ITEM 1. BUSINESS The Company
The Company develops, manages and operates integrated dental networks through contractual affiliations with general, orthodontic and multi-specialty dental practices in the United States. The Company currently conducts operations in the states of Texas, Florida, Tennessee and California. The Company does not engage in the practice of dentistry but rather establishes integrated dental networks by entering into management services agreements with affiliated dental practices to provide, on an exclusive basis, management and administrative services to affiliated dental practices. The Company's strategy is to provide high-quality care in selected markets with a view to achieving broad geographic coverage within those markets. The Company seeks to achieve operating efficiencies by consolidating and integrating affiliated practices into regional networks, realizing economies of scale in such areas as marketing, administration and purchasing and enhancing the revenues of its affiliated dental practices by increasing both patient visits and the range of specialty services offered. As of December 31, 2000, the Company provided management services to 101 dental centers with approximately 200 affiliated dentists, orthodontists and other dental specialists.
The Company's objective is to make each of its dental networks the leading group dental care provider in each market it serves. Since its formation, the Company has applied traditional retail principles of business and marketing techniques to the practice of dentistry, including locating practices in high- profile locations, offering more affordable fees and payment plans, expanding the range of services offered, increasing market share through targeted advertising and offering extended office hours. By using the Castle Dental Centers' approach to managing affiliated dental practices, the Company believes it enables affiliated dentists, orthodontists and other dental specialists to focus on delivering quality patient care and realize significantly greater productivity than traditional individual and small-group dental practices.
The Company believes that the provision of a full range of dental services through an integrated network is attractive to managed care payers and intends to continue to pursue managed care contracts. The Company negotiates capitated managed care contracts on behalf of its affiliated dental practices, which maintained an aggregate of 40 capitated managed care contracts covering approximately 170,000 members at December 31, 2000. The Company believes that the continued development of its networks will assist it in negotiating national and regional capitated arrangements with managed care payors on behalf of the affiliated practices.
The Company intends to establish a consistent national identity for its business by implementing common practice management policies and procedures in all of its dental centers and affiliated dental practices nationwide. Moreover, the Company believes that its experience and expertise in managing multi- specialty dental group practices, as well as the development of name recognition associated with the name "Castle Dental Centers," will provide its affiliated dental practices with a competitive advantage in attracting and retaining patients and realizing practice efficiencies.
The Company was formed in 1981 by Jack H. Castle, D.D.S. and Jack H. Castle, Jr., as a single location, multi-specialty dental practice in Houston, Texas. From 1982 through 1996, the Company expanded to a total of 10 locations with 39 dentists in the Houston metropolitan area. During this period the Company developed, implemented and refined the integrated dental network approach that it utilized as a basis for its expansion.
At December 31, 1997, the Company operated 42 dental centers, with 25 in Texas, 6 in Tennessee and 11 in Florida. In March 1998, the Company acquired six dental centers in Houston owned by Dental World, Inc. Also in March 1998, the Company expanded into the southern California market through the acquisition of an 80% interest in ("Castle West") a company formed to acquire Dental Consulting Services LLC, which managed five dental centers in the Los Angeles area. Subsequent to March 1998, Castle West acquired four additional dental offices in the Los Angeles area, one of which was closed in 2000. In July 1998, the Company acquired a dental management company and five related dental practices in Florida. In December 1998, the Company acquired from Dental Centers of America and its affiliated dental practices 16 dental centers in San Antonio, Austin, Waco and the Dallas/Fort Worth metroplex. In January 2000, the Company acquired the 20% minority in Castle West that it did not previously own. The Company opened 9, 20 and 4 de novo offices in
1998, 1999 and 2000, respectively. The Company closed or consolidated 8 dental centers in 1999 and 2000. At December 31, 2000, the Company operated 65, 12, 17 and 7 dental centers in Texas, Tennessee, Florida and California, respectively.
RECENT DEVELOPMENTS
In January 2000, the Company entered into a senior subordinated note agreement ("Subordinated Note Agreement") and a subordinated convertible note agreement ("Convertible Note Agreement") pursuant to which it borrowed $13.7 million and $1.3 million, respectively, and, in connection with such other borrowings, amended its existing bank credit agreement (the "Credit Agreement" and, together with the Subordinated Note Agreement and the Convertible Note Agreement, the "Debt Agreements"). In March 2000, as a result of write-downs of the Company's accounts receivable, the Company determined that it was in violation of financial covenants under the Debt Agreements. Accordingly, in May 2000, the Company amended the Debt Agreements to cure its covenant violations and to provide additional availability for the Company to complete the de novo dental centers that were under development in 2000. In June 2000, the Company recorded litigation expenses of $1,495,000 resulting from an adverse arbitration award in an arbitration proceeding in Los Angeles, California. As a result of this litigation expense, the Company was again in default under the Debt Agreements.
The Company reported additional losses in the third and fourth quarters of 2000 and, as a result, has not been in compliance with the financial covenants of the Debt Agreements since June 30, 2000. At December 31, 2000, approximately $45.2 million in senior debt and $15 million in subordinated debt were outstanding under the Debt Agreements in addition to approximately $3.5 million in other outstanding subordinated debt. Since the Company is in default under these agreements, all amounts outstanding are subject to acceleration and have been classified as current liabilities.
On February 15, 2001, the Company retained Getzler and Co., a New York based turnaround specialist, to assist the Company in addressing its operational issues and restructuring of the Company's debt. The Company's board of directors has appointed Getzler's designee, Ira Glazer, to serve as the Company's acting Chief Executive Officer and initiated an executive search for a permanent Chief Executive Officer. Jack Castle, Jr., the Company's former Chief Executive Officer, continues to serve as the Company's Chairman of the Board. The Company's President and Chief Operating Officer resigned to pursue other opportunities.
The Company has continued to pay interest (other than default interest) on the amounts outstanding under the Credit Agreement, but has not made principal or interest payments of $1.9 million owed to subordinated creditors since July 2000. The Company has requested waivers of these covenant violations, a forbearance of scheduled principal payments and is negotiating with its lenders to restructure the Debt Agreements. However, these negotiations have not resulted in a forbearance agreement or waivers of the defaults as of April 16, 2001. Given the financial position of the Company and the current condition of financial markets, the Company believes that it is unlikely that either a new lender group will be brought in to replace the existing lender group or that an equity investment by a third party in the Company will be obtained that would be sufficient to satisfy its capital needs.
The Company believes that it will be able to continue to make interest payments, exclusive of default interest, on its outstanding debt, but was not able to make required principal payments on its senior debt, which began becoming due in March 2001. There can be no assurance that the Company's lenders will consent to the waivers and restructuring necessary to allow the Company to continue to operate. If the Company and its lenders cannot reach an agreement, it may be necessary for the Company to seek protection under Chapter 11 of the Bankruptcy Code. These factors, among others, may indicate that the Company will be unable to continue as a going concern for a reasonable period of time.
The Company has developed a plan that will allow it to continue to operate without the need for additional borrowings and to make principal payments to its senior bank creditors out of available funds. Components of this plan include: (i) reorganization of field management to improve efficiency and reduce regional overhead costs; (ii) reduction in corporate general and administrative costs through job eliminations and reduction in
other overhead expenses; (iii) closing of unprofitable and under-performing dental centers; (iv) realignment of accounts receivable management to focus on improved collection of insurance and patient receivables; (v) restructuring of compensation for management to emphasize performance-based incentives; and, (vi) cancellation of further de novo development and reducing capital expenditures to maintenance levels of approximately $1.2 million for 2001.
However, there can be no assurance that these efforts to improve operating results and cash flows will be sufficient to allow the Company to meet its obligations in a timely manner. Therefore, there is substantial doubt about the Company's ability to continue in existence.
THE DENTAL INDUSTRY
Dental care services in the United States are generally delivered through a fragmented system of local providers, primarily sole practitioners, or small groups of dentists, orthodontists or other dental specialists, practicing at a single location with a limited number of professional assistants and business office personnel. According to the American Dental Association 1996 Survey of Dental Practice ("ADA Survey"), there were approximately 152,000 actively practicing dental professionals in the U.S., of which approximately 8,900 were practicing orthodontists. Nearly 88% of the nation's private practitioners work either as sole practitioners or in a practice with one other dentist. The balance of these dentists practice in about 4700 groups of three or more dentists. However, dental, orthodontic and other specialty practices have followed the trend of the health care industry generally and are increasingly forming larger group practices.
The annual aggregate domestic market for dental services was estimated by the Health Care Financing Administration, Health Care Financing Review (1999) to be approximately $53.8 billion for 1998, representing approximately 4.7% of total health care expenditures in the United States, and is projected to reach $93.1 billion by 2008. Within the total market for dental services in the United States, there are, in addition to general dentistry, a number of specialties, including orthodontics (the straightening of teeth and remedy of occlusion), periodontics (gum care), endodontics (root canal therapy), oral surgery (tooth extraction) and pedodontics (care of children's teeth). The dental services market has grown at a compound annual growth rate of approximately 8.0% from 1980 to 1998, and is projected to grow at a compound annual growth rate of approximately 6.0% through the year 2008. In contrast to other health care expenditures, dental services are primarily paid for by the patient. According to the U.S. Department of Health and Human Services, in 1998, consumer out-of- pocket expenditures accounted for 48% of the payment for dental services, compared to 16% for other medical services.
Management believes that the growth in the dental industry has largely been driven by four factors: (i) an increase in the availability and types of dental insurance; (ii) an increasing demand for dental services from an aging population; (iii) the evolution of technology which makes dental care less traumatic; and (iv) an increased focus on preventive and cosmetic dentistry.
Concerns over the accelerating cost of health care have resulted in the increasing importance of managed care in the dental industry. Managed care typically involves a third party (frequently the payer) assuming responsibility for ensuring that health care is provided in a high quality, cost-effective manner. According to industry sources, approximately 18% of the estimated 147 million people covered by dental benefits in 1997 were enrolled in managed care programs. Enrollment in managed dental care plans, according to the National Association of Dental Plans, is estimated to have grown from 7.8 million patients in 1990 to 22.8 million patients in 1995.
BUSINESS STRATEGY
The Company's strategy is to develop integrated networks for the provision of a broad range of dental services that provide high-quality, cost-effective dental care in target markets. Key elements of this strategy are to:
Provide High-Quality, Comprehensive, One-Stop Family Dental Health Care. The prototypical Castle Dental Center provides general dentistry as well as a full range of dental specialties (including
orthodontics, pedodontics, periodontics, endodontics, oral surgery and implantology), thereby allowing the majority of specialty referrals to remain in-house within the Company's network of facilities. By bringing together multi-specialty dental services within a single practice, the Company is able to realize operating efficiencies and economies of scale and to promote increased productivity, higher utilization of professionals and facilities, and the sharing of dental specialists among multiple locations. The Company's practice model also incorporates quality assurance and quality control programs, including peer review and continuing education and technique enhancement. The Company believes that its multi-specialty strategy significantly differentiates it from both individual and multi-center practices that typically offer only general dentistry, orthodontics or other single specialty dental1 services.
Develop Comprehensive Dental Networks in Target Markets. The Company seeks to consolidate and integrate its affiliated practices to establish regional dental care networks. The Company believes this network system will enable it to reduce the operating costs of its affiliated practices by centralizing certain functions such as telemarketing and advertising, billing and collections, payroll and accounting and by negotiating regional and national contracts for supplies, equipment, services and insurance. Once practice affiliations are established in a market, the Company seeks to assist the affiliated practices in expanding their range of services to make available specialty dental services not previously offered.
