issued to affiliated orthodontists to acquire the assets of existing orthodontic practices was about $3.5 million, compared to about $8.2 million at December 31, 1999, with maturities ranging from one to three years and interest rates ranging from 7.0% to 9.0% per year. Our financing activities included the repayment of notes to banks and our affiliated orthodontists in the amount of $6.5 million for 2000, a decrease of 3.0% from $6.7 million for 1999, which represented a decrease of 14.2% from $7.9 million for 1998. Our financing activities also included proceeds from the issuance of our common stock under our stock purchase program and stock option plans in the amount of $4.3 million for 2000, a significant increase from $114,000 for 1999 and $595,000 for 1998, primarily due to an increase in the number of options exercised by our employees and affiliated orthodontists and amounts received under our stock purchase program for affiliated orthodontists. In October 1998, we entered into a $100.0 million revolving line of credit with a lending group that currently consists of First Union National Bank, Bank of America FSB, Bank One, N.A., Hibernia National Bank and Wachovia Bank, N.A. The line of credit provides an aggregate of $100.0 million for general working capital needs and expansion of the number of orthodontic centers, and bears interest at varying rates above the lender's prime rate or LIBOR. Amounts borrowed under the line of credit are secured by a security interest in all of our assets, including our accounts receivable and equipment. At December 31, 2000, $57.4 million of indebtedness was outstanding under the line of credit, compared to $50.6 million at December 31, 1999. See Note 5 to our Consolidated Financial Statements that are included elsewhere in this Report. We expect that we will require cash in the future primarily for developing additional orthodontic centers, acquiring assets from and affiliating with additional orthodontists, capital expenditures, repayment of long-term debt, payment of income taxes and general corporate purposes. Our cash needs could significantly change depending upon our ability to recruit orthodontists, find appropriate sites, enter into long-term service or consulting agreements and acquire the assets of existing orthodontic practices. We believe that the combination of funds available under our revolving line of credit and cash flow from operations will be sufficient to meet our anticipated funding requirements for at least the next 12 months. RISK FACTORS This report contains some forward-looking statements about our financial condition, results of operations, business and prospects. These statements appear in several sections of this Report and generally include any of the words "believe," "expect," "anticipate," "intend," "estimate," "should," "will," "plan" or similar expressions. These forward-looking statements include, without limitation, statements regarding our future growth, development and affiliation of new orthodontic centers, affiliation with additional orthodontic practices, relocation of existing centers, international expansion, use of technology and improved efficiency and costs, new case starts, national advertising and branding, legal proceedings, deferred tax assets, advancement of funds to affiliated orthodontists, continued leasing of orthodontic 13 14 center facilities, complimentary services, liquidity and capital resources, funding of our expansion, operations and capital expenditures, payment or nonpayment of dividends, market for orthodontic services, capacity of our affiliated orthodontic centers, general dentists as orthodontic assistants and compliance with laws. Forward-looking statements are not guarantees of future performance. They involve risks, uncertainties and assumptions, many of which are unpredictable and not within our control. Our future results and shareholder values may differ materially from those expressed in these forward-looking statements because of a variety of risks and uncertainties, including: o general economic and business conditions; o our expectations and estimates concerning future financial performance, financing plans and the impact of competition; o anticipated trends in our business; o existing and future regulations affecting our business; and o other risk factors described below and in our other filings with the Securities and Exchange Commission and our public announcements. We do not intend to update these forward-looking statements after the date of this Report, even if new information, future events or other circumstances have made them incorrect or misleading as of any future date. For all of these statements, we claim the protection of the safe harbor for forward-looking statements provided in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. OUR GROWTH STRATEGY MAY NOT SUCCEED, WHICH COULD HAVE AN ADVERSE EFFECT ON OUR FINANCIAL PERFORMANCE. Since we began operating in 1985, we have expanded to being affiliated with 395 orthodontists practicing in 592 orthodontic centers as of December 31, 2000. We expect to continue to add additional orthodontic centers and affiliated orthodontists. Our growth, however, will depend on a number of factors, including: o our ability to identify and affiliate with a sufficient number of orthodontists to open new orthodontic centers or operate within our existing network of affiliated orthodontic centers; o our ability to obtain quality locations for orthodontic centers in suitable markets; o our ability to identify and affiliate with a sufficient number of existing orthodontic practices; o the ability of our affiliated orthodontists to add new patients; o our ability to implement initiatives designed to increase the productivity of our affiliated orthodontic centers; o our ability to obtain adequate financing to fund our expansion strategy; o our ability to successfully operate under applicable government regulations; o our ability to establish brand identity; and o our ability to affiliate with orthodontists in other countries and successfully operate in those markets. Our growth strategy may not succeed, and we may have to modify it. We may be unable to identify and recruit suitable orthodontists. A shortage of available orthodontists with the skills we require would have a material adverse effect on our ability to grow. In addition, many of our service agreements include covenants not to compete, 14 15 in which we agreed that we would not affiliate with other orthodontists within a specified area and that we would limit the total number of orthodontic practices with which we affiliate within a particular market area. This could limit our ability to add orthodontists and orthodontic centers within the markets in which we have existing affiliated orthodontic centers. Our ability to attract additional orthodontists, and our prospects for success and growth, depend on our ability to integrate an increasing number of affiliated orthodontists, orthodontic centers and employees. If we fail to manage our growth, our business may suffer. OUR AFFILIATED ORTHODONTISTS ARE EXTENSIVELY REGULATED, WHICH MAY ADVERSELY AFFECT OUR BUSINESS AND LIMIT HOW WE CAN OPERATE. Governmental authorities regulate the orthodontic industry and orthodontic practices extensively. We do not control the practice of orthodontics by our affiliated orthodontists or their compliance with legal requirements that apply to orthodontists and their practices. Many states prohibit us, as a non-professional corporation, from: o practicing orthodontics, which, in some states, includes managing or operating an orthodontic office; o splitting professional fees with orthodontists; o owning or controlling equipment used in orthodontic practice; o employing orthodontists; o setting fees charged for orthodontic services; o maintaining an orthodontist's patient records; or o controlling the content of an orthodontist's advertising. Many states also prohibit orthodontists from paying any portion of fees received for orthodontic services in exchange for a patient referral. In addition, many states impose limits on the tasks an orthodontist may delegate to other staff members. These laws and their interpretation vary from state to state, and regulatory authorities enforce them with broad discretion. If a court or regulatory authority reviewed our business arrangements with an affiliated orthodontist and concluded that our arrangements did not comply with applicable law, we might have to change those arrangements in a way that adversely affects us. An affiliated orthodontist may successfully challenge the legality of our long-term service and consulting agreements, and we may be unable to enforce non-competition and other provisions of those agreements. The laws and regulations of states and countries in which we operate or seek to expand may restrict or adversely affect our relationships with orthodontists in those states and countries. The laws and regulations of states and countries in which we currently operate could change or be interpreted in a way that adversely affects our operations and relationships with affiliated orthodontists. We may have to change our contractual relationships, alter our financial arrangements or restrict our operations in those states and countries. These laws and regulations could also prevent us from affiliating with, or providing business services to, orthodontists practicing in those states and countries. OUR FINANCIAL SUCCESS DEPENDS ON THE EFFORTS AND SUCCESS OF OUR AFFILIATED ORTHODONTISTS, AND OUR BUSINESS COULD SUFFER IF THEY DO NOT SUCCEED OR IF OUR SERVICE OR CONSULTING AGREEMENTS WITH THEM ARE TERMINATED. We receive fees for services we provide for orthodontic practices under service and consulting agreements. These fees under the service agreements are generally tied to the financial performance of our affiliated orthodontists, so our success depends on the success of our affiliated orthodontists. Changes in the healthcare industry, such as the growth of managed care organizations and provider networks, may result in lower compensation for the services of our affiliated orthodontists. Our service agreements and some of our consulting agreements with affiliated orthodontists have terms ranging from 20 to 40 years, with most ranging from 20 to 25 years. Affiliated 15 16 orthodontists may terminate those agreements for "cause," which generally includes our material breach of the agreement. In some cases, an affiliated orthodontist may terminate his or her agreement without cause after a specified period of time, subject to substitution of another affiliated orthodontist and an obligation not to compete within a specified area. The loss of a substantial number of our agreements with affiliated orthodontists or a material