Apply Traditional Retail Principles of Business to Dental Care. The Company believes it can enhance revenues and profitability by applying traditional retail principles of business to the provision of dental services in its target markets. These principles include professionally produced broadcast and print advertisements targeting specific audiences, and extended hours of operation which are convenient for patients, including weekend and evening hours. As part of its retail-oriented strategy, the Company seeks to establish or, where appropriate, relocate each Castle Dental Center in a convenient location in or near a high-profile neighborhood retail area and utilizes innovative sales and marketing programs designed to create strong name recognition and increase patient visits. In addition, the Company stresses the breadth and affordability of its services and works closely with patients to establish treatment schedules and affordable payment plans tailored to the patients' needs.
Market its Networks to Managed Care Entities. The Company believes that managed care will play an increasing role in the provision of dental services and therefore intends to market the services of its dental practice networks to the managed care community. The Company believes that contracting with managed care entities will facilitate entry into new markets and the expansion of existing networks, as well as improve the utilization of existing facilities by providing a source of patients to dentists with whom the Company is affiliated. In addition, such contracts, including capitated contracts, enable the Company to leverage its infrastructure and marketing efforts by increasing patient visits.
DENTAL NETWORK DEVELOPMENT
Prior to 1999, the Company expanded into new markets through the acquisition of multi-location group dental practices. Once the market entry acquisition was made, the Company expanded within its target markets primarily through the de novo development of new dental centers. During 1999 and 2000, the Company expanded solely through the development of de novo centers and did not complete any acquisitions of dental practices. In 2000, four de novo dental centers were opened, four dental centers were closed and two dental centers in Houston were consolidated into a new dental center. The Company has no plans to develop any de novo dental centers in 2001.
De novo Development
The Company has opened 24 newly developed dental centers since 1999; three in Houston, two in Austin, three in Dallas/Fort Worth, five in San Antonio, two in Corpus Christi, Texas, six in Nashville, Tennessee and three in the Tampa/Clearwater area in Florida. All of the new centers were located in leased facilities in neighborhood retail shopping centers areas. Development of each de novo dental center costs approximately $315,000 in leasehold improvements, signage, and dental and office equipment, depending primarily on the size of the dental facility. All new dental centers in the Company's existing markets utilize the Castle Dental Centers name and logo.
The Company expanded through development of de novo dental centers in existing markets because management believes that opening new dental centers that conform to the Company's operating model is more effective in creating brand awareness and increasing market share in existing markets than acquiring dental practices that have different operating characteristics. In addition, the cost of building and equipping a new dental center has generally been less than the cost of acquiring dental centers. Due to the lack of capital necessary for continued expansion, the Company ceased development of new dental centers in early 2000, and did not have any centers under construction at December 31, 2000. Until such time as the Company's liquidity improves, the Company anticipates that it will not open or acquire any additional dental centers.
MANAGEMENT SERVICES AGREEMENT
The Company has entered into a management services agreement with each of its affiliated dental practices pursuant to which the Company becomes the exclusive manager and administrator of all non-dental services relating to the operation of the practice. The amount of the management fee charged by the Company to an affiliated dental practice is intended to reflect and is based on the fair value of the management services rendered by the Company to the affiliated dental practice. Subject to applicable law, the Company is paid a monthly management fee comprised of three components: (i) the costs incurred by it on behalf of the affiliated practice; (ii) a base management fee in an amount ranging from 12.5% to 20.0% of adjusted gross revenues; and (iii) a performance fee equal to the patient revenues of the affiliated dental practice less (a) the expenses of the affiliated dental practice and (b) the sum of (i) and (ii), as described in each agreement. In California, the Company is paid a monthly management fee comprised of two components: (i) the costs incurred by it on behalf of the affiliated practice and (ii) a management fee in an amount ranging from 15.0% to 30.0% of net patient revenues. With respect to the three of the California professional corporations, the Company is paid a bonus equal to 30% of patient revenues in excess of average monthly patient revenues over the prior two-year period. The amount of the management fee is reviewed by the Company and the affiliated dental practice not less frequently than annually in order to determine whether such fee should be adjusted, up or down, to continue to reflect the fair value of the management services rendered by the Company.
The obligations of the Company under its management services agreements include assuming financial and other responsibility, either on its own or with the input and participation of the policy board of the affiliated practice, for the following (subject to limitations imposed by applicable state law): facilities, equipment and supplies; advertising, marketing and sales; training and development; operations management; provision of support services; risk management and utilization review; application and maintenance of applicable local licenses and permits; negotiation of contracts between the affiliated dental practice and third parties, including third-party payors, alternative delivery systems and purchasers of group health care services; establishing and maintaining billing and collection policies and procedures; fiscal matters, such as annual budgeting, maintaining financial and accounting records, and arranging for the preparation of tax returns; and maintaining insurance. The Company does not assume any authority, responsibility, supervision or control over the provision of dental services to patients or for diagnosis, treatment, procedure or other health care services, or the administration of any drugs used in connection with any dental practice.
The typical management services agreement is for an initial term of 25 to 40 years, and is automatically renewed for successive five-year terms unless terminated at least 90 days before the end of the initial term or any renewal term. As part of the management services agreement, the Company requires that the majority shareholder of the affiliated dental practice execute an option agreement that grants the Company's designee the right to acquire all the shareholder's interest in the practice at a nominal cost. The Company can exercise the option at any time on 10 days written notice. The Company may nominate without restriction any licensed dentist as its designee and may transfer the option at any time to any qualified person, subject to applicable state regulations governing the practice of dentistry. The management services agreement does not limit the number of times that the option may be exercised. At December 31, 2000, each of the Company's affiliated dental practices were wholly-owned by an individual dentist. Additionally, the management services agreement may be terminated by the Company or the affiliated dental practice only in the event of default in the performance of the material duties of the non-terminating party.
DENTIST EMPLOYMENT AGREEMENTS
Each affiliated dental practice has entered into employment agreements with substantially all of its full-time dentists, orthodontists and other dental specialists. Although the form of contract varies somewhat among practices and among dentists with different specialties, the typical contract for a full-time dentist provides for a defined compensation arrangement, including performance- based compensation and, where market conditions permit and to the extent deemed enforceable under applicable law, a covenant not to compete. Each full-time dentist, whether or not a party to a dentist employment agreement, is required to maintain professional liability insurance, and mandated coverage limits are generally at least $1.0 million per claim and $3.0 million in the aggregate. In addition, many affiliated dental practices employ part-time dentists. Not all part-time dentists have employment agreements, but all part-time dentists are required to carry professional liability insurance in specified amounts. Certain part-time dentists retained by some of the affiliated dental practices are independent contractors and have entered into independent contractor agreements.
SERVICES
The Company provides management expertise, marketing, information systems, capital resources and acquisition services to its affiliated dental practices. As a result, the Company is involved in the financial and administrative management of the affiliated dental practices, including legal, financial reporting, cash management, human resources and insurance assistance. The Company's goals in providing such services are (i) to allow the dentists associated with affiliated dental practices to dedicate their time and efforts more fully to patient care and professional practice activities; (ii) to improve the performance of affiliated dental practices in these administrative and sales activities; and (iii) to enhance the financial return to the Company.
Aside from the centralization of functions mentioned above, the affiliated dental practices are encouraged to administer their practices in accordance with the needs of their specific patient populations. The practice of dentistry at each affiliated dental practice is under the exclusive control of the dentists who practice at those locations.
The majority of services provided by the Company's affiliated dental centers are classified as general dentistry. General dentistry includes diagnostics, treatment planning, preventive care, removal of infection, fillings, crowns, bridges, partials, dentures, and extractions, all of which are currently being provided by the affiliated dental practices. Within its networks, the Company provides a wide range of specialty dental services. The Company seeks to expand the services offered by affiliated practices beyond general dentistry to include other dental specialty services and to improve efficiency by improving appointment availability, increasing practice visibility and assisting the practices in adding complementary services. These complementary services include orthodontics, periodontics (the diagnosis, treatment and prevention of infection of the gums and supporting bone around the teeth), endodontics (the diagnosis, treatment and prevention of infection of the oral tissues), oral surgery and implantology (the placement of abutments (implants) in the jaw bones to support tooth replacement). By adding these complementary services to the practice, the affiliated dental practices will retain the majority of specialty service referrals in-house, thereby increasing patient revenues.
OPERATIONS
Center Design and Location
The Company's dental centers are generally located in retail environments. Many of the dental centers include semi-private general dentistry treatment rooms, private treatment rooms and orthodontic bays. Currently, the Company's dental centers include from four to 22 treatment rooms and range in size from approximately 1,000 square feet to approximately 6,000 square feet. New dental centers, developed by the Company, range in size from 1,600 square feet to 4,000 square feet, and have from five to fourteen operatories.
Since its formation, the Company has adapted its locations to accommodate the full range of dental specialties. The Company believes the application of its method of designing and locating dental centers will facilitate the expansion of services offered by the acquired practices. Where a dental center is not able, due to limitations of floor space, zoning or other reasons, to accommodate new services or specialists, the Company may seek to relocate such dental center to a more desirable retail location as soon as practicable.
Staffing and Scheduling
The Company believes that making its facilities available at times which are convenient to its patients is an important element of its strategy. As a result, the affiliated dental practices maintain extended hours of operation, with many dental centers opening as early as 7:00 a.m. and closing as late as 9:00 p.m. on weekdays and 5:00 p.m. on Saturdays. The dental centers are staffed with dentists and dental assistants every day they are open, with orthodontists and other specialists rotating among several centers in order to utilize their time optimally. Each patient typically is assigned to and sees the same dentist or specialist on all visits to the center. Each dental center is also regularly staffed with an office manager, front office staff and other support staff.
Fees and Payment Plans
The Company believes that fees charged by its affiliated practices are typically lower than usual and customary fees within their respective markets. The affiliated practices generally provide a wide range of payment options, including cash, checks, credit cards, third party insurance and various forms of credit. In general, most general dentistry and specialty services, other than orthodontics, are paid for by the patient, or billed to the patient's insurance carrier, on the date the service is rendered. In some instances, the Company will extend credit in accordance with its established credit policies. The Company believes that its lower fees and ability to assist patients in obtaining financing provides it with a competitive advantage compared to sole practitioners and small group practices.
The Company's typical orthodontic payment plan consists of no initial down payment and equal monthly payments during the term of treatment ranging from $88 to $98 per month, with an average contract period of approximately 26 months. After consultation with the orthodontic staff at the initial visit, the patient signs a contract outlining the terms of the treatment, including the anticipated length of treatment and the total fees. The number of required monthly payments is fixed at the beginning of the case and corresponds to the anticipated number of monthly treatments. In 1999, the Company adopted a payment policy requiring that new orthodontic patients arrange for an automatic monthly bank draft. Previously existing patients are billed in advance by the Company on a monthly basis.
Quality Assurance
Affiliated dental practices are solely responsible for all aspects of the practice of dentistry. The Company has responsibility for the business and administrative aspects of the practices and exercises no control over the provision of dental services. The Company's management structure is designed to bring to its affiliated dental practices improvements in their recruiting and professional training. The Company expects that the increased visibility of the Company, the ability to offer career paths previously unavailable to dentists and the ability to recruit for multiple markets will give it an advantage in recruiting and retaining dentists. In addition, the Company believes that the ability to offer dentists in private practice the chance to practice in an environment where they do not assume capital risks and administrative burdens normally associated with private practice will make joining the Company an attractive choice for private practitioners.