loss of revenue by our affiliated orthodontists, for whatever reason, could materially and adversely affect our financial condition and results of operations. OTHER ORTHODONTISTS AND DENTISTS COMPETE WITH OUR AFFILIATED ORTHODONTISTS, AND OTHER COMPANIES COMPETE WITH US. Orthodontics is a highly competitive business in each market in which our affiliated orthodontists operate. Our affiliated orthodontists face competition from other orthodontists and general dentists in the communities they serve. Many of these competing orthodontists and general dentists have more established practices. Providing business services to orthodontic practices is also a competitive business. We compete with other companies with strategies similar to ours in providing business services to orthodontic practices. Competitors with greater access to financial resources may enter our markets and compete with us. We may not be able to compete successfully with existing or new competitors. Also, additional competition may make it more difficult for us to affiliate with additional orthodontists on terms that are favorable to us. Any of these factors could cause us to become less profitable. OUR FINANCIAL RESULTS MAY SUFFER IF WE HAVE TO WRITE OFF INTANGIBLE ASSETS. In connection with our affiliations with existing orthodontic practices, we recorded intangible assets, net of accumulated amortization, of about $194.5 million on our balance sheet as of December 31, 2000. We may not realize the value of these intangible assets. We expect to engage in additional transactions that will result in our recognition of additional intangible assets and amortization expense. Part of the amortization generated by these intangible assets is not deductible for tax purposes. We evaluate on a regular basis whether events and circumstances have occurred that indicate that all or a portion of the carrying amount of these intangible assets may no longer be recoverable, and is therefore impaired. Under current accounting rules, any future determination that impairment has occurred would require us to write off the impaired portion of unamortized intangible assets, resulting in a charge to our earnings. Such a write-off could have a material adverse effect on our financial condition and results of operations. CHANGES IN ACCOUNTING PRINCIPLES MAY AFFECT OUR REPORTED OPERATING RESULTS AND STOCK PRICE. As a public company with securities registered under the Securities Exchange Act of 1934, we prepare our financial statements in accordance with generally accepted accounting principles. SEC Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," which summarizes the SEC staff's views in applying generally accepted accounting principles to revenue recognition in financial statements, became effective in the fourth quarter of 2000 for companies, such as us, with fiscal years ending on December 31. We have modified our revenue recognition policies to conform with the guidance in Staff Accounting Bulletin No. 101, which resulted in a cumulative charge to our earnings in 2000 to reflect the change in accounting principle effective January 1, 2000. This change may make it more difficult for investors to compare our historical operating results against out future operating results. In addition, any further changes to generally accepted accounting principles or additional SEC statements or guidance on accounting policies may require us to further change our accounting practices and policies. These uncertainties may cause our stock price to decline or result in additional adjustments to our financial results. OUR INFORMATION SYSTEMS ARE CRITICAL TO OUR BUSINESS, AND A FAILURE OF THOSE SYSTEMS COULD HAVE A MATERIAL ADVERSE EFFECT ON US. Our business and success depends, in part, upon our ability to store, retrieve, process and manage a significant amount of information, and to provide our affiliated orthodontists with efficient and effective inventory, accounting and scheduling systems. If our information systems fail to perform as expected, of if we suffer an interruption, malfunction or loss of information processing capabilities, it could have a material adverse effect on our business, results of operations, relationships with our affiliated orthodontists and ability to affiliate with additional orthodontists. 16 17 OUR INTERNATIONAL ACTIVITIES EXPOSE US TO OPERATIONAL CHALLENGES THAT WE MIGHT NOT OTHERWISE FACE. We currently operate in Japan and Mexico, and may expand into additional countries. As we increase our international activities, we will have to confront and manage a number of risks and expenses that we would not otherwise face if we conducted our operations solely in the United States, which could have a material negative effect on our operating results. These risks and expenses include: o Difficulties in staffing and managing foreign offices as a result of, among other things, language and cultural differences; o Foreign currency exchange rate fluctuations; o Protectionist laws and business practices that favor local companies; o Political and economic instability in some international markets; o Multiple, conflicting and changing government laws and regulations; o Trade barriers; o Reduced protection for intellectual property rights in some countries; and o Potentially adverse tax consequences. WE DEPEND ON A FEW KEY EMPLOYEES, AND IF WE LOSE THEM OUR BUSINESS COULD SUFFER. Our success depends upon the continued active participation of our senior management, particularly our Chairman of the Board, Dr. Gasper Lazzara, Jr., our Chief Executive Officer and President, Bartholomew F. Palmisano, Sr., our Chief Operating Officer, Michael C. Johnsen, and our Chief Financial Officer, Bartholomew F. Palmisano, Jr. The loss of the services of any of these officers could have a material adverse effect on our business. Our success also depends on our ability to attract and retain other highly qualified managerial personnel. OUR FINANCIAL RESULTS MAY BE DAMAGED BY SUCCESSFUL CLAIMS AGAINST OUR AFFILIATED ORTHODONTISTS. We provide business services to orthodontists who provide orthodontic treatment to the public and are exposed to the risk of professional liability and other claims. Those claims, if successful, could result in substantial damage awards. Those awards might exceed the limits of any applicable insurance coverage. Insurance against losses of this type can be expensive. Insurance rates vary from state to state. We do not control the practice of orthodontics by our affiliated orthodontists or their compliance with the legal and other requirements applicable to orthodontists and their practices. A successful malpractice claim against us or an affiliated orthodontist could have a material adverse effect on our financial position and results of operations. ANTITRUST LAWS COULD LIMIT OUR ABILITY TO OPERATE OR EXPAND. We are subject to a range of antitrust laws that prohibit anticompetitive conduct, including price fixing, concerted refusals to deal and divisions of markets. These laws may limit our ability to enter into service or consulting agreements with separate orthodontists who compete with one another in the same geographic market. OUR ANTI-TAKEOVER PROVISIONS MAY PREVENT A CHANGE IN OUR CONTROL, EVEN IF IT WOULD BENEFIT OUR STOCKHOLDERS. Some of the provisions of Delaware law and our certificate of incorporation and bylaws may discourage a change in our control or make it more difficult to achieve, even if a change in control is in our stockholders' best interests. For example, some actions by our Board of Directors require a supermajority vote rather than a simple majority vote. In addition, our certificate of incorporation allows our Board of Directors to determine the preferences and rights of preferred stock which we may issue without any vote or approval of the holders of our common stock. The rights of 17 18 common stockholders will be subject to and may be adversely affected by the rights of the holders of any preferred stock that we may issue in the future. Through the issuance of preferred stock with certain powers, the Board of Directors may prevent changes in our management and control. Our Board of Directors is divided into three classes of directors. Directors from each class serve staggered three-year terms, which may limit our stockholders' ability to replace a majority of our directors. 18 19 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Orthodontic Centers of America, Inc. Index to Consolidated Financial Statements Years ended December 31, 2000, 1999 and 1998
PAGE ---- Report of Independent Auditors ..................................................................... 36 Audited Consolidated Financial Statements: Consolidated Balance Sheets - December 31, 2000 and 1999 ........................................... 37 Consolidated Statements of Income - Years Ended December 31, 2000, 1999 and 1998 ................... 38 Consolidated Statements of Shareholders' Equity - Years Ended December 31, 2000, 1999 and 1998 .... 39 Consolidated Statements of Cash Flows - Years Ended December 31, 2000, 1999 and 1998 ............... 40 Notes to Consolidated Financial Statements - December 31, 2000 ..................................... 41 Schedule II -- Valuation and Qualifying Accounts ................................................... 52
19 20 Report of Independent Auditors The Board of Directors Orthodontic Centers of America, Inc. We have audited the accompanying consolidated balance sheets of Orthodontic Centers of America, Inc. as of December 31, 2000 and 1999, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2000. Our audits also included the financial statement schedule listed in the index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Orthodontic Centers of America, Inc. at December 31, 2000 and 1999, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for revenue in 2000 and start-up costs in 1999. /s/ ERNST & YOUNG LLP New Orleans, Louisiana April 12, 2001 20 21 Orthodontic Centers of America, Inc. Consolidated Balance Sheets (In thousands, except share data)
DECEMBER 31, -------------------------- 2000 1999 ---------- ---------- ASSETS Current assets: Cash and cash equivalents ............................................................. $ 4,690 $ 5,822 Investments ........................................................................... 999 983 Service fees receivable, net of allowance for uncollectible amounts of $2,598 in 2000 and $9,644 in 1999........................................................... 35,350 87,563 Advances to orthodontic entities ...................................................... 7,644 7,944 Deferred income taxes ................................................................. 1,978 4,455 Supplies inventory .................................................................... 7,306 8,195 Prepaid expenses and other assets ..................................................... 3,782 1,920 ---------- ---------- Total current assets ............................................................ 61,749 116,882 Property, equipment and improvements, net ................................................ 76,686 64,566 Advances to orthodontic entities, less current portion ................................... 9,057 12,586 Deferred income taxes .................................................................... 24,030 -- Intangible assets ........................................................................ 194,544 167,348 Other assets ............................................................................. 1,881 1,434 ---------- ---------- Total other assets .............................................................. 306,198 245,934 ---------- ---------- Total assets .................................................................... $ 367,947 $ 362,816 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable ...................................................................... $ 7,855 $ 2,104 Accrued salaries and other accrued liabilities ........................................ 4,054 3,647 Deferred revenue ...................................................................... 2,516 -- Income taxes payable .................................................................. 2,913 935 Amounts payable to orthodontic entities ............................................... 2,412 1,900 Current portion of notes payable to affiliated orthodontists .......................... 2,426 6,020 ---------- ---------- Total current liabilities ....................................................... 22,176 14,606 Notes payable to affiliated orthodontists, less current portion .......................... -- 2,141 Long-term debt, less current portion ..................................................... 58,575 50,632 Deferred income taxes .................................................................... -- 16,910 Shareholders' equity: Preferred stock, $.01 par value; 10,000,000 shares authorized, no shares outstanding .. -- -- Common stock, $.01 par value; 100,000,000 shares authorized at December 31, 2000 and 1999; 48,600,000 and 48,066,000 shares issued and outstanding at December 31, 2000 and 1999, respectively ............................. 487 481 Additional paid-in capital ............................................................ 168,661 161,465 Retained earnings ..................................................................... 121,581 124,435 Accumulated other comprehensive income ................................................ (127) -- Due from key employees for stock purchase program ..................................... (1,604) (5,236) Capital contributions receivable from shareholders .................................... (1,802) (2,618) ---------- ---------- Total shareholders' equity ...................................................... 287,196 278,527 ---------- ---------- Total liabilities and shareholders' equity ...................................... $ 367,947 $ 362,816 ========== ==========
See accompanying notes. 21 22 Orthodontic Centers of America, Inc. Consolidated Statements of Income (In thousands, except per share data)
Year Ended December 31, --------------------------------------- 2000 1999 1998 --------- --------- --------- Net revenue .......................................................... $ 268,836 $ 226,290 $ 171,298 Direct expenses: Employee costs .................................................... 78,051 61,224 46,878 Orthodontic supplies .............................................. 21,274 17,136 13,287 Rent .............................................................. 23,973 18,624 14,128 Marketing and advertising ......................................... 22,001 16,874 15,491 --------- --------- --------- Total direct expenses ....................................... 145,299 113,858 89,784 General and administrative ........................................... 28,360 23,270 18,104 Depreciation and amortization ........................................ 15,175 12,238 9,124 --------- --------- --------- Operating profit ..................................................... 80,002 76,924 54,286 Interest expense ..................................................... (4,571) (2,599) (337) Interest income ...................................................... 840 395 617 --------- --------- --------- Income before income taxes ........................................... 76,271 74,720 54,566 Provision for income taxes ........................................... 28,549 28,206 20,753 --------- --------- --------- Net income before cumulative effect of changes in accounting principles ...................................................... 47,722 46,514 33,813 Cumulative effect of changes in accounting principles, net of income tax benefit ....................................... (50,576) (678) -- --------- --------- --------- Net income (loss) .................................................... $ (2,854) $ 45,836 $ 33,813 ========= ========= ========= Net income (loss) per share: Basic before cumulative effect of changes in accounting principles ........................................... $ .99 $ .97 $ .71 Cumulative effect of changes in accounting principles ............. (1.04) (.02) -- --------- --------- --------- Basic ............................................................. $ (.05) $ .95 $ .71 ========= ========= ========= Diluted before cumulative effect of changes in accounting principles ...................................................... $ .96 $ .96 $ .70 Cumulative effect of changes in accounting principles ............. (1.02) (.02) -- --------- --------- --------- Diluted ........................................................... $ (.06) $ .94 $ .70 ========= ========= ========= Weighted average shares outstanding: Basic ............................................................. 48,412 47,998 47,690 ========= ========= ========= Diluted ........................................................... 49,845 48,643 48,502 ========= ========= ========= Pro forma net income for change in accounting principle effective January 1, 2000 ......................................... N/A $ 32,326 $ 22,276 Pro forma net income per share diluted for change in accounting principle effective January 1, 2000 ............................... N/A $ .66 $ .46
See accompanying notes. 22 23 Orthodontic Centers of America, Inc. Consolidated Statements of Shareholders' Equity (In thousands, except share data)
Due From Key Employees Additional For Stock Common Paid-In Retained Purchase Stock Capital Earnings Program ------------ ------------ ------------ ------------ Balance at January 1, 1998 ......... $ 474 $ 153,334 $ 44,786 $ (5,236) Issuance of shares under stock option plans (223,000 shares) .............. 2 2,396 -- -- Issuance of shares of common stock to obtain Service Agreements (253,000 shares) ... 2 4,206 -- -- Net income ...................... -- -- 33,813 -- ------------ ------------ ------------ ------------ Balance at December 31, 1998 ....... 478 159,936 78,599 (5,236) Issuance of shares under stock option plans (123,000 shares) .............. 1 619 -- -- Issuance of shares of common stock to obtain Service Agreements (80,000 shares) .... 2 800 -- -- Issuance of shares under orthodontist stock purchase program (21,000 shares)........ -- 110 -- -- Net income ...................... -- -- 45,836 -- ------------ ------------ ------------ ------------ Balance at December 31, 1999 ....... 481 161,465 124,435 (5,236) ------------ ------------ ------------ ------------ Issuance of shares under stock option plans (479,000 shares) .............. 3 3,512 -- -- Issuance of shares of common stock to obtain Service Agreements (185,000 shares) ... 2 4,056 -- -- Repayment of loans from key employee program .............. -- (1,816) -- 3,632 Issuance of shares under orthodontist stock purchase program (227,000 shares)....... 1 1,444 -- -- Foreign currency translation adjustment .................... -- -- -- -- Net income (loss)................ -- -- (2,854) -- ------------ ------------ ------------ ------------ Balance at December 31, 2000 ....... $ 487 $ 168,661 $ 121,581 $ (1,604) ============ ============ ============ ============ Capital Contributions Accumulated Receivable Other Total From Comprehensive Shareholders' Shareholders Income Equity ------------- ------------- ------------ Balance at January 1, 1998 ......... $ (2,618) $ -- $ 190,740 Issuance of shares under stock option plans (223,000 shares) .............. -- -- 2,398 Issuance of shares of common stock to obtain Service Agreements (253,000 shares) ... -- -- 4,208 Net income ...................... -- -- 33,813 ------------- ------------- ------------ Balance at December 31, 1998 ....... (2,618) -- 231,159 Issuance of shares under stock option plans (123,000 shares) .............. -- -- 620 Issuance of shares of common stock to obtain Service Agreements (80,000 shares) .... -- -- 802 Issuance of shares under orthodontist stock purchase program (21,135 shares)........ -- -- 110 Net income ...................... -- -- 45,836 ------------- ------------- ------------ Balance at December 31, 1999 ....... (2,618) -- 278,527 ------------- ------------- ------------ Issuance of shares under stock option plans (479,000 shares) .............. -- -- 3,515 Issuance of shares of common stock to obtain Service Agreements (185,000 shares) ... -- -- 4,058 Repayment of loans from key employee program .............. 816 -- 2,632 Issuance of shares under orthodontist stock purchase program (227,000 shares) ...... -- -- 1,445 Foreign currency translation adjustment .................... -- (127) (127) Net income (loss) ............... -- -- (2,854) ------------- ------------- ------------ Balance at December 31, 2000 ....... $ (1,802) $ (127) $ 287,196 ============= ============= ============
See accompanying notes. 23 24 Orthodontic Centers of America, Inc. Consolidated Statements of Cash Flows (In thousands, except share data)