SALES AND MARKETING
The Company has established a consistent national identity for its business and to utilizes the "Castle Dental Centers" name and logo at all its dental centers. As of December 31, 2000, the Castle Dental Centers name had been implemented at all affiliated locations except for two dental centers in California. The Company applies traditional retail principles of business to the provision of dental care. These principles
include network development, extended hours of operation, location optimization, signage, customized treatment schedules, affordable fees and payment plans. The Company uses both print advertising and professionally produced broadcast advertising to market its dental services to potential patients.
The Company has also established a national telemarketing system in Houston, Texas to field calls generated by advertising, to confirm upcoming scheduled patient visits and to encourage patients to return for follow-up visits. The national telemarketing system is based on a national 800 number (1-800-TO SMILE) and utilizes state-of-the-art software to identify patients and direct them to the nearest Company operated dental center. The telemarketers can enter all relevant information into the Company's management information system for patients making appointments for an initial visit, including pre-screening patients for insurance and other credit information.
MANAGED CARE CONTRACTS
The Company negotiates, on behalf of its affiliated dental practices, contracts with dental healthcare maintenance organizations, insurance companies, self insurance plans and other third-party payers pursuant to which services are provided on some type of discounted fee-for-service or capitated basis. Under capitated contracts the affiliated dental practice receives a predetermined amount per patient per month in exchange for providing certain necessary covered services to members of the plan. Usually, the capitated plans also provide for supplemental payments and/or co-payments by members for certain higher cost procedures such as crowns, root canal therapy and dentures. These contracts typically result in lower average fees for services than the usual and customary fees charges by the Company's affiliated dental practices and may, in certain instances, expose the Company to losses on contracts where the total revenues received are less than the costs of providing such dental care. The Company generally bears the risk of such loss because it consolidates the financial results of its affiliated dental practices. However, most of these contracts are cancelable by either party on 30 to 90 days written notice thereby reducing the risk of long-term adverse impact on the Company.
At December 31, 2000, the Company and its affiliated dental practices maintained an aggregate of 40 capitated managed care contracts covering approximately 170,000 members. Capitation fees, excluding supplemental fees and co-payments by members, totaled $9.1 million, or approximately 8.6% of total patient revenues in 2000. No single contract amounted to a significant portion of the Company's revenues, as each of the Company's regional operations contracts separately with managed care providers. The Company periodically evaluates its capitated managed care contracts by comparing the average reimbursement per procedure plus the total capitation fees per contract to the usual and customary fees charged by the affiliated dental practice. If the aggregate reimbursement percentage for the capitated contract exceeds 55% of the usual and customary fees, the Company believes that the incremental costs of providing covered services are being recovered. Management believes that capitated managed care contracts, in the aggregate, are profitable and will continue to increase as a percentage of total patient revenues in the future.
A component of the Company's strategy is to seek long-term relationships with insurance companies on a regional and national basis. The expanded networks of dentists and dental specialists in the Company's markets makes the Company's dental networks attractive to insurance companies and other third-party payers. Management believes that negotiating with major dental healthcare providers on a national basis will result in better coordination and improved financial results from its managed care contracts.
COMPETITION
The dental care industry is highly fragmented, comprised principally of sole practitioners and group practices of dental and orthodontic services. The dental practice management industry is subject to continuing changes in the provision of services and the selection and compensation of providers. The Company is aware of several dental practice management companies, both publicly-traded and privately owned, that it competes with in its markets. Publicly traded dental practice management companies that compete with the Company include Monarch Dental Corporation, American Dental Partners, Inc., Interdent, Inc., and Coast Dental Services, Inc., as well as others. Certain of the Company's competitors are larger and better capitalized, may provide a wider variety of services, may have greater experience in providing dental care management services
and may have longer established relationships with buyers of such services.
In certain markets, the demand for dental care professional personnel presently exceeds the supply of qualified personnel. As a result, the Company experiences competitive pressures for the recruitment and retention of qualified dentists to deliver their services. The Company's future success depends in part on its ability to continue to recruit and retain qualified dentists to serve as employees or independent contractors of the affiliated dental practices. There can be no assurance that the Company will be able to recruit or retain a sufficient number of competent dentists to continue to expand its operations.
MANAGEMENT INFORMATION SYSTEMS
During 1999, the Company completed the integration of the dental practice management systems in all its offices into a single practice management system that is centralized in Houston. This system monitors and controls patient treatment, scheduling, invoicing of patients and insurance companies, productivity of clinical staffs and other practice related activities. During the third quarter of 1999 the Company implemented a web-based purchase order system to enable management to monitor and control dental and office supplies purchasing.
The Company also utilizes centralized financial information and accounting systems. These systems are linked to the practice management systems allowing for automatic transfer of data between the practice management and financial information systems.
REGULATION
General
The practice of dentistry is highly regulated, and there can be no assurance that the regulatory environment in which the affiliated dental practices and the Company operate will not change significantly in the future. In general, regulation of health care related companies also is increasing.
Every state imposes licensing and other requirements on individual dentists and dental facilities and services. In addition, federal and state laws regulate health maintenance organizations and other managed care organizations for which dentists may be providers. In connection with its operations in existing markets and expansion into new markets, the Company may become subject to compliance with additional laws, regulations and interpretations or enforcement thereof. The ability of the Company to operate profitably will depend in part upon the Company and its affiliated dental practices obtaining and maintaining all necessary licenses, certifications and other approvals and operating in compliance with applicable health care regulations.
Dental practices must meet federal, state and local regulatory standards in the areas of safety and health. Historically, those standards have not had any material adverse effect on the operations of the dental practices managed by the Company. Based on its familiarity with the operations of the dental practices managed by the Company, management believes that it, and the practices it manages, are in compliance in all material respects with all applicable federal, state and local laws and regulations relating to safety and health.
Medicare and Medicaid Fraud and Abuse
Federal law prohibits the offer, payment, solicitation or receipt of any form of remuneration in return for, or in order to induce, (i) the referral of a person for services, (ii) the furnishing or arranging for the furnishing of items or services or (iii) the purchase, lease or order or arranging or recommending purchasing, leasing or ordering of any item or service, in each case, reimbursable under Medicare or Medicaid. Because dental services are covered under various government programs, including Medicare, Medicaid or other federal and state programs, the law applies to dentists and the provision of dental services. Pursuant to this anti-kickback law, the federal government announced a policy of increased scrutiny of joint ventures and other transactions among health care providers in an effort to reduce potential fraud and abuse related to Medicare and Medicaid costs. Many states have similar anti- kickback laws, and in many cases these laws apply to all types of patients, not just Medicare and Medicaid beneficiaries. The applicability of these federal and state laws to many business transactions in the health care industry, including the Company's operations, has not yet been subject to judicial interpretation.
Significant prohibitions against physician self-referrals, including those by dentists, for services covered by Medicare and Medicaid programs were enacted, subject to certain exceptions, by Congress in the Omnibus Budget Reconciliation Act of 1993. These prohibitions, commonly known as "Stark II," amended prior physician and dentist self-referral legislation known as "Stark I" (which applied only to clinical laboratory referrals) by dramatically enlarging the list of services and investment interests to which the referral prohibitions apply. Effective January 1, 1995 and subject to certain exceptions, Stark II prohibits a physician or dentist or a member of his immediate family from referring Medicare or Medicaid patients to any entity providing "designated health services" in which the physician or dentist has an ownership or investment interest, or with which the physician or dentist has entered into a compensation arrangement, including the physician's or dentist's own group practice unless such practice satisfies the "group practice" exception. The designated health services include the provision of clinical laboratory services, radiology and other diagnostic services (including ultrasound services), radiation therapy services, physical and occupational therapy services, durable medical equipment, parenteral and enteral nutrients, certain equipment and supplies, prosthetics, orthotics, outpatient prescription drugs, home health services and inpatient and outpatient hospital services. A number of states also have laws that prohibit referrals for certain services such as x- rays by dentists if the dentist has certain enumerated financial relationships with the entity receiving the referral, unless an exception applies.
Noncompliance with, or violation of, the federal anti-kickback legislation or Stark II can result in exclusion from Medicare and Medicaid as well as civil and criminal penalties. Similar penalties are provided for violation of state anti- kickback and self-referral laws. To the extent that the Company or any affiliated dental practice is deemed to be subject to these federal or similar state laws, the Company believes its intended activities will comply in all material respects with such statutes and regulations.
State Legislation
In addition to the anti-kickback laws and anti-referral laws noted above, the laws of many states prohibit dentists from splitting fees with non-dentists and prohibit non-dental entities such as the Company from engaging in the practice of dentistry and from employing dentists to practice dentistry. The specific restrictions against the corporate practice of dentistry, as well as the interpretation of those restrictions by state regulatory authorities, vary from state to state. However, the restrictions are generally designed to prohibit a non-dental entity from controlling the professional assets of a dental practice (such as patient records, payer contracts and, in certain states, dental equipment), employing dentists to practice dentistry (or, in certain states, employing dental hygienists or dental assistants), controlling the content of a dentist's advertising or professional practice or sharing professional fees. The laws of many states also prohibit dental practitioners from paying any portion of fees received for dental services in consideration for the referral of a patient. In addition, many states impose limits on the tasks that may be delegated by dentists to dental assistants.
State dental boards do not generally interpret these prohibitions as preventing a non-dental entity from owning non-professional assets used by a dentist in a dental practice or providing management services to a dentist provided that the following conditions are met: a licensed dentist has complete control and custody over the professional assets; the non-dental entity does not employ or control the dentists (or, in some states, dental hygienists or dental assistants); all dental services are provided by a licensed dentist; licensed dentists have control over the manner in which dental care is provided and all decisions affecting the provision of dental care. State laws generally require that the amount of a management fee be reflective of the fair market value of the services provided by the management company and certain states require that any management fee be a flat fee or cost-plus fee based on the cost of services performed by the Company. In general, the state dental practice acts do not address or provide any restrictions concerning the manner in which companies account for revenues from a dental practice subject to the above-noted restrictions relating to control over the professional activities of the dental practice, ownership of the professional assets of a dental practice and payments for management services.
The Company does not control the practice of dentistry or employ dentists to practice dentistry. Moreover, in states in which it is prohibited the Company does not employ dental hygienists or dental assistants. The Company provides management services to its affiliated practices, and the management fees the Company charges for those services are consistent with the laws and regulations of the jurisdictions in which it operates.
In addition, there are certain regulatory risks associated with the Company's role in negotiating and administering managed care and capitation contracts. The application of state insurance laws to reimbursement arrangements other than various types of fee-for-service arrangements is an unsettled area of law and is subject to interpretation by regulators with broad discretion. As the Company or its affiliated practices contract with third-party payors, including self- insured plans, for certain non-fee-for-service basis arrangements, the Company or the affiliated dental practices may become subject to state insurance laws. In the event that the Company or the affiliated practices are determined to be engaged in the business of insurance, these parties could be required either to seek licensure as an insurance company or to change the form of their relationships with third-party payors, and may become subject to regulatory enforcement actions. In such events, the Company's revenues may be adversely affected.
Regulatory Compliance
The Company regularly monitors developments in laws and regulations relating to dentistry. The Company may be required to modify its agreements, operations or marketing from time to time in response to changes in the business, statutory and regulatory environments. The Company plans to structure all of its agreements, operations and marketing in compliance with applicable law, although there can be no assurance that its arrangements will not be successfully challenged or that required changes may not have a material adverse effect on operations or profitability.