YEAR ENDED DECEMBER 31, -------------------------------- 2000 1999 1998 -------- -------- -------- OPERATING ACTIVITIES Net income (loss)..................................................... $ (2,854) $ 45,836 $ 33,813 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Provision for bad debt expense .................................... 373 2,079 2,295 Depreciation and amortization ..................................... 15,175 12,238 9,124 Deferred income taxes ............................................. (7,792) 1,273 (2,767) Cumulative effect of changes in accounting principles ............. 50,576 678 -- Changes in operating assets and liabilities: Service fee receivables ........................................... (13,549) (27,491) (22,733) Supplies inventory ................................................ 889 (2,305) (2,663) Prepaid expenses and other ........................................ (2,309) (1,342) 228 Advances to/amounts payable to orthodontic entities.... ........... (8,233) (2,420) (1,756) Accounts payable and other current liabilities .................... 7,368 (5,199) 6,568 -------- -------- -------- Net cash provided by operating activities ............................ 39,644 23,347 22,109 INVESTING ACTIVITIES Purchases of property, equipment and improvements .................... (20,271) (22,520) (17,638) Proceeds from (sales of) available-for-sale investments ....................................................... (16) 204 19,674 Intangible assets acquired ........................................... (28,246) (17,178) (42,216) Advances to orthodontic entities ..................................... -- (3,951) (4,906) Payments from orthodontic entities ................................... -- 370 1,927 -------- -------- -------- Net cash used in investing activities ................................ (48,533) (43,075) (43,159) FINANCING ACTIVITIES Repayment of notes payable to affiliated orthodontists and long- term debt........................................................... (6,530) (6,742) (7,864) Proceeds from long-term debt ......................................... 7,483 30,577 20,055 Repayment of loans from key employee program ......................... 2,632 -- -- Issuance of common stock ............................................. 4,299 114 595 -------- -------- -------- Net cash provided by financing activities ............................ 7,884 23,949 12,786 Foreign currency translation adjustment .............................. (127) -- -- -------- -------- -------- Change in cash and cash equivalents .................................. (1,132) 4,221 (8,264) Cash and cash equivalents at beginning of year ....................... 5,822 1,601 9,865 -------- -------- -------- Cash and cash equivalents at end of year ............................. $ 4,690 $ 5,822 $ 1,601 ======== ======== ======== SUPPLEMENTAL CASH FLOW INFORMATION Cash paid during the year for: Interest .......................................................... $ 4,271 $ 2,499 $ 337 ======== ======== ======== Income taxes ...................................................... $ 31,568 $ 33,931 $ 19,287 ======== ======== ======== SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES Notes payable and common stock issued to obtain Service Agreements ........................................................ $ 5,974 $ 4,512 $ 13,609 ======== ======== ========
See accompanying notes. 24 25 Orthodontic Centers of America, Inc. Notes to Consolidated Financial Statements 1. DESCRIPTION OF BUSINESS Orthodontic Centers of America, Inc. (the "Company") provides integrated business services to orthodontists practicing throughout the United States and in Japan, Mexico and Puerto Rico. The Company provides business operations, financial, marketing and administrative services to orthodontic practices. These services are provided under service and consulting agreements (hereafter referred to as "Service Agreements") with the orthodontist and their wholly owned orthodontic entities (hereafter referred to as "Affiliated Orthodontists"). The Affiliated Orthodontists own the orthodontic entities. As the Company does not control the orthodontic entities, it does not consolidate the financial results of the orthodontic entities. The financial statements include service fees earned under the Service Agreements and the expenses of providing the Company's services, which generally includes all expenses of the orthodontic practices except for orthodontist compensation and certain expenses directly related to the orthodontic entities, such as professional insurance coverage. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Orthodontic Centers of America, Inc. and its wholly owned subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. ACCOUNTING CHANGES Effective January 1, 2000, the Company adopted a change in accounting for revenue in connection with Securities and Exchange Commission Staff Accounting Bulletin No. 101 (SAB 101), "Revenue Recognition in Financial Statements." The cumulative effect of this accounting change, calculated as of January 1, 2000, was $50.6 million, net of income tax benefit of $30.6 million. The effect of this accounting change in 2000 was to reduce revenue by $26.3 million. In 2000, the Company recognized revenue of $57.3 million that was included in the cumulative effect adjustment. The pro forma amounts presented in the consolidated statements of income were calculated assuming the accounting change was made retroactive to prior periods. Effective January 1, 1999, the Company adopted SOP 98-5, "Reporting the Costs of Start-Up Activities." The cumulative effect of this accounting change, calculated as of January 1, 1999, was $678,000, net of income tax benefit. The pro forma amounts in prior periods were not material. CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. INVESTMENTS Management determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each balance sheet date. All investments held at December 31, 2000 and 1999 are classified as available-for-sale because management does not have positive intent to hold until maturity. Available-for-sale investments are carried at amortized cost, which approximates fair value. At December 31, 2000, investments were included in current assets as management expects to use the proceeds from the sale of the investments in its current operations. At December 31, 2000 and 1999, the Company's amortized cost of investments held consisted of $999,000 and $983,000, respectively, of government bonds. The unrealized gains and losses on these investments at December 31, 2000 and 1999 were not significant. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity and included in interest income. The cost of investments sold is based on the specific identification method. Interest on investments classified as available-for-sale is included in interest income. 25 26 Orthodontic Centers of America, Inc. Notes to Consolidated Financial Statements (continued) FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: CASH AND CASH EQUIVALENTS: The carrying amount reported in the balance sheets for cash and cash equivalents approximates their fair value. INVESTMENTS: The fair values for marketable debt securities are based on quoted market prices. SERVICE FEES RECEIVABLE AND ADVANCES TO ORTHODONTIC ENTITIES: The carrying amounts reported on the balance sheets for service fees receivable and advances to orthodontic entities approximate their fair values. LONG-TERM DEBT: The fair values of the Company's long-term debt are estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements, and approximate their carrying values. The Company will adopt Financial Accounting Standards Board Statement FASB No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, on January 1, 2001. As the Company has no derivatives at the date of adoption, there will be no financial statement impact. REVENUE RECOGNITION Net revenue consists of service fees earned by the Company under the Service Agreements. Effective January 1, 2000, the Company changed its method of revenue recognition for service fees earned under its Service Agreements with Affiliated Orthodontists. The Company recognizes service fees based on patient contract revenues calculated on a straight-line basis over the term of the patient contracts, net of amounts to be retained by the orthodontists. The amounts to be retained by orthodontists is the Company's estimate of the orthodontists' proportionate share of straight-line patient contract revenues, reduced by the amount of Company expenses incurred and not yet reimbursed by the orthodontists. Prior to the change in method, the Company recognized service fee revenues pursuant to the terms of the Service Agreements. Such fees were recognized on a monthly basis as approximately 24% of new patient contract balances plus a portion of existing patient contract balances, less amounts retained by the orthodontists. This method was supported by proportional performance of business services provided under the Service Agreements. Under the terms of the Service Agreements, the Affiliated Orthodontists assign their patient receivables to the Company in payment of their service fees. Service fees receivable represents the portion of these patient receivables that the Company expects to retain and which has been recognized as net revenue. Orthodontists retain patient revenue not paid to the Company as the service fee. The amounts ultimately retained by orthodontists are dependent upon the financial performance of their practices. RECEIVABLES Service fee receivables and advances to orthodontic entities are classified on the consolidated balance sheets based upon the expected date of collection. Collection of amounts due from orthodontic entities is highly dependent on the entities' financial performance. Therefore, the Company is exposed to certain credit risk. However, management believes such risk is minimized by the Company's involvement in certain business aspects of the orthodontic entity. Management evaluates the collectibility of these receivables based upon a number of factors relevant to the affiliated orthodontist, including recent new patient contract performance, active patient base and center cost structure. The Company has a history of collecting amounts due from affiliated orthodontists. Under the terms of the Service Agreements, the orthodontic entities assign their patient receivables (billed and unbilled) to the Company in payment of their service fees. The Company is responsible for collection. Unbilled patient receivables represent the earned revenue in excess of billings to patients as of the end of each period. There are no unbilled receivables which will not be billed. The Company is exposed to certain credit risks. The Company manages such risks by regularly reviewing the accounts and contracts, and providing appropriate allowances. Provisions are made currently for all known or anticipated losses for billed and unbilled patient receivables. Such deductions totaled $373,000, $2,079,000 and $2,295,000, for the years ended December 31, 2000, 1999 and 1998, respectively, and have been within management's expectations. SUPPLIES INVENTORY Supplies inventory is valued at the lower of cost or market determined on the first-in, first-out basis. PROPERTY, EQUIPMENT AND IMPROVEMENTS Property, equipment and improvements are stated at cost. Depreciation expense is provided using the straight-line method over the estimated useful lives of the assets, which range from 5 to 10 years. Leasehold improvements are amortized over the original lease terms which are generally 5 to 10 years. The related depreciation and amortization expense for the years ended December 31, 2000, 1999 and 1998 was $8,151,000, $6,519,000 and $4,575,000, respectively. INTANGIBLE ASSETS The Company affiliates with a practicing orthodontist by acquiring substantially all of the non-professional assets of the orthodontist's practice, either directly or indirectly through a stock purchase, and entering into a Service Agreement with the orthodontist. The terms of the Service Agreements range from 20 to 40 years, with most ranging from 20 to 25 years. The acquired assets generally consist of equipment, furniture, fixtures and leasehold interests. The Company records these acquired tangible assets at their fair value as of the date of acquisition, and depreciates or amortizes the acquired assets using the straight-line method over their useful lives. The remainder of the purchase price is allocated to an intangible asset, which represents the costs of obtaining the Service Agreement, pursuant to which the Company obtains the exclusive right to provide business operations, financial, marketing and administrative services to the orthodontist during the term of the Service Agreement. In the event the Service Agreement is terminated, the related orthodontic entity is generally required to purchase all of the related assets, including the unamortized portion of intangible assets, at the current book value. 26 27 Orthodontic Centers of America, Inc. Notes to Consolidated Financial Statements (continued) The Company may issue shares of its common stock as consideration when it acquires the assets of and enters into Service Agreements with practicing orthodontists. The Company values the shares of stock issued in these transactions at the average closing market price during a few days prior to the date on which the particular transaction is closed. Service Agreements are amortized over the shorter of their term or 25 years. Amortization expense for the years ended December 31, 2000, 1999 and 1998, was $7,024,000 $5,719,000 and $4,549,000 respectively. Accumulated amortization was $20,737,000 and $13,713,000 as of December 31, 2000 and 1999, respectively. Intangible assets and the related accumulated amortization are written off when fully amortized. IMPAIRMENT OF LONG-LIVED ASSETS The Company assesses long-lived assets for impairment under FASB Statement No. 121, "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" (FAS 121). Under those rules, Service Agreements are included in impairment evaluations when events or circumstances exist that indicate the carrying amounts of those assets may not be recoverable. The recoverability of Service Agreements is assessed periodically and takes into account whether the Service Agreements should be completely or partially written off or the amortization period accelerated based on management's estimate of future operating income over the remaining term of the Service Agreement. If a Service Agreement is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the Service Agreement exceeds its fair value using estimated cash flows on a discounted basis. MARKETING AND ADVERTISING COSTS Marketing and advertising costs are expensed as incurred. INCOME TAXES Income taxes for the Company are determined by the liability method in accordance with Statement of Financial Accounting Standards 109, "Accounting for Income Taxes." STOCK COMPENSATION ARRANGEMENTS As permitted by FASB Statement No. 123 "Accounting for Stock-Based Compensation," FAS 123 the Company accounts for its stock compensation arrangements with employees under the intrinsic value method prescribed by APB 25, "Accounting for Stock Issued to Employees." The Company accounts for stock options granted to non-employees, primarily orthodontists, at fair value determined according to FAS 123. RECLASSIFICATIONS Amounts reported as patient receivables, unbilled patient receivables and patient prepayments in the financial statements for 1999 and 1998 have been reclassified as service fees receivables to conform to their 2000 presentation. 27 28 Orthodontic Centers of America, Inc. Notes to Consolidated Financial Statements (continued) 3. TRANSACTIONS WITH ORTHODONTIC ENTITIES The following table summarizes the Company's finalized agreements with orthodontic entities to obtain Service Agreements and to acquire other assets for the years ended December 31, 2000, 1999 and 1998:
Total Remainder Share Value Common Acquisition Notes Payable (Primarily (at average Stock Shares Costs Issued Cash) cost) Issued ----------- ------------- ----------- ----------- ------------ 2000....... $34,220,000 $ 1,255,000 $28,246,000 $ 4,719,000 227,000 1999....... 21,700,000 3,600,000 17,190,000 910,000 80,000 1998....... 56,900,000 8,700,000 43,994,000 4,206,000 253,000
At December 31, 2000 and 1999, advances to orthodontic entities totaled $16,701,000 and $20,530,000, respectively. Of these amounts, approximately $1,208,000 and $5,045,000 related to orthodontic entities that generated operating losses during the three months ended December 31, 2000 and 1999, respectively. At December 31, 2000 and 1999, advances to orthodontic entities in international locations totaled $6,196,000 and $1,413,000, respectively. Orthodontic centers that have been newly developed by the Company have typically generated initial operating losses as the orthodontists practicing in the centers begin to build a patient base. These newly developed centers have typically begun to generate operating profits after approximately 12 months of operations. To assist Affiliated Orthodontists in obtaining financing for their portion of initial operating losses and capital improvements for newly developed orthodontic centers, the Company has entered into an agreement with a financial institution under which (i) the financial institution finances these operating losses and capital improvements directly to the orthodontic entity, subject to the financial institution's credit approval of the orthodontic entity, and (ii) the Company remains a guarantor of the related debt. At December 31, 2000 and 1999, the Company was a guarantor for approximately $2,914,000 and $4,356,000, respectively, of loans under this arrangement. Of these amounts, approximately $172,000 and $392,000 related to orthodontic centers that generated operating losses during the three months ended December 31, 2000 and 1999, respectively. The Company has reserved 2,000,000 shares of common stock for issuance to Affiliated Orthodontists through a stock purchase program that allows participating Affiliated Orthodontists to acquire shares of common stock from the Company. 4. PROPERTY, EQUIPMENT AND IMPROVEMENTS Property, equipment and improvements consisted of the following (in thousands):
DECEMBER 31, ----------------------- 2000 1999 -------- -------- Leasehold improvements ......................................................... $ 51,408 $ 45,237 Furniture and fixtures ......................................................... 44,916 35,603 Other equipment ................................................................ 155 110 Centers in progress ............................................................ 7,408 2,666 -------- -------- 103,887 83,616 Less accumulated depreciation and amortization ................................. (27,201) (19,050) -------- -------- $ 76,686 $ 64,566 ======== ========
28 29 Orthodontic Centers of America, Inc. Notes to Consolidated Financial Statements (continued) 5. LONG-TERM DEBT AND NOTES PAYABLE Long-term debt consisted of the following (in thousands):
DECEMBER 31, ----------------------- 2000 1999 -------- -------- Senior Credit Facility ................................. $ 57,466 $ 50,632 Notes payable to affiliated orthodontists, interest rates from 7 to 10%, with maturity dates ranging from 2001 to 2004, unsecured ......... 3,535 8,161 -------- -------- 61,001 58,793 Less current portion ................................... 2,426 6,020 -------- -------- $ 58,575 $ 52,773 ======== ========
The aggregate maturities of long-term debt as of December 31, 2000 for each of the next five years are as follows (in thousands): 2001--$2,426; 2002--$851; 2003--$57,721; 2004--$0; and 2005--$3. The Company has a syndicated $100,000,000 Senior Revolving Credit Facility Agreement (the "Senior Credit Facility"). The Senior Credit Facility provides for an interest rate based on LIBOR, plus the Applicable Margin, as defined in the Senior Credit Facility. As of December 31, 2000, the Company had $42.5 million available for borrowing under its Senior Credit Facility. The Company's outstanding borrowings under the Senior Credit Facility at December 31, 2000 included $37.4 million in U.S. dollars and $20.1 million in Japanese yen (converted to U.S. dollars). The Company pays a quarterly commitment fee ranging from 0.25% to 0.375% per annum of the unused portion of available credit under the Senior Credit Facility. The interest rate outstanding as of December 31, 2000 ranged from 1.86% to 7.94% per annum, with a maturity date of October 2003. The Company utilizes the proceeds to refinance certain existing indebtedness, to finance certain acquisitions of assets of existing orthodontic centers, and for working capital. The amounts borrowed under the Senior Credit Facility are secured by security interests in all of the Company's assets, including its accounts receivable and equipment. The Company is required to maintain certain financial and nonfinancial covenants under the terms of the Senior Credit Facility, including a maximum leverage ratio, minimum fixed charge coverage ratio and minimum consolidated net worth ratio. At December 31, 2000, the Company was in compliance with the covenants and restrictions of the Senior Credit Facility. At December 31, 2000, the Company also had a $3,000,000 line of credit with a financial institution. There was no outstanding balance on this line of credit as of December 31, 2000. The line of credit is available for general working capital needs, the development of new orthodontic centers and the acquisition of assets from existing orthodontic centers. The Company is required to maintain certain financial covenants under the terms of this line of credit. The line of credit agreement also restricts certain activities of the Company, including limiting the declaration of dividends to current earnings. At December 31, 2000, the Company was in compliance with the covenants and restrictions of the agreement. 6. EARNINGS PER SHARE The following table sets forth the components of the basic and diluted net income (loss) per share calculations (in thousands).