EMPLOYEES
As of December 31, 2000, the Company and its affiliated dental practices employed approximately 985 administrative and dental office personnel on a full- time or part-time basis, and the affiliated dental practices employed approximately 200 general dentists and specialists on a full-time or part-time basis. The Company generally enters into employment or independent contractor agreements with its affiliated dentists. The Company believes that its relations with its employees are good.
CORPORATE LIABILITY AND INSURANCE
The provision of dental services entails an inherent risk of professional malpractice and other similar claims. Although the Company does not influence or control the practice of dentistry by dentists or have responsibility for compliance with certain regulatory and other requirements directly applicable to dentists and dental groups, the contractual relationship between the Company and the affiliated dental practices may subject the Company to some medical malpractice actions under various theories, including successor liability. There can be no assurance that claims, suits or complaints relating to services and products provided by managed practices will not be asserted against the Company in the future. The availability and cost of professional liability insurance has been affected by various factors, many of which are beyond the control of the Company. Significant increases in the cost of such insurance to the Company and its affiliated dental practices may have an adverse effect on the Company's operations.
The Company requires each affiliated dental practice to maintain comprehensive general liability and professional liability coverage covering the practice and each dentist retained or employed by the affiliated dental practice, which normally provide for comprehensive general liability coverage of $1.0 million for each occurrence and $3.0 million annual aggregate, and professional liability coverage of not less than $1.0 million for each occurrence and $3.0 million annual aggregate.
The Company maintains other insurance coverage including general liability, property, business interruption and workers' compensation, which management considers to be adequate for the size of the Company and the nature of its business.
ITEM 2.
ITEM 2. PROPERTIES
The Company leases approximately 12,000 square feet of space for executive, administrative, sales and marketing and operations offices in Houston, Texas. The Company's initial lease term, which expired in May 2000, has been extended at the Company's option for an additional 12 months. The Company will relocate its corporate headquarters in June 2001 to another leased location in Houston with approximately 9,600 square feet of office space.
All of the Company's existing centers are leased. Three of the centers are owned by affiliates of the companies from whom the Company acquired affiliated dental practices and one dental center is owned by a director of the Company.
The Company intends to lease centers or enter into build-to-suit arrangements with third parties for dental centers to be leased by the Company. Certain leases provide for fixed minimum rentals and provide for additional rental payments for common area maintenance, insurance and taxes. The leases carry varying terms expiring between 2001 and 2009 excluding options to renew.
The majority of the centers are located in retail locations. The Company believes that its leased facilities are well maintained, in good condition and adequate for its current needs. Furthermore, the Company believes that suitable additional or replacement space will be available when required.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In August 1998, the former owner of certain dental practices acquired by the Company in August 1996, filed a lawsuit against the Company in the 190th District Court of Harris County, Texas. The lawsuit alleged that the Company committed various acts of fraud, securities fraud, conspiracy, breach of contract and misrepresentation concerning the value of the Company's common stock issued in the acquisition of the dental practices. In August 1999, the Company settled the lawsuit and recorded a one-time charge of $1.4 million, all of which has been paid.
In December 1998, a dentist with whom the Company had entered into an agreement to acquire his dental practice filed a demand for arbitration alleging that the Company is liable for damages resulting from the failure to complete the transaction. In August 2000, the arbitrator found that the subsidiaries had breached a contractual agreement to complete the acquisition and awarded the plaintiffs actual damages and costs of $442,000. In August 2000, the arbitrator awarded the plaintiffs an additional $666,000 for attorney fees and costs, resulting in a total judgment of $1,108,000 against the Company's subsidiaries. This amount, as well as additional legal expenses incurred by the Company, was included in the litigation expenses of $1.5 million recorded in June 2000. None of the judgment amount awarded to the plaintiffs has been paid as of April 16, 2001.
The Company and certain of its subsidiaries are parties to a number of legal proceedings that have arisen in the ordinary course of business. While the outcome of these proceedings cannot be predicted with certainty, management does not expect these matters to have a material adverse effect on the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
PART II
Item 5.
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded in the over-the-counter market and quoted on the Nasdaq National Market under the symbol "CASL." The following table presents the quarterly high and low sale prices as reported by the Nasdaq National Market for the quarters indicated. These quotations reflect the inter- dealer prices, without retail mark-up, markdown or commission and may not necessarily represent actual transactions.
HIGH LOW 1999: ----- First Quarter........................ 7.00 5.31 Second Quarter....................... 8.25 6.25 Third Quarter........................ 6.56 2.50 Fourth Quarter....................... 4.09 2.13
2000: ----- First Quarter........................ 4.88 2.31 Second Quarter....................... 4.00 1.50 Third Quarter........................ 3.25 1.88 Fourth Quarter....................... 2.00 0.19
In March 2001, the Company received notification from the Nasdaq National Market that it failed to meet the minimum market value of public float and minimum bid price requirements as set forth in the Nasdaq Marketplace Rules, and that its Common Stock is therefore subject to delisting from the Nasdaq National Market. The Company requested a hearing before a Nasdaq Listing Qualifications Panel to review the delisting notification. The hearing is scheduled for April 19, 2001. There can be no assurance that the Nasdaq will grant the Company's request for continued listing. If its request is denied, the Company intends to have its common stock trade on the OTC bulletin board.
As of April 16, 2001, there were 6,417,206 shares of the Company's Common Stock outstanding held by approximately 42 stockholders of record. The Company believes there are approximately 1,000 beneficial owners of the Common Stock.
The Company has never paid a cash dividend on its Common Stock. The Company currently intends to retain earnings to finance the development of its business and does not anticipate paying any cash dividends on the Common Stock in the foreseeable future. In addition, the Company's bank credit facility prohibits the payment of dividends while the Company is in default thereunder.
RECENT SALES OF UNREGISTERED SECURITIES
On March 24, 1998, in connection with the acquisition by the Company of all of the outstanding capital stock of Dental World, Inc. ("Dental World"), the Company issued 23,342 shares of common stock to Reality, Ltd., the sole shareholder of Dental World.
On March 30, 1998, the Company, through its wholly owned subsidiary, CDC of California, Inc. ("CDC"), formed Castle Dental Centers of California, L.L.C. ("Castle West") for the purpose of acquiring the business of Dental Consulting Services, LLC ("DCS"). In connection with this acquisition, the Company issued an aggregate of $2,689,151 in its 8% subordinated promissory notes due March 30, 2001 to the five members of DCS ("DCS Members"). Following Castle West's formation: (i) CDC owned the Class A Membership Interest and the Class D Membership Interest in Castle West; (ii) sole-purpose corporations owned by the DCS Members ("Corporate B Members") collectively owned 100% of DCS, which owned the Class B Membership Interest in Castle West; and (iii) sole-purpose corporations (the "Corporate C Members") owned by the DCS Members plus one additional person collectively owned 100% of Castle West Holdings, L.L.C. ("Holdings"), which owned the Class C Membership Interest in Castle West. The Corporate B Members as a group were granted the one-time right (the "B Merger Option"), beginning March 30, 1999, to merge all of the Corporate B Members into CDC in exchange for the issuance of shares of the Company's common stock. The number of shares of common stock issuable upon exercise of the B Merger Option ("B Merger Consideration") was initially set at 407,452 shares of common stock, subject to an adjustment based upon the purchase price of practices acquired by Castle West between the closing of such transaction and the one-year anniversary thereof. Each Corporate C Member was granted the one-time right (the "C Merger Option"), beginning March 30, 2000, to merge into CDC in exchange for cash, notes and common stock. The
consideration to be received upon the exercise of the C Merger Option ("C Merger Consideration") is based upon the economic performance of Castle West following the closing date of the DCS acquisition. At least 50% of the C Merger Consideration was payable by CDC in common stock (based upon its trading price) and, if a Corporate C Member elects to receive more than 25% of the C Merger Consideration in cash, CDC would have the option of delivering a promissory note of Castle for the amount by which such cash payment would otherwise exceed 25% of the C Merger Consideration. On January 28, 2000, CDC acquired the Class B Membership Interest and the Class C Membership Interest in Castle West from DCS and Holdings, respectively, and the B Merger Option and the C Merger Option were cancelled. CDC now owns all of the outstanding membership interests in Castle West.
On July 9, 1998, in connection with the Company's acquisition of the assets of Jared Woolf, D.D.S. & Associates of Palmetto, P.A., Jared Woolf, D.D.S. & Associates of Venice, P.A. and Woolf Dentistry, P.A. ("Woolf Dentistry"), the Company issued 15,424 shares of common stock to Woolf Dentistry. In connection with this acquisition, the Company issued an aggregate of $370,000 in its 9% subordinated promissory notes due July 9, 2001 to Woolf Dentistry. On that same date, in connection with the Company's acquisition of the stock of Dentcor, Inc., the Company issued an aggregate of 20,566 shares to the two shareholders of Dentcor, Inc.
On August 1, 1998, in connection with the acquisition by the Company of all of the outstanding capital stock of NA Dental Management, Inc., the Company issued 3,635 shares of common stock and $32,580 in its 8% subordinated promissory notes due June 30, 2000 to the sole shareholder of NA Dental Management, Inc.
In September 1997, the Company issued 119,231 shares of Series B Convertible Preferred Stock (the "Series B Stock") in connection with the acquisition of SW Dental. The number of shares issued were equivalent to $1,550,000 divided by the initial public offering price of the Company's common stock of $13.00 per share. The Series B Stock was convertible at the holder's option, for a thirty-day period beginning one year after its issuance into an equivalent number of shares of the Company's common stock. On October 1, 1998, the holder of the 119,231 shares of Series B Preferred Stock exercised the right to redeem the shares into an 8% subordinated note, due June 2002, in the original principal amount of $1,550,000, payable in quarterly installments of $114,000 in principal and interest.
On December 30, 1998, in connection with the Company's acquisition of the assets of DCA Limited Partnership, L.L.P. ("DCA") and Dental Administrators of Texas Limited Partnership, L.L.P. ("DAI") and 16 related dental practices, the Company issued 79,352 and 45,648 shares of common stock to DCA and DAI, respectively. In addition, in connection with such acquisition, the Company issued to DCA and DAI an aggregate of $1,250,000 in 6% Subordinated Promissory Notes due December 30, 2001.
Each of the foregoing transactions was exempt from registration under Section 4(2) of the Securities Act, no public offering being involved.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data of the Company should be read in conjunction with the related consolidated financial statements, notes thereto and "Management's Discussion and Analysis of Financial condition and Results of Operations" appearing elsewhere herein.
(1) The Company recorded a non-cash dividend to accrete the Series A Convertible Preferred Stock and Series C Convertible Preferred Stock to their estimated fair value.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
The Company develops, manages and operates integrated dental networks through contractual affiliations with general, orthodontic and multi-specialty dental practices in Texas, Florida, Tennessee and California. The Company does not engage in the practice of dentistry but rather establishes integrated dental networks by entering into management services agreements with affiliated dental practices to provide on an exclusive basis management and administrative services to affiliated dental practices. The Company's strategy is to provide high-quality care in selected markets with a view to achieving broad geographic coverage within those markets. The Company seeks to achieve operating efficiencies by consolidating and integrating affiliated practices into regional networks, realizing economies of scale in such areas as marketing, administration and purchasing and enhancing the revenues of its affiliated dental practices by increasing both patient visits and the range of specialty services offered. As of December 31, 2000, the Company provided management services to 101 dental centers with approximately 200 affiliated dentists, orthodontists and other dental specialists.