YEAR ENDED DECEMBER 31, ---------------------------------------- 2000 1999 1998 -------- -------- -------- Numerator: Income before cumulative effect of accounting change for basic and diluted earnings per share .................... $ 47,722 $ 46,514 $ 33,813 Cumulative effect of changes in accounting principles, net of income tax benefit ....................... (50,576) (678) -- -------- -------- -------- Numerator for basic and diluted earnings per share ............... $ (2,854) $ 45,836 $ 33,813 ======== ======== ======== Denominator: Denominator for basic earnings per share ...................... 48,412 47,998 47,690 Effect of dilutive securities ................................. 1,433 645 812 -------- -------- -------- Denominator for diluted earnings per share .................... 49,845 48,643 48,502 ======== ======== ========
29 30 Orthodontic Centers of America, Inc. Notes to Consolidated Financial Statements (continued) 7. LEASES Facilities for the orthodontic centers and administrative offices are rented under long-term leases accounted for as operating leases. The original lease terms are generally 5 to 10 years with options to renew the leases for specified periods subsequent to their original terms. The leases have other various provisions, including sharing of certain executory costs and scheduled rent increases. Minimum rent expense is recorded on a straight-line basis over the life of the lease. Minimum future rental commitments as of December 31, 2000 are as follows (in thousands): 2001........................ $16,680 2002........................ 13,037 2003........................ 5,942 2004........................ 2,447 2005........................ 1,524 Thereafter.................. 2,811 ------- $42,441 =======
Many of the lease agreements provide for payments comprised of a minimum rental payment plus a contingent rental payment based on a percentage of cash collections and other amounts. Rent expense attributable to minimum and additional rentals along with sublease income was as follows (in thousands):
YEAR ENDED DECEMBER 31, ---------------------------------------- 2000 1999 1998 -------- -------- -------- Minimum rentals .............. $ 15,589 $ 13,769 $ 10,446 Additional rentals ........... 8,521 5,014 3,783 Sublease income .............. (137) (159) (101) -------- -------- -------- $ 23,973 $ 18,624 $ 14,128 ======== ======== ========
8. INCOME TAXES Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the consolidated deferred tax liabilities and assets were as follows (in thousands):
DECEMBER 31, ----------------------- 2000 1999 -------- -------- Deferred tax liabilities: Intangible assets ......................... $(14,633) $(16,622) Other ..................................... (769) (288) -------- -------- Total deferred tax liabilities .............. (15,402) (16,910) Deferred tax assets: Service fees receivable ................... 41,410 4,455 -------- -------- Total deferred tax assets ................... 41,410 4,455 -------- -------- Net deferred tax asset (liability) .......... $ 26,008 $(12,455) ======== ========
Components of the provision (benefit) for income taxes before the tax effect of the change in accounting were as follows (in thousands):
YEAR ENDED DECEMBER 31, --------------------------------------- 2000 1999 1998 -------- -------- -------- Current ...................... $ 36,341 $ 26,933 $ 23,520 Deferred ..................... (7,792) 1,273 (2,767) -------- -------- -------- Total ........................ $ 28,549 $ 28,206 $ 20,753 ======== ======== ========
30 31 Orthodontic Centers of America, Inc. Notes to Consolidated Financial Statements (continued) The reconciliation of income tax computed at the federal statutory rates to the provision for income taxes before the tax effect of the change in accounting is (in thousands):
YEAR ENDED DECEMBER 31, -------------------------------------------- 2000 1999 1998 ------- ------- ------- Tax at federal statutory rates.............................. $25,551 $25,237 $18,460 Other, primarily state income taxes......................... 2,998 2,969 2,293 ------- ------- ------- Total....................................................... $28,549 $28,206 $20,753 ======= ======= =======
9. BENEFIT PLANS STOCK OPTION PLANS The Company has reserved 3,400,000 of the authorized shares of common stock for issuance pursuant to options granted and restricted stock awarded under the Orthodontic Centers of America, Inc. 1994 Incentive Stock Plan (the "Incentive Option Plan"). Options may be granted to officers, directors and employees of the Company, for terms not longer than 10 years at prices not less than fair market value of the common stock on the date of grant. Grant options generally become exercisable in four equal installments beginning two years after the grant date, and expire 10 years after the grant date. At December 31, 2000, 526,664 shares were available for issuance under the Incentive Option Plan. The Company has reserved 600,000 of the authorized shares of common stock for issuance pursuant to options granted and restricted stock awarded under the Orthodontic Centers of America, Inc. 1994 Non-Qualified Stock Option Plan for Non-Employee Directors (the "Director Option Plan"). The Director Option Plan provides for the grant of options to purchase 2,400 shares of common stock on the first trading date each year to each non-employee director serving the Company on such date, at prices equal to the fair market value of the common stock on the date of grant. Grant options generally become exercisable in four equal annual installments beginning two years after the grant date, and expiring 10 years after the grant date, unless canceled sooner due to termination of service or death. At December 31, 2000, 552,000 shares were available for issuance under the Director Option Plan. The Company has reserved 2,000,000 of the authorized shares of common stock for issuance pursuant to options granted under the Orthodontic Centers of America, Inc. 1995 Restricted Stock Option Plan (the "Orthodontist Option Plan"). Options may be granted to orthodontists who own an orthodontic entity which has a service or consulting agreement with the Company, at prices not less than 100% of the fair market value of the common stock on the date of grant. Grant options generally become exercisable in four equal annual installments beginning two years after grant date, and expire 10 years after grant date. At December 31, 2000, 1,042,024 shares were available for issuance under the Orthodontist Option Plan. Compensation expense of $110,000, $410,000 and $95,000 has been recognized for the Orthodontist Option Plan for 2000, 1999 and 1998, respectively. The Company has reserved 200,000 of the authorized shares of common stock for issuance under the 1996 Employee Stock Purchase Plan (the "Employee Purchase Plan"), which allows participating employees of the Company to purchase shares of common stock from the Company through a regular payroll deduction of up to 10% of their respective normal monthly pay. Deducted amounts are accumulated for each participating employee and used to purchase the maximum reported on the New York Stock Exchange on the applicable purchase date or the first trading date of the year, whichever is lower. Additionally, the Company has reserved 2,000,000 shares of common stock for issuance to affiliated orthodontists through a stock purchase program that allows participating affiliated orthodontists to acquire shares of common stock from the Company. At December 31, 2000, a total of 2,126,207 shares were available for issuance under these stock purchase plans. FASB Statement No. 123, "Accounting for Stock-Based Compensation," requires the Company to disclose pro forma information regarding net income and earnings per share as if the Company had accounted for its employee stock options under the fair value method. The fair value was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions.
2000 1999 1998 ---------- ---------- ---------- Risk-free interest rate............................................ 6.52% 6.25% 6.11% Dividend yield: Volatility factor............................................... .553 .505 .490 Weighted-average expected life.................................. 6.43 years 6.65 years 7.43 years
31 32 Orthodontic Centers of America, Inc. Notes to Consolidated Financial Statements (continued) The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the option is amortized to expense over the option's vesting period. Had the Company's stock-based compensation plans been determined based on the fair value at the grant dates, the Company's net income and earnings per share would have been reduced to the pro forma amounts before the effect of the change in accounting principle indicated below (in thousands, except per share data):
2000 1999 1998 ---- ------- ------- Pro forma net income................................................. $46,467 $44,431 $33,111 Pro forma earnings per share: Basic............................................................. $ .96 $ .93 $ .69 Diluted........................................................... $ .93 $ .91 $ .68
A summary of the Company's stock option activity, and related information for the years ended December 31 follows:
2000 1999 1998 --------------------------- --------------------------- --------------------------- WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE OPTIONS EXERCISE PRICE OPTIONS EXERCISE PRICE OPTIONS EXERCISE PRICE ---------- -------------- ---------- -------------- ---------- -------------- Outstanding at beginning of year 4,333,585 $11.63 3,272,886 $10.72 3,130,072 $ 9.57 Granted 302,466 15.33 1,254,018 14.26 373,943 16.36 Exercised (479,473) 10.49 (122,775) 4.87 (181,729) 3.54 Forfeited (299,164) 15.25 (70,544) 17.42 (49,400) 4.72 ---------- ---------- ---------- Outstanding at end of year 3,857,414 12.28 4,333,585 11.63 3,272,886 10.72 ========== ========== ========== Exercisable at end of year 2,242,142 10.26 1,664,468 10.21 901,575 6.47 ========== ========== ========== Weighted average fair value of options granted during the year $ 11.31 $ 9.26 $ 12.05 ========== ========== ==========
Of the options outstanding at December 31, 2000, approximately 809,000 were issued on or about the date of the Company's initial public offering and have exercise prices which range from $2.75 to $3.25, a weighted average exercise price of $3.06, and a weighted average remaining contractual life of 4 years. The remaining options outstanding at December 31, 2000 have exercise prices which range from $2.75 to $33.13, a weighed average exercise price of $14.63, and a weighed average remaining contractual life of 7.02 years. KEY EMPLOYEE STOCK PURCHASE PLAN The Company implemented the Orthodontic Centers of America, Inc. 1997 Key Employee Stock Purchase Plan (the "Key Employee Purchase Plan") to encourage ownership of the Company's common stock by executive officers and other key employees of the Company and thereby align their interests with those of the Company's shareholders. For each employee participating in the Key Employee Purchase Plan, the Company will finance 50% of the purchase price through a loan from the Company. Each such loan will be evidenced by a promissory note and will 32 33 Orthodontic Centers of America, Inc. Notes to Consolidated Financial Statements (continued) be a full recourse obligation of the employee, secured by all of the shares of common stock acquired by the employee in connection with the loan. Each such loan will bear a market rate of interest and the outstanding principal and accrued interest under the loan will be payable, in one lump-sum payment, on the earlier of (i) the fifth anniversary of the date of the loan or (ii) termination of the applicable employee's employment with the Company. A proportionate amount of the outstanding principal and accrued interest under the loan will be payable upon the sale or transfer by the employee of shares of common stock purchase in connection with the loan. The Key Employee Purchase Plan includes a risk-sharing provision, whereby during their term of employment with the Company a participating employee will be responsible for 100% of any losses, but is entitled to only 50% of any gains (with the Company being entitled to the other 50% of such gains), occurring with respect to the sale by the employee of shares of common stock purchased under the Key Employee Purchase Plan and held for less than three years. In addition, with respect to the sale by the employee of shares purchased under the Key Employee Purchase Plan and held for more than three but less than five years, the employee will be entitled to 100% of any gains and the principal amount of the loan to the employee from the Company will be reduced by 50% of any losses during the term of the employee's employment with the Company. In 1997, 295,000 shares of common stock were purchased under the Key Employee Purchase Plan. The 50% of the loan not financed by the Company was financed personally by major shareholders on terms comparable to the loan from the Company. This loan has been recorded as a capital contribution to the Company with the corresponding amount due from the key employees recorded as a deduction from shareholders' equity. The loan to be financed personally by shareholders was paid by the Company at the time of the offering and has not been repaid at December 31, 2000. Therefore, a capital contribution receivable from the shareholders had been recorded at December 31, 2000 as a reduction from shareholders' equity. The total amount due from key employees in conjunction with the Key Employee Purchase Plan as of December 31, 2000 was $1,604,000. DEFINED CONTRIBUTION PLAN The Company sponsors a 401(k) plan for all employees who have satisfied minimum service and age requirements. Employees may contribute up to 15% of their earnings to the plan. The Company matches 40% of an employee's contribution to the plan, up to a maximum of $600 per year. Plan expense totaled $45,000, $59,000, and $52,000 for years ended December 31, 2000, 1999 and 1998, respectively. 33 34 Orthodontic Centers of America, Inc. Notes to Consolidated Financial Statements (continued) 10. COMMITMENTS AND CONTINGENCIES In May 2000, Benjamin M. Pridemore, Jr., D.D.S. and B. Morgan Pridemore, III filed a lawsuit against the Company alleging that the Company breached the terms of an agreement reached in settlement of previous litigation, and that the Company fraudulently induced them to enter into that settlement agreement. The plaintiffs are seeking specific enforcement of the settlement agreement and unspecified compensatory and punitive damages and attorney's fees. While the Company believes that the plaintiffs' claims lack merit, it is not possible to predict the outcome of this matter, and these matters could have a material adverse effect on the Company's financial position and results of operations. In October 2000, the Company filed a lawsuit against Dr. Ronald M. Roncone. Shortly before filing the litigation, the Company terminated Dr. Roncone's employment for cause. In its lawsuit, the Company alleges that Dr. Roncone failed to satisfy a condition to the Company's performance under the employment agreement by refusing to affiliate his orthodontic practice with the Company and by failing to recruit the minimum number of affiliated orthodontists, and is therefore not entitled to certain incentive compensation specified by the employment agreement. The Company also seeks repayment of $2.3 million that the Company loaned to Dr. Roncone, about $1.4 million that the Company paid to a third-party lender as guarantor of a loan to Dr. Roncone and about $1.0 million that the Company advanced on Dr. Roncone's behalf to lease, improve and equip a training center and orthodontic office for Dr. Roncone. In November 2000, Dr. Ronald M. Roncone filed litigation against the Company alleging that the Company breached the terms of an employment agreement and the terms of an alleged oral agreement to convert about $3.0 million in loans to Dr. Roncone to an interest-free basis and, at his option, compensation, and to waive Dr. Roncone's obligation to affiliate his practice with the Company. Dr. Roncone seeks an unspecified amount of money damages or 700,000 shares of the Company's common stock. While the Company believes the plaintiff's claims lack merit, it is not possible to predict the outcome of this matter and these matters could have a material adverse effect on the Company's financial position and results of operations. On April 9, 2001, a lawsuit purported to be a class action on behalf of purchasers of shares of the Company's stock from April 27, 2000 through March 15, 2001, was filed against the Company, Bartholomew F. Palmisano, Sr., Bartholomew F. Palmisano, Jr., and Dr. Gasper Lazzara, Jr. In the complaint, the plaintiffs alleged that the Company and the other defendants violated certain provisions of federal securities laws by allegedly recognizing revenue in violation of generally accepted accounting principles in the United States and SEC disclosure requirements and by allegedly making false and misleading statements about our financial results and accounting, which the plaintiffs alleged artificially inflated the market price of the Company's common stock. The plaintiffs' allegations related in part to the Company's change in revenue recognition policy pursuant to SEC Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," which is discussed in Note 2 to the consolidated financial statements. The plaintiff is seeking unspecified compensatory damages, interest and attorney's fees. While the Company believes the plaintiffs' claims lack merit, it is not possible to predict the outcome of this matter and these matters could have a material adverse effect on the Company's financial position and results of operations. In the normal course of business, the Company becomes a defendant or plaintiff in various lawsuits. Although a successful claim for which the Company is not fully insured could have a material effect on the Company's financial condition, management is of the opinion that it maintains insurance at levels sufficient to insure itself against the normal risk of operations. 34 35 Orthodontic Centers of America, Inc. Notes to Consolidated Financial Statements (continued) 11. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a tabulation of the unaudited quarterly results of operations for the years ended December 31, 2000 and 1999 (in thousands, except per share data). For the year ended December 31, 2000, the amounts include results previously reported by the Company and results restated to reflect the Company's change in revenue recognition pursuant to Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" effective January 1, 2000.
QUARTER ENDED ---------------------------------------------------------------------------------------------------- MARCH 2000 JUNE 2000 SEPTEMBER 2000 DECEMBER 2000 ---------------------- ----------------------- --------------------- --------------------- As As As Previously As Previously As Previously As Reported Restated Reported Restated Reported Restated ---------- -------- ---------- -------- ---------- -------- Net revenue................ $ 65,765 $ 59,282 $ 71,767 $ 65,842 $ 77,515 $ 69,724 $ 73,988 Operating profit........... 23,197 16,821 25,473 19,897 27,253 19,752 23,532 Net income before cumulative effect of changes in accounting principles............... 14,024 9,982 15,373 11,829 16,321 11,578 14,333 Cumulative effect of changes in accounting principles, net of income tax benefit.............. -- (50,576) -- -- -- -- -- Net income (loss).......... 14,024 (40,594) 15,373 11,829 16,321 11,578 14,333 Net income per share assuming dilution: Net income per share before cumulative effect of changes in accounting principles.. 0.29 0.20 0.31 0.24 0.33 0.23 0.29 Cumulative effect of changes in accounting principles, net of income tax benefit, per share.............. -- (1.04) -- -- -- -- -- Net income (loss) per share.................... 0.29 (0.84) 0.31 0.24 0.33 0.23 0.29
A portion of the revenue that was included in the cumulative effect adjustment as of January 1, 2000 was recognized as revenue in 2000. The amount of this recycled revenue was $16.9 million during the quarter ended March 31, 2000, $15.3 million during the quarter ended June 30, 2000, $13.6 million during the quarter ended September 30, 2000, and $11.5 million during the quarter ended December 31, 2000.