The Company's objective is to make each of its dental networks the leading group dental care provider in each market it serves. The Company applies traditional retail principles of business to the practice of dentistry, including situating practices in high-profile locations, offering affordable fees and payment plans, expanding the range of services offered, increasing market share through targeted advertising and offering extended office hours. By using the Castle Dental Centers' approach to managing affiliated dental practices, the Company believes it will enable affiliated dentists, orthodontists and other dental specialists to focus on delivering quality patient care and to realize greater productivity than traditional retail and small group dental practices.
Certain of the affiliated dental practices derive a significant portion of their revenues from managed care contracts, preferred provider arrangements and other negotiated price agreements. While the Company generally negotiates the terms and conditions of managed care contracts, preferred provider arrangements and other negotiated price agreements, the affiliated dental practices are the contracting parties for all such relationships, and the Company is dependent on its affiliated dental practices for the success of such relationships. The Company generally bears the risk of loss resulting from any such arrangements because it consolidates the financial results of its affiliated dental practices. However, most of these contracts are cancelable by either party on 30 to 90 days written notice thereby reducing the risk of long-term adverse impact on the Company.
At December 31, 2000, the Company and its affiliated dental practices maintained an aggregate of 40 capitated managed care contracts covering approximately 170,000 members. Capitation fees, excluding supplemental fees and co-payments by members, totaled $9.1 million, or approximately 8.6% of total patient revenues, in 2000. No single contract amounted to a significant portion of the Company's revenues, as each of
the Company's regional operations contracts separately with managed care providers. The Company periodically evaluates its capitated managed care contracts by comparing the average reimbursement per procedure plus the total capitation fees per contract to the usual and customary fees charged by the affiliated dental practice. If the aggregate reimbursement percentage for the capitated contract exceeds 55% of the usual and customary fees, the Company believes that the incremental costs of providing covered services are being recovered. Management believes that capitated managed care contracts, in the aggregate, are profitable and the Company will continue to contract with capitated managed care providers on a case-by-case basis.
COMPONENTS OF REVENUES AND EXPENSES
Net patient revenues represent amounts billed by the affiliated dental practices to patients and third-party payors for dental services rendered. Such amounts also include monthly capitation payments received from third-party payors pursuant to managed care contracts. Net revenues are reported at established rates reduced by contractual amounts based on agreements with patients, third party payers and others obligated to pay for services rendered.
Under the terms of the typical management services agreement with an affiliated dental practice, the Company becomes the exclusive manager and administrator of all non-dental services relating to the operation of the practice. While actual terms of the various management agreements may vary from practice to practice, material aspects of all the management service agreements, including the ability of the Company to nominate the majority shareholder and the calculation of the management fees, are consistent. The obligations of the Company include assuming responsibility for the operating expenses incurred in connection with managing the dental centers. These expenses include salaries, wages and related costs of non-dental personnel, dental supplies and laboratory fees, rental and lease expenses, advertising and marketing costs, management information systems, and other operating expenses incurred at the dental centers. In addition to these expenses, the Company incurs general and administrative expenses related to the billing and collection of accounts receivable, financial management and control of the dental operations, insurance, training and development, and other general corporate expenditures.
RESULTS OF OPERATIONS
The following table sets forth the percentages of patient revenues represented by certain items reflected in the Company's Statements of Operations. The information that follows represents historical results of the Company and does not include pre-acquisition results of the dental practices that the Company has acquired. In March 1998, the Company acquired Dental World, Inc. a dental practice management company located in Houston, Texas. In March 1998, the Company acquired an 80.0% interest in Castle West, which was formed to acquire Dental Consulting Services, LLC, a California-based dental practice management company. In July 1998, the Company acquired Dentcor, Inc., a dental management company, and five related dental practices in Florida. In August 1998, the Company acquired all the outstanding stock of two dental practices in the Los Angeles area and purchased the assets of a dental office in Houston. In December 1998, the Company acquired the assets of Crenshaw Family Dental in Los Angeles and of Dental Centers of America, Inc., which managed 16 dental centers in San Antonio, Austin and Dallas/Fort Worth, Texas. In January 2000, the Company acquired the 20% minority interest in Castle West that it did not previously own. (All of the acquisitions collectively referred to as the "Completed Acquisitions").
TWELVE MONTHS ENDED DECEMBER 31, 2000 COMPARED TO TWELVE MONTHS ENDED DECEMBER 31, 1999
Net Patient Revenue - Net patient revenues of affiliated dental practices increased from $102.7 million for the year ended December 31, 1999, to $106.0 million for the year ended December 31, 2000, an increase of $3.3 million or 3.2%. Approximately $5.4 million of the increase was attributable to the opening of de novo dental centers in Texas, Florida and Tennessee. Patient revenues for dental centers open for more than one year increased approximately $1.2 million, or 1.2%, offset by decreased revenues of approximately $3.3 million from dental centers closed in the last year.
Dentist Salaries and Other Professional Costs - Dentist salaries and other professional costs consist primarily of compensation paid to dentists, orthodontists, and hygienists employed by the affiliated dental practices. For the year ended December 31, 2000, dentist salaries and other professional costs were $28.4 million, an increase of $1.4 million or 5.2% from the comparable period of 1999. The increase was due primarily to the staffing of de novo dental centers and increased dentist compensation resulting from higher patient revenues. Expressed as a percentage of net patient revenue, dentist salaries and other professional costs increased from 26.3% for 1999 to 26.8% for 2000.
Clinical Salaries - Clinical salaries decreased from $21.4 million for the year ended December 31, 1999, to $20.8 million for the year ended December 31, 2000, a decrease of $0.6 million or 2.9%. The decrease was due primarily to reduced staffing in the dental centers. Expressed as a percentage of net patient revenues, clinical salaries decreased from 20.8% to 19.6% for the years ended December 31, 1999 and 2000, respectively.
Dental Supplies and Laboratory Fees - Dental supplies and laboratory fees increased from $9.6 million for the year ended December 31, 1999 to $11.7 million for the year ended December 31, 2000, an increase of $2.1 million or 21.7%. The increase is attributable to additional dental supplies required for the opening of de novo dental centers and increased laboratory costs. Expressed as a percentage of patient revenues, dental supplies and laboratory fees increased from 9.4% in 1999 to 11.1% in 2000.
Rent and Lease Expense - Rent and lease expense increased from $6.2 million for the year ended December 31, 1999 to $7.6 million for the year ended December 31, 2000, an increase of $1.4 million or 22.7%. Lease expense in 2000 included the accrual of $0.7 million in lease expense on closed dental centers and on properties that are under lease but that will not be built-out due to the Company's plan to reduce capital expenditures. Excluding this charge, rent and lease expense, expressed as a percentage of net patient revenues,
increased from 6.0% in 1999 to 6.5% for the comparable 2000 period. This increase is attributable primarily to the addition of de novo dental centers.
Advertising and Marketing - Advertising and marketing expense increased from $3.6 million for the year ended December 31, 1999, to $3.8 million for the year ended December 31, 2000, an increase of $0.2 million, or 5.4%. Expressed as a percentage of net patient revenues, advertising and marketing expense of 3.6% for the year ended December 31, 2000 was unchanged from the prior year.
Depreciation and Amortization - Depreciation and amortization increased from $5.8 million for the year ended December 31, 1999 to $6.8 million for the year ended December 31, 2000, an increase of $1.0 million, or 17.3%. The increase resulted from the addition of leasehold improvements and dental equipment associated with de novo centers and management information system updates. Expressed as a percentage of net patient revenues, depreciation and amortization increased from 5.6% to 6.4% for the years ended December 31, 1999 and 2000, respectively.
Other Operating Expenses - Other operating expenses increased from $6.2 million for the year ended December 31, 1999, to $7.3 million for the year ended December 31, 2000, an increase of $1.2 million or 19.3%. Other operating expenses include certain costs related to the operation of the Company's dental centers such as maintenance, utilities and communications expenses. The increase is attributable primarily to additional operating expenses associated with the opening of de novo dental centers. Expressed as a percentage of net patient revenues, other operating expenses increased from 6.0% for the year ended December 31, 1999 to 6.9% in 2000.
Bad Debt Expense - Bad debt expense increased from $4.2 million for the year ended December 31, 1999 to $15.3 million for the year ended December 31, 2000, including charges of $10.0 million to record additional allowance for doubtful accounts receivable. The Company has changed its estimates for the collectibility of certain categories of accounts receivable resulting in additional charges of $7.9 million on billed accounts receivable and $2.1 million of unbilled accounts receivable from orthodontic patients. Lower collection rates on patients with insurance, slower payments from insurance companies, and higher than expected attrition of orthodontic patients accounted for the change in estimates. Management is continuing to review and modify credit and collection policies in order to reduce the level of accounts receivable and to increase collection of past-due accounts. It is anticipated that the change in estimates for the collection of accounts receivable will result in lower rates of bad debt expense in future periods than incurred in 2000, as the collectibility of accounts receivable improves.
General & Administrative Expense - General and administrative expenses increased from $10.9 million for the year ended December 31, 1999, to $13.1 million for the year ended December 31, 2000, an increase of $2.2 million, or 20.3%. In the third and fourth quarters of 2000, the Company recorded costs of $1.4 million including investment costs related to the investigation of strategic alternatives, provisions for litigation and severance costs. Excluding these costs, general and administrative expenses, expressed as a percentage of net patient revenues, were 11.1% for the year ended December 31, 2000 compared to 10.6% for the prior year.
Asset Impairment - In the third quarter of 2000, the Company recorded a charge of $1.9 million related to the closing of six dental centers in Florida, California and Texas. The closed offices included two dental centers on the east coast of Florida, two centers in the Los Angeles area, and two centers in Texas. In December 2000, the Company recognized an additional charge of $1.7 million to reflect the impairment in the value of fixed assets for eleven under- performing offices.
Litigation expense - For the year ended December 31, 2000 the Company recorded a $1.5 million charge resulting from an adverse arbitration award in an arbitration proceeding in Los Angeles, California (Note 5 of Notes to Consolidated Financial Statements). In the year ended December 31, 1999, litigation expense of $1.4 million resulted from the settlement of a lawsuit filed by the former owner of certain dental practices acquired by the Company in 1996.
Interest Expense - Interest expense increased from $4.4 million for the year ended December 31, 1999 to $7.8 million for the year ended December 31, 2000, an increase of $3.4 million, or 77.4%. The increase resulted from higher borrowings and an increase in variable interest rates during 2000. Also, in the fourth quarter of 2000, the Company accrued additional interest expense of $0.5 million resulting from default interest charged by its lenders as a result of the defaults on the Company's senior and senior subordinated credit facilities.
Provision for Income Taxes - For the year ended December 31, 1999, the Company recorded a provision for income taxes of $0.8 million, resulting from income before income taxes of $2.0 million. For the year ended December 31, 2000, the Company recorded a benefit for income taxes of $2.6 million resulting from a loss before income taxes of $21.7 million. The benefit for income taxes in fiscal 2000 was reduced by a valuation allowance of approximately $5.2 million that was recorded against the Company's entire deferred tax asset because there is no assurance that the Company will be able to recognize the tax asset in the future. Accordingly, the benefit for income taxes recorded in the 2000 was limited to 11.9% of the loss before income taxes compared to an effective tax rate of 41.1% recorded in the prior year.