QUARTER ENDED -------------------------------------------------- MARCH JUNE SEPTEMBER DECEMBER 1999 1999 1999 1999 -------- -------- --------- -------- Net revenue .............. $ 49,048 $ 55,401 $ 59,770 $ 62,071 Operating profit ......... 16,666 18,923 20,094 21,241 Net income ............... 9,479 11,523 12,095 12,738 Net income per share: Basic ................. $ .20 $ .24 $ .25 $ .26 Diluted ............... .19 .24 .25 .26
35 36 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
----------------------------------------------------------------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E --------------------------------------- ------------------- ------------------------------------ ------------ ------------ Additions (1) (2) Balance at Charged to costs Charged to Other Deduction-- Balance at Description Beginning of Period and expenses Accounts-Describe Describe End of Period --------------------------------------- ------------------- ---------------- ----------------- ------------ ------------- Amounts in thousands Year ended December 31, 2000: Allowance for uncollectible service fees.......................... $ 9,644 $ 373 $ (5,049)(A) $ (2,370)(B) $ 2,598 ============ ============ ============ ============ ============ Year ended December 31, 1999: Allowance for uncollectible service fees.......................... $ 7,565 $ 2,079 -- -- $ 9,644 ============ ============ ============ ============ ============ Year ended December 31, 1998: Allowance for uncollectible service fees.......................... $ 5,270 $ 2,295 -- -- $ 7,565 ============ ============ ============ ============ ============
---------- (A) Cumulative effect of a change in accounting principle. (B) Deductions are for the write-off of uncollectible billings and uncollectible unbilled amounts directly to expense, net of recoveries. 36 37 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Index to Consolidated Financial Statements, Financial Statement Schedules and Exhibits The following consolidated financial statements are included in Item 8 of this Report. (1) FINANCIAL STATEMENTS: Report of Independent Auditors Consolidated Balance Sheets - December 31, 2000 and 1999 Consolidated Statements of Income - Years Ended December 31, 2000, 1999 and 1998 Consolidated Statements of Equity - Years Ended December 31, 2000, 1999 and 1998 Consolidated Statements of Cash Flows - Years Ended December 31, 2000, 1999 and 1998 Notes to Consolidated Financial Statements - December 31, 2000 (2) FINANCIAL STATEMENT SCHEDULE: Schedule II - Valuation and Qualifying Accounts All other schedules are omitted, because they are not applicable or not required, or because the required information is included in our consolidated financial statements or notes thereto. (3) EXHIBITS:
Exhibit Number Description of Exhibit ------- ---------------------- 3.1 -- Bylaws of Orthodontic Centers of America, Inc. (1) 3.2 -- Restated Certificate of Incorporation of Orthodontic Centers of America, Inc. (2) 4.1 -- Specimen Stock Certificate (1) 10.1 -- Form of Service Agreement (confidential treatment granted as to a portion of the agreement) (1) 10.2 -- Form of Management Agreement (confidential treatment granted as to a portion of the agreement) (1) 10.3 -- Form of Consulting Agreement (1)
37 38
Exhibit Number Description of Exhibit ------- ---------------------- 10.4 -- Employment Agreement, dated as of November 21, 1994, between Orthodontic Centers of America, Inc. and Gasper Lazzara, Jr., D.D.S. (1)(7) 10.5 -- Employment Agreement, dated as of November 21, 1994, between Orthodontic Centers of America, Inc. and Bartholomew F. Palmisano, Sr. (1)(7) 10.6 -- Orthodontic Centers of America, Inc. 1994 Incentive Stock Plan (1)(7) 10.7 -- Orthodontic Centers of America, Inc. 1994 Non-Qualified Stock Option Plan for Non-Employee Directors (1)(7) 10.8 -- First Union National Bank Defined Contribution Master Plan and Trust Agreement, and Adoption Agreement relating thereto, between Orthodontic Centers of America, Inc. and First Union National Bank (1)(7) 10.9 -- Orthodontic Centers of America, Inc. 1995 Restricted Stock Option Plan (3) 10.10 -- Orthodontic Centers of America, Inc. 1996 Employee Stock Purchase Plan (4)(7) 10.11 -- Orthodontic Centers of America, Inc. 1997 Key Employee Stock Purchase Plan Participation Agreement, dated as of November 5, 1997, between Orthodontic Centers of America, Inc. and Michael C. Johnsen (5)(7) 10.12 -- Orthodontic Centers of America, Inc. 1997 Key Employee Stock Purchase Plan Participation Agreement, dated as of November 5, 1997, between Orthodontic Centers of America, Inc. and Bartholomew F. Palmisano, Jr. (6)(7) 10.13 -- Revolving Credit and Security Agreement, dated as of October 8, 1998, among Orthodontic Centers of America, Inc. and certain of its subsidiaries, as Borrowers, the Lenders named therein, First Union National Bank, as Agent, Bank of America, FSB, as Documentation Agent, and Citibank, N.A., as Syndication Agent (6) 10.14 -- Lease Agreement, dated October 7, 1999 and amended and restated as of April 16, 2001, between Orthodontic Centers of America, Inc. and Ponte Vedra Management Group, Ltd. (8) 10.15 -- Asset Purchase Agreement, dated as of April 7, 2000, among Orthodontic Centers of America, Inc. and Apple Orthodontix, Inc. and certain of its subsidiaries (8) 10.16 -- Employment Agreement, dated as of November 6, 1996, between Orthodontic Centers of America, Inc. and Dr. Ronald M. Roncone (8) 21.1 -- List of subsidiaries of Orthodontic Centers of America, Inc. (8) 23.1 -- Consent of Ernst & Young LLP (filed herewith)
---------- 38 39 (1) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-1, Registration Statement No. 33-85326. (2) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-3, Registration Statement No. 333-36799. (3) Incorporated by reference to exhibits filed with the Registrant's Annual Report on Form 10-K for the year ended December 31, 1994. (4) Incorporated by reference to exhibits filed with the Registrant's Annual Report on Form 10-K for the year ended December 31, 1995. (5) Incorporated by reference to exhibits filed with the Registrant's Annual Report on Form 10-K for the year ended December 31, 1997. (6) Incorporated by reference to exhibits filed with the Registrant's Annual Report on Form 10-K for the year ended December 31, 1998. (7) Executive compensation plan or arrangement. (8) Previously filed as an exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 2000. (b) Reports on Form 8-K No current reports on Form 8-K were filed during the fourth quarter of 2000. 39 40 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, in the City of Metairie, State of Louisiana, on April 26, 2001. ORTHODONTIC CENTERS OF AMERICA, INC. By: /s/ Bartholomew F. Palmisano, Sr. ------------------------------------- Bartholomew F. Palmisano, Sr. President and Chief Executive Officer 40 41 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION OF EXHIBIT ------- ---------------------- 3.1 -- Bylaws of Orthodontic Centers of America, Inc. (1) 3.2 -- Restated Certificate of Incorporation of Orthodontic Centers of America, Inc. (2) 4.1 -- Specimen Stock Certificate (1) 10.1 -- Form of Service Agreement (confidential treatment granted as to a portion of the agreement) (1) 10.2 -- Form of Management Agreement (confidential treatment granted as to a portion of the agreement) (1) 10.3 -- Form of Consulting Agreement (1) 10.4 -- Employment Agreement, dated as of November 21, 1994, between Orthodontic Centers of America, Inc. and Gasper Lazzara, Jr., D.D.S. (1)(7) 10.5 -- Employment Agreement, dated as of November 21, 1994, between Orthodontic Centers of America, Inc. and Bartholomew F. Palmisano, Sr. (1)(7) 10.6 -- Orthodontic Centers of America, Inc. 1994 Incentive Stock Plan (1)(7) 10.7 -- Orthodontic Centers of America, Inc. 1994 Non-Qualified Stock Option Plan for Non-Employee Directors (1)(7) 10.8 -- First Union National Bank Defined Contribution Master Plan and Trust Agreement, and Adoption Agreement relating thereto, Option Plan (3) 10.9 -- Orthodontic Centers of America, Inc. 1995 Restricted Stock Option Plan (3) 10.10 -- Orthodontic Centers of America, Inc. 1996 Employee Stock Purchase Plan (4)(7) 10.11 -- Orthodontic Centers of America, Inc. 1997 Key Employee Stock Purchase Plan Participation Agreement, dated as of November 5, 1997, between Orthodontic Centers of America, Inc. and Michael C. Johnsen (5)(7) 10.12 -- Orthodontic Centers of America, Inc. 1997 Key Employee Stock Purchase Plan Participation Agreement, dated as of November 5, 1997, between Orthodontic Centers of America, Inc. and Bartholomew F. Palmisano, Jr. (6)(7) 10.13 -- Revolving Credit and Security Agreement, dated as of October 8, 1998, among Orthodontic Centers of America, Inc. and certain of its subsidiaries, as Borrowers, the Lenders named therein, First Union National Bank, as Agent, Bank of America, FSB, as Documentation Agent, and Citibank, N.A., as Syndication Agent (6) 10.14 -- Lease Agreement, dated as of October 7, 1999 and amended and restated as of April 16, 2001, between Orthodontic Centers of America, Inc. and Ponte Vedra Management Group, Ltd. (8) 10.15 -- Asset Purchase Agreement, dated as of April 7, 2000, among Orthodontic Centers of America, Inc. and Apple Orthodontics, Inc. and certain of its subsidiaries (8) 10.16 -- Employment Agreement, dated as of November 6, 1996, between Orthodontic Centers of America, Inc. and Dr. Ronald M. Roncone (8) 21.1 -- List of subsidiaries of Orthodontic Centers of America, Inc. (8) 23.1 -- Consent of Ernst & Young LLP (filed herewith)
---------- 42 (1) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-1, Registration Statement No. 33-85326. (2) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-3, Registration Statement No. 333-36799. (3) Incorporated by reference to exhibits filed with the Registrant's Annual Report on Form 10-K for the year ended December 31, 1994. (4) Incorporated by reference to exhibits filed with the Registrant's Annual Report on Form 10-K for the year ended December 31, 1995. (5) Incorporated by reference to exhibits filed with the Registrant's Annual Report on Form 10-K for the year ended December 31, 1997. (6) Incorporated by reference to exhibits filed with the Registrant's Annual Report on Form 10-K for the year ended December 31, 1998. (7) Executive compensation plan or arrangement. (8) Previously filed as an exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 2000.