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
Net Patient Revenues - Net patient revenues increased from $74.8 million for the year ended December 31, 1998 to $102.7 million for the year ended December 31, 1999, an increase of $27.9 million or 37.3%. Approximately $21.2 million of the increase was attributable to the acquisitions completed in 1998. Revenues from de novo dental centers opened in 1998 and 1999 contributed $7.3 million of the increase, accounting for 26.2% of the revenue increase from 1998. Patient revenues from dental centers open for more than one year decreased from 1998.
Dentist Salaries and Other Professional Costs -- Dentist salaries and other professional costs increased from $18.5 million for the year ended December 31, 1998 to $27.0 million for the year ended December 31, 1999, an increase of $8.5 million or 45.7%. Expressed as a percentage of net patient revenues, dentist salaries increased from 24.7% to 26.3% for the years ended December 31, 1998 and 1999, respectively, reflecting higher compensation paid to dentists and the impact of new dental center openings in 1998 and 1999.
Clinical Salaries -- Clinical salaries increased from $16.6 million for the year ended December 31, 1998 to $21.4 million for the year ended December 31, 1999, an increase of $4.8 million or 28.9%. The Completed Acquisitions accounted for $4.3 million of the increase and the de novo centers accounted for $1.4 million. Clinical salaries in dental centers open for more than one year decreased by $0.9 million. Expressed as a percentage of patient revenues, clinical salaries decreased from 22.2% to 20.8% for the years ended December 31, 1998 and 1999, respectively, primarily due to productivity improvements.
Dental Supplies and Laboratory Fees -- Dental supplies and laboratory fees increased from $7.2 million for the year ended December 31, 1998 to $9.6 million for the year ended December 31, 1999, an increase of $2.4 million or 34.0%. This increase resulted primarily from the Completed Acquisitions, which incurred $2.1 million in dental supplies and laboratory expenses. Expressed as a percentage of patient revenues, dental supplies and laboratory fees decreased from 9.6% in 1998 to 9.4% in 1999.
Rental and Lease Expense -- Rental and lease expense increased from $4.1 million for the year ended December 31, 1998 to $6.2 million for the year ended December 31, 1999, an increase of $2.1 million or 51.6%. Rental expense from the 29 dental centers opened in 1998 and 1999 accounted for $0.8 million of the increase and the Completed Acquisitions in Florida, California, and Texas accounted for $1.1. Expressed as a percentage of patient revenues, rental and lease expense increased from 5.5% in 1998 to 6.0% in 1999 due primarily to higher relative lease expense at the de novo centers.
Advertising and Marketing -- Advertising and marketing expense increased from $2.8 million for the year ended December 31, 1998 to $3.7 million for the year ended December 31, 1999, an increase of 32.1%. Expressed as a percentage of patient revenues, advertising and marketing costs decreased from 3.7% in 1998 to 3.6% in 1999, as advertising expenses in established markets were favorably leveraged over additional dental centers opened in 1998 and 1999.
Depreciation and Amortization -- Depreciation and amortization increased from $3.5 million for the year ended December 31, 1998 to $5.8 million for the year ended December 31, 1999, an increase of $2.3 million or 63.8%, primarily resulting from higher depreciation and amortization of management services agreements and other intangibles related to the Completed Acquisitions. As a percentage of patient revenues, depreciation and amortization increased from 4.7% to 5.6% for the years ended December 31, 1998 and 1999, respectively.
Other Operating and Bad Debt Expenses -- Other operating and bad debt expenses increased from $7.0 million for the year ended December 31, 1998 to $10.3 million for the year ended December 31, 1999, an increase of approximately $3.3 million or 47.8%. Other operating expenses include expenses related to the operation of the Company's dental centers, such as utilities, taxes and management information systems, and bad debt expense incurred in the financing of patient receivables at the affiliated dental practices. The increase from 1998 to 1999 resulted from higher bad debt expense and operating expenses at the de novo dental centers and the Completed Acquisitions. The increase in bad debt expense from $2.5 million, or 3.4% of revenues, in 1998 to $4.2 million, or 4.1% of revenues, in 1999 resulted from higher levels of patient receivables. Expressed as a percentage of revenues, other operating and bad debt expenses increased from 9.3% in 1998 to 10.1% in 1999, primarily due to the higher provision for bad debts.
General & Administrative Expense -- General and administrative expenses increased from $8.1 million for the year ended December 31, 1998 to $10.9 million for the year ended December 31, 1999, an increase of $2.8 million or 33.9%. The increase resulted from the addition of general and administrative expenses of the Completed Acquisitions, the centralization of certain functions formerly performed at a clinical level, and increased personnel and general corporate expenses at the Company's headquarters in Houston. Expressed as a percentage of patient revenues, general and administrative expense, however, decreased from 10.9% to 10.6% for years ended December 31, 1998 and 1999, respectively, due to relatively greater percentage increase in the Company's patient revenues.
Litigation Settlement -- In August 1998, the former owner of certain dental practices acquired by the Company in August 1996, filed a lawsuit against the Company. The lawsuit alleged that the Company committed various acts of fraud, securities fraud, conspiracy, breach of contract and misrepresentation concerning the value of the Company's common stock issued in the acquisition of the dental practices. In August 1999, the Company settled the lawsuit and recorded a charge of $1.4 million.
Interest Expense -- Interest expense increased from $2.0 million for the year ended December 31, 1998 to $4.4 million for the year ended December 31, 1999 primarily resulting from higher bank borrowings. Bank borrowings increased from $39.4 million at December 31, 1998 to $50.9 million at December 31, 1999.
Income Taxes -- For the year ended December 31, 1998, the Company recorded a provision for income taxes of $1.5 million resulting from income before income taxes of $5.1 million. For the year ended December 31, 1999, the Company recorded a provision for income taxes of $0.8 million resulting from the income before income taxes of $2.0 million. The Company's average tax rate for 1998 was 29.4%, compared to an average tax rate of 41.1% in 1999. A portion of the litigation settlement was non-deductible for income tax purposes, resulting in the higher average rate. In addition, during 1998, the Company continued to realize benefits from net operating loss carry forwards and other tax deductions not recognized in prior years.
LIQUIDITY AND CAPITAL RESOURCES
Historically the Company has relied on cash flow from operations and borrowings on its senior credit facility to finance its operations, and on a combination of bank borrowings, the issuance of Company common stock and subordinated seller notes, and the assumption of certain debt and lease obligations to finance its acquisitions.
At December 31, 2000 the Company had a net working capital deficit of $62.3 million, resulting primarily from the classification as a current liability of $45.2 million of outstanding borrowings under the Company's senior bank credit facility, $15.0 million in senior subordinated note and convertible note agreements (see below) and $2.9 million in other subordinated notes. Current assets consisted of cash and cash equivalents of $0.9 million, billed and unbilled accounts receivable of $8.9 million and $1.9 million of prepaid expenses and
other current assets. Current liabilities totaled $76.9 million, consisting of $13.1 million in accounts payable and accrued liabilities, $63.7 million in current maturities of long-term debt and $0.1 million of deferred compensation payable to a stockholder.
For the year ended December 31, 2000, cash provided by operating activities was approximately $3.5 million compared to cash used in operating activities of $0.9 million in 1999. In 1999, cash used in investing activities amounted to $10.4, primarily for the construction and equipping of new dental centers. For the year ended December 31, 2000, cash used in investing activities was $8.3 million, consisting of $5.0 million to acquire the 20% minority interest in the Company's California subsidiary and $3.3 million for capital expenditures. For the year ended December 31, 1999, cash provided by financing activities totaled $10.6 million, primarily reflecting proceeds from bank borrowings of $11.5 million partially offset by $1.5 million in repayments of long-term debt. For the year ended December 31, 2000, cash provided by financing activities totaled $5.7 million representing $16.9 million in proceeds from long-term debt offset partially by $9.1 million in repayments of long-term debt and capital lease obligations, payment of $1.3 million in debt issuance costs and $0.8 million reduction in bank overdrafts.
During 2000, the Company's principal sources of liquidity consisted primarily of cash and cash equivalents and borrowings under the Company's bank credit facility. In January 2000, the Company amended its Credit Agreement with its existing banks and entered into a senior subordinated note agreement ("Subordinated Note Agreement") and a subordinated convertible note agreement ("Convertible Note Agreement") with two lenders. In May 2000, the Company amended its Credit Agreement to provide additional availability for the Company to complete the de novo dental centers that were under development for 2000. In August 2000, the Company advised its lenders that it was in violation of certain financial covenants of the Credit Agreement, the Subordinated Note Agreement and the Convertible Note Agreement as a result of losses incurred in the second quarter of 2000 (collectively "Debt Agreements").
The Credit Agreement provides for borrowings up to $55.0 million and matures November 2002. Advances under the Credit Agreement require quarterly interest payments through March 2001 at which time principal becomes payable quarterly based on a five-year amortization with final payment at maturity. Borrowings under the Credit Agreement may at no time exceed a specified borrowing base, which is calculated as a multiple of the Company's earnings before interest, income taxes, depreciation and amortization ("EBITDA"), as adjusted. The Credit Agreement bears interest at variable rates, which are based upon either the bank's base rate or LIBOR, plus, in either case, a margin which varies according to the ratio of the Company's funded debt to the EBITDA, each as defined in the Credit Agreement. A commitment fee is payable quarterly at rates ranging from 0.125 percent to 0.5 percent of the unused amounts for such quarter. The Credit Agreement contains affirmative and negative covenants that require the Company to maintain certain financial ratios, limit the amount of additional indebtedness, limit the creation or existence of liens, set certain restrictions on acquisitions, mergers and sales of assets and restrict the payment of dividends. In addition, under the May 2000 amended Credit Agreement, capital expenditures for 2000 were limited to no more than $3.5 million, further acquisitions are not permitted in 2000, and the payment of any litigation settlement was restricted to no more than $100,000, without consent of the lenders. At December 31, 2000, $45.2 million was outstanding under the Credit Agreement.
The Subordinated Note Agreement and Convertible Note Agreement provided borrowings of $13.7 and $1.3 million, respectively. Proceeds from these notes were used to reduce borrowings under the bank credit facility, to acquire a 20% minority interest in the Company's California subsidiary and to reduce other accrued liabilities and accounts payable. Loans under the Subordinated Note Agreement bear interest at the 90-day LIBOR rate plus five and one-half percent, payable quarterly, and are due in eight quarterly installments beginning in the sixty-third month following the closing date. Loans under the Convertible Note Agreement bear interest at the same rate as loans under the Subordinated Note Agreement and are due on demand beginning seven years after the closing date with a final maturity date of January 30, 2009. The convertible note is convertible at any time into 442,880 shares of Company common stock at the request of the holders at a fixed conversion price of $3.1125 per share. The Subordinated Note Agreement and Convertible Note Agreement contain affirmative and negative covenants that require that Company to maintain certain financial ratios, limit the amount of additional indebtedness, limit the creation or existence of liens, set certain
restrictions on acquisitions, mergers and sales of assets and restrict the payment of dividends. At December 31, 2000, the Company was not in compliance with the financial covenants of the Subordinated Note Agreement and Convertible Note Agreement. In addition, the Company has not made $1.9 million in principal and interest payments due to the subordinated note holders in October 2000 and January 2001, because it is restricted from making such payments as long as the Company is in default under the Credit Agreement.
As a result of additional losses incurred in the third and fourth quarters of 2000, the Company has not been in compliance with the financial covenants of the Debt Agreements since June 30, 2000. At December 31, 2000, approximately $45.2 million in senior debt and $15.0 million in subordinated debt were outstanding under the Debt Agreements in addition to approximately $3.5 million in other outstanding subordinated debt. Since the Company is in default under these agreements, all amounts outstanding are subject to acceleration and have been classified as current liabilities. On February 15, 2001, the Company retained Getzler and Co., a New York based turnaround specialist, to assist the Company in addressing its operational issues and restructuring of the Company's debt. The Company's board of directors has appointed Getzler's designee, Ira Glazer, to serve as the Company's acting Chief Executive Officer and initiated an executive search for a permanent Chief Executive Officer. Jack Castle, Jr., the Company's former Chief Executive Officer, continues to serve as the Company's Chairman of the Board. The Company's President and Chief Operating Officer resigned to pursue other opportunities.
The Company has continued to pay interest (other than default interest) on the amounts outstanding under the Credit Agreement, but has not made principal or interest payments due to subordinated creditors since July 2000. The Company has requested waivers of these covenant violations and a forbearance of scheduled principal payments and is negotiating with its lenders to restructure the Debt Agreements. However, these negotiations have not resulted in a forbearance agreement or waivers of the defaults as of April 16, 2001. Given the financial position of the Company and the current condition of financial markets, the Company believes that it is unlikely that either a new lender group will be brought in to replace the existing lender group or that an equity investment by a third party in the Company will be obtained that would be sufficient to satisfy its capital needs.
The Company believes that it will be able to continue to make interest payments, exclusive of default interest, on its outstanding debt, but was not able to make scheduled principal payments on its senior debt, which began becoming due in March 2001. There can be no assurance that the Company's lenders will consent to the waivers and restructuring necessary to allow the Company to continue to operate. If the Company and its lenders cannot reach an agreement, it may be necessary for the Company to seek protection under Chapter 11 of the Bankruptcy Code.
The Company has developed a plan that will allow it to continue to operate without the need for additional borrowings and to make principal payments to its senior bank creditors out of available funds. Components of this plan include: (i) reorganization of field management to improve efficiency and reduce regional overhead costs; (ii) reduction in corporate general and administrative costs through job eliminations and reduction in other overhead expenses; (iii) closing of unprofitable and under-performing dental centers; (iv) realignment of accounts receivable management to focus on improved collection of insurance and patient receivables; (v) restructuring of compensation for management to emphasize performance-based incentives; and, (vi) cancellation of further de novo development and reducing capital expenditures to maintenance levels of approximately $1.2 million for 2001.
However, there can be no assurance that the these efforts to improve operating results and cash flows will be sufficient to allow the Company to meet its obligations in a timely manner or that the Company's creditors will agree with the its plan. Therefore, there is substantial doubt about the Company's ability to continue in existence.
INFLATION Inflation has not had a significant impact on the results of operations of the Company during the last three years.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's financial instruments with market risk exposure are revolving credit borrowings under its Debt Agreements which total $60.2 million at December 31, 2000. Based on this balance, a change of one percent in the interest rate would cause a change in interest expense of approximately $602,000, or $0.09 per share, on an annual basis. The bank credit facility was not entered into for trading purposes and carries interest at a pre-agreed upon percentage point spread from either the prime interest rate or Eurodollar interest rate.
As of December 31, 2000, the Company entered into a swap agreement with a bank to receive variable rate interest payments in exchange for fixed rate interest payments on original notional amounts of $32.0 million. The amounts exchanged are based on the notional amounts multiplied by the difference between the fixed interest rate and variable interest rate in effect. At December 31, 2000, the fixed interest rate applicable to this agreement was 7.37% and the variable rate of interest, based upon a three-month LIBOR rate, was 6.825%. For 2000, the weighted-average variable rate, based upon a three-month LIBOR rate, was 6.78%. The weighted-average variable rates are subject to change over time as LIBOR fluctuates. During 2000, the Company was required to pay $52,000 in payments under the swap agreement. The term of the swap agreement expires July 20, 2001.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements required by this Item 8 are incorporated under Item 14 in Part IV of this Annual Report on Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
Item 10.
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after December 31, 2000. Such information is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after December 31, 2000. Such information is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after December 31, 2000. Such information is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after December 31, 2000. Such information is incorporated herein by reference.
PART IV
Item 14.
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) Financial Statements
The following financial statements and the Report of Independent Accountants are filed as a part of this report on the pages indicated:
(a) (2) Financial Statement Schedules
The following Financial Statement Schedule and the Report of Independent Accountants on Financial Statement Schedule are included in this report on the pages indicated:
All other schedules are omitted because the required information is inapplicable or the information is presented in the consolidated financial statements or related notes.
(a) (3) Exhibits
The exhibits to this report have been included only with the copies of this report filed with the Commission. Copies of individual exhibits will be furnished to stockholders upon written request to the Company and payment of a reasonable fee.
(b) Reports on Form 8-K
NONE
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Houston, State of Texas on April 18, 2001.
CASTLE DENTAL CENTERS, INC.
By: /s/ IRA GLAZER -------------------------------- IRA GLAZER Chief Executive Officer
POWER OF ATTORNEY
We, the undersigned, directors and officers of Castle Dental Centers, Inc. (the "Company"), do hereby severally constitute and appoint Ira Glazer and John M. Slack and each or any of them, our true and lawful attorneys and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000, and to file the same with all exhibits thereto, and all other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys and agents, and each or any of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys and agents, and each of them, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.
CASTLE DENTAL CENTERS, INC.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Castle Dental Centers, Inc.
In our opinion, the accompanying consolidated financial statements present fairly, in all material respects, the financial position of Castle Dental Centers, Inc. at December 31, 1999 and 2000, and the 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 of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has suffered recurring losses from operations, negative working capital, and defaults under the Company's senior and subordinated debt agreements. In addition, at December 31, 2000, the Company had $63.7 million of notes payable that were either due on or before March 31, 2001 or subject to acceleration. The Company was not able to make scheduled principal payments on these notes at March 31, 2001. Management's plans concerning these matters are also discussed in Note 1. The uncertainties associated with these matters raise substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements do not include adjustments that might result from the outcome of this uncertainty.
PricewaterhouseCoopers LLP
April 16, 2001 Houston, Texas
CASTLE DENTAL CENTERS, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements.
CASTLE DENTAL CENTERS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements.
CASTLE DENTAL CENTERS, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (in thousands, except share data)
The accompanying notes are an integral part of the consolidated financial statements.
CASTLE DENTAL CENTERS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS
1. CORPORATE ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
GOING CONCERN BASIS
The accompanying financial statements of the Company have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company incurred net losses of $19.1 million in 2000 and, as a result, has not been in compliance with the financial covenants of its Debt Agreements since June 30, 2000. At December 31, 2000, approximately $45.2 million in senior debt and $15.0 million in subordinated debt were outstanding under the Debt Agreements in addition to approximately $3.5 million in other outstanding subordinated debt. Since the Company is in default under these agreements, all amounts outstanding are subject to acceleration and have been classified as current liabilities. The Company has continued to pay interest (other than default interest) on the amounts outstanding under the Credit Agreement, but has not made principal or interest payments of $1.9 million owed to subordinated creditors since July 2000. The Company has requested waivers of these covenant violations and a forbearance of scheduled principal payments and is negotiating with its lenders to restructure the debt agreements. However, these negotiations have not resulted in a forbearance agreement or waivers of the defaults as of April 16, 2001. Given the financial position of the Company and the current condition of financial markets, the Company believes that it is unlikely that either a new lender group will be brought in to replace the existing lender group or that an equity investment by a third party in the Company will be obtained that would be sufficient to satisfy its capital needs.
The Company has developed a plan that will allow it to continue to operate without the need for additional borrowings and to make principal payments to its senior bank creditors out of available funds. Components of this plan include: (i) reorganization of field management to improve efficiency and reduce regional overhead costs; (ii) reduction in corporate general and administrative costs through job eliminations and reduction in other overhead expenses; (iii) closing of unprofitable and under-performing dental centers; (iv) realignment of accounts receivable management to focus on improved collection of insurance and patient receivables; (v) restructuring of compensation for management to emphasize performance-based incentives; and, (vi) cancellation of further de novo development and reducing capital expenditures to maintenance levels of approximately $1.2 million for 2001.
However, there can be no assurance that these efforts to improve operating results and cash flows will be sufficient to allow the Company to meet its obligations in a timely manner or that the Company's creditors will agree with the plan. Therefore, there is substantial doubt about the Company's ability to continue in existence. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities that might be necessary should the Company be unable to continue in existence.
Corporate Organization and Basis of Presentation
Castle Dental Centers, Inc. and subsidiaries (the "Company") provide administrative and management services, non-healthcare personnel, facilities and equipment to certain professional corporations in Texas, Florida, California and Tennessee ("affiliated dental practices") under long-term management services agreements.
The consolidated financial statements include the accounts of the Company and all wholly-owned and beneficially-owned subsidiaries and the accounts of affiliated dental practices in which the Company has a long-term controlling financial interest. Because of corporate practice of medicine laws in the states in which the Company operates, the Company does not own dental practices but instead enters into exclusive long-term management services agreements ("Management Services Agreements") with professional corporations that operate the dental practices. In addition, the Company has the contractual right to designate, in its sole discretion and at any time, the licensed dentist who is the majority shareholder of the capital stock of the
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
professional corporation at a nominal cost ("nominee arrangements"). At December 31, 2000, all of the affiliated dental practices were owned by dentists with whom the Company had a nominee arrangement. Under the Management Services Agreements, the Company establishes annual operating and capital budgets for the professional corporations and compensation guidelines for the licensed dental professionals. The Management Services Agreements have initial terms of twenty- five to forty years. The management fee charged by the Company to an affiliated dental practice is intended to reflect and is based on the fair value of the management services rendered by the Company to the affiliated dental practice. Subject to applicable law, the management fee earned by the Company, except professional corporations located in California, is generally comprised of three components: (i) the costs incurred by it on behalf of the affiliated dental practice; (ii) a base management fee ranging from 12.5% to 20.0% of patient revenues; and, (iii) a performance fee equal to the patient revenues of the affiliated dental practice less (a) the expenses of the affiliated dental practice and (b) the sum of (i) and (ii), as described in the agreements.
In California, the Company is paid a monthly management fee comprised of two components: (i) the costs incurred by it on behalf of the affiliated practice and (ii) a management fee in an amount ranging from 15.0% to 30.0% of net patient revenues. With respect to certain professional corporations in California, the Company is paid a bonus equal to 30% of patient revenues in excess average monthly patient revenues over the prior two-year period. The amount of the management fee is reviewed by the Company and the affiliated dental practice at least annually in order to determine whether such fee should be adjusted to continue to reflect the fair value of the management services rendered by the Company.
Through the management services agreements and the nominee arrangements, the Company has a significant long-term controlling financial interest in the affiliated dental practices and, therefore, according to Emerging Issues Task Force Issue No. 97-2, "Application of FASB Statement No. 94, Consolidation of All Majority-Owned Subsidiaries, and APB No. 16, Business Combinations, to Physician Practice Management Entities and Certain Other Entities with Contractual Management Agreements," must consolidate the results of the affiliated practices with those of the Company. Net patient revenues are presented in the accompanying statement of operations because the Company must present consolidated financial statements. All significant intercompany accounts and transactions, including management fees, have been eliminated in consolidation.
Revenue Recognition
Net patient revenues represent the estimated realizable amounts to be received from patients, third-party payors and others for services rendered by affiliated dentists. They are reported at established rates reduced by contracted amounts based on agreements with patients, third party payers and others obligated to pay for service rendered. Patient revenues from general dentistry are recognized as the services are performed. Patient revenues from orthodontic services are recognized in accordance with the proportional performance method. Under this method, revenue is recognized as services are performed under the terms of contractual agreements with each patient. Approximately 25% of the services are performed in the first month with the remaining services recognized ratably over the remainder of the contract. Billings under each contract, which average approximately 26 months, are made equally throughout the term of the contract, with final payment at the completion of the treatment.
Net patient revenues include amounts received from capitated managed care contracts that the Company negotiates on behalf of its affiliated dental practices. Under capitated contracts the affiliated dental practice receives a predetermined amount per patient per month in exchange for providing certain necessary covered services to members of the plan. Usually, the capitated plans also provide for supplemental payments and/or co-payments by members for certain higher cost procedures. These contracts typically result in lower average fees for services than the usual and customary fees charged by the Company's affiliated dental practices and may, in certain instances, expose the Company to losses on contracts where the total revenues received are less than the costs of providing such dental care. The Company generally bears the risk of such loss because it consolidates the financial results of its affiliated dental practices. However, most of these contracts are cancelable by either party on 30 to 90 days written notice thereby reducing the risk of long-term adverse
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
impact on the Company. Fees from capitated contracts totaled $5.1 million, $7.4 million and $9.1 million in 1998, 1999 and 2000, respectively, excluding supplemental payments and co-payments by members. No single contract amounted to a significant portion of the Company's revenues, as each of the Company's regional operations contracts separately with managed care providers. The Company periodically evaluates its capitated managed care contracts by comparing the average reimbursement per procedure plus the total capitation fees per contract to the usual and customary fees charged by the affiliated dental practice.
Accounts receivable consist primarily of receivables from patients, insurers, government programs and contracts between the affiliated dental practices and third-party payors for dental services provided by dentists. The Company does not believe that change in the reimbursement arrangements for its affiliated dental practice contracts with third-party payors would have a material impact on revenues. An allowance for doubtful accounts is recorded by the Company based on historical experience and collection rates.
Cash and Cash Equivalents
The Company considers all highly liquid debt investments with original maturities of three months or less at the date of acquisition to be cash equivalents.
Property and Equipment
Property and equipment are stated at cost. Interest is capitalized on the construction of new centers. Depreciation is provided using the straight-line method over the estimated useful lives of the various classes of depreciable assets. Fully depreciated assets are retained in property and equipment until they are removed from service. Maintenance and repairs are charged to expense whereas renewals and major replacements are capitalized. Gains and losses from dispositions are included in operations.
Useful lives for property and equipment are as follows:
Equipment 3 - 7 years Leasehold improvements 5 - 10 years Furniture and fixtures 5 - 7 years Vehicles 3 - 5 years
Management reviews property, plant and equipment, whenever events or changes in circumstances indicate that the carrying value of an asset or group of assets may not be recoverable on the bases of undiscounted future cash flows. The reviews are carried out at the lowest level of assets to which the Company is able to attribute future cash flows. The net book value of the underlying assets is adjusted to their fair value if the sum of the cash flows is less than the book value.
Intangible Assets
The Company's acquisitions involve the purchase of tangible and intangible assets and the assumption of certain liabilities of the affiliated dental practices. As part of the purchase allocation, the Company allocates the purchase price to the tangible assets acquired and liabilities assumed, based on estimated fair market values. In connection with each acquisition, the Company enters into a long-term management services agreement with each affiliated dental practice, which cannot be terminated by either party without cause. The cost of the management services agreement is amortized on a straight line basis over its term, or such shorter period as may be indicated by the facts and circumstances, as described below. Amortization periods of the management services agreements acquired through December 31, 2000 are 25 years.
In connection with the allocation of the purchase price to identifiable intangible assets, the Company analyzes the nature of the group with which a management services agreement is entered into, including the number of dentists in each group, number of dental centers and ability to recruit additional dentists, the affiliated dental practice's relative market position, the length of time each affiliated dental practice has been in existence, and the term and enforceability of the management services agreement. Because the Company does not practice dentistry, maintain patient relationships, hire dentists, enter into employment and non-compete agreements with the dentist, or directly contract with payors, the intangible asset created in the purchase allocation process is associated primarily with the management services agreement with the affiliated dental practice.
The Company reviews intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If this review indicates that the carrying amount of the asset may not be recoverable, as determined based on the undiscounted cash flows of the related
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
operations over the remaining amortization period, the carrying value of the asset is reduced to estimated fair value. Among the factors that the Company will continually evaluate are unfavorable changes in each affiliated dental practice's relative market share and local market competitive environment, current period and forecasted operating results and cash flows of the affiliated dental practice and its impact on the management fee earned by the Company, and legal factors governing the practice of dentistry.
Other Assets
Other assets consist primarily of debt issuance costs and other receivables. The costs related to the issuance of debt are capitalized and amortized into interest expense using the straight-line method, which approximates the interest method, over the term of the related debt. Accumulated amortization was $238,000 and $650,000 as of December 31, 1999 and 2000, respectively. Other receivables included $238,000 and $67,500 at December 31, 1999 and 2000, respectively, in loans made to executive officers (see Note 12).
Income Taxes
The Company accounts for income taxes under the liability method. Under this method, deferred taxes are determined based on the differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted marginal tax rates currently in effect.
Advertising
Costs incurred for advertising are expensed when incurred.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of net revenue and expenses during the reporting periods. Actual results could differ from those estimates.
Recent Accounting Pronouncements
During June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which requires that companies recognize all derivative instruments as either assets or liabilities on the balance sheet and measure those instruments at fair value. SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133," deferred the implementation of SFAS 133 until the fiscal year ending December 31, 2001. The Company implemented SFAS 133 effective January 1, 2001. Due to our limited use of derivative instruments, the impact of adopting SFAS No. 133 will not be material to our financial statements.
In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements". SAB No. 101, as amended was implemented in the fourth quarter of 2000 and did not have a material effect on our consolidated financial position, results of operations or cash flows.
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
2. SELECTED BALANCE SHEET INFORMATION
The details of certain balance accounts were as follows.
December 31, ------------------------ 1999 2000 --------- ---------- (in thousands) Property and equipment: Equipment......................................... $ 13,644 $ 16,362 Leasehold improvements............................ 9,265 10,399 Furniture and fixtures............................ 2,009 2,498 Vehicles.......................................... 132 132 Construction-in-progress.......................... 3,213 - --------- ---------- Total property and equipment.................. 28,263 29,391 Less accumulated depreciation..................... 7,902 11,312 --------- ---------- Property and equipment, net................... $ 20,361 $ 18,079 ========= ==========
Depreciation expense was approximately $1.8 million, $3.0 million and $4.0 million for the years ended December 31, 1998, 1999 and 2000, respectively. Capitalized interest cost was $329,000 for the year ended December 31, 1999. There were no amounts capitalized during 1998 and 2000. Fully depreciated assets in use as of December 31, 1999 and 2000 were approximately $1.3 million and $2.5 million, respectively.
December 31, ------------------------ 1999 2000 --------- ---------- (in thousands) Intangible assets: Management services agreements.................... $ 69,251 $ 68,213 Other............................................. 355 355 --------- ---------- Total intangible assets....................... 69,606 68,568 Less accumulated amortization..................... 5,586 8,320 --------- ---------- Intangible assets, net........................ $ 64,020 $ 60,248 ========= ==========
Amortization expense was approximately $1.8 million, $2.8 million and $2.8 million for the years ended December 31, 1998, 1999 and 2000, respectively.
December 31, ------------------------ 1999 2000 --------- ---------- (in thousands) Accounts payable and accrued liabilities: Bank overdraft................................... $ 818 $ - Trade............................................ 3,792 2,587 Salaries, wages and payroll taxes................ 2,021 2,646 Due to patients.................................. 1,772 2,543 Legal............................................ 991 1,487 Interest......................................... 385 3,068 Other............................................ 76 776 --------- ---------- Total accounts payable and accrued liabilities. $ 9,855 $ 13,107 ========= ===========
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
3. ACQUISITIONS:
In January 2000, the Company entered into a settlement agreement with Dental Consulting Services, LLC ("DCS"), a 20% shareholder in the Castle Dental Centers of California, LLC. Pursuant to the terms of the settlement agreement, the Company acquired the 20% minority interest and a conversion right held by DCS. Total consideration paid by the Company was $5.3 million of which $300,000 was paid in November 1999 as a deposit.
During 1999, certain purchase price allocations were adjusted by approximately $667,000 to reflect additional information that became available throughout the year related to acquisitions made in 1998.
The assets and liabilities have been recorded at their estimated fair values at the date of acquisition. The aggregate purchase price and related expenses exceeded the fair market value of net assets, which has been assigned to management services agreements, included in intangible assets. Patient revenues, management fees and related costs are included in the consolidated financial statements from their acquisition dates.
The estimated fair value of assets acquired and liabilities assumed are summarized as follows:
Unaudited pro forma combined results of operations for the year ended December 31, 1998, assuming all acquisitions occurred at the beginning of the year, are as follows:
------ (in thousands) Net patient revenues............................ $93,473 Net income ..................................... 3,918 Income per common share: Basic......................................... 0.58 Diluted....................................... 0.57
The unaudited pro forma summary is not necessarily indicative either of results of operations that would have occurred had the acquisitions been made at the beginning of the period presented, or of future results of operations of the combined companies.
4. LONG-TERM DEBT:
Long-term debt consisted of the following:
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
In December 1998, the Company entered into a credit agreement with a bank group (the "Credit Agreement") that provides for borrowings up to $55.0 million and matures in November 2002. Advances under the Credit Agreement require quarterly interest payments through March 2001 at which time principal becomes payable quarterly based on a five-year amortization with final payment at maturity. Borrowings under the Credit Agreement may at no time exceed a specified borrowing base, which is calculated as a multiple of the Company's earnings before interest, income taxes, depreciation and amortization ("EBITDA"), as adjusted. The bank credit facility bears interest at variable rates, which are based upon either the bank's base rate or LIBOR, plus, in either case, a margin which varies according to the ratio of the Company's funded debt to the EBITDA, each as defined in the Credit Agreement. A commitment fee is payable quarterly at rates ranging from 0.125 percent to 0.5 percent of the unused amounts for such quarter. The Credit Agreement contains affirmative and negative covenants that require the Company to maintain certain financial ratios, limit the amount of additional indebtedness, limit the creation or existence of liens, set certain restrictions on acquisitions, mergers and sales of assets and restrict the payment of dividends. At December 31, 2000, $45.2 million was outstanding under the Credit Agreement and the average interest rate on the Company's bank borrowings was 13.7%, including default interest of 2.0%.
In January 2000, the Company amended the Credit Agreement and entered into a senior subordinated note agreement ("Subordinated Note Agreement") and a subordinated convertible note agreement ("Convertible Note Agreement") with two lenders. The Subordinated Note Agreement and Convertible Note Agreement provide for borrowings of $13.7 million and $1.3 million, respectively. Loans under the Subordinated Note Agreement bear interest at the 90-day LIBOR rate plus five and one-half percent, payable quarterly, and are due in eight quarterly installments beginning in the sixty-third month following the closing date. Loans under the Convertible Note Agreement bear interest at the same rate as loans under the Subordinated Note Agreement and are due on demand beginning seven years after the closing date with a final maturity date of January 30, 2009. The convertible note is convertible at any time into 442,880 shares of Company common stock at the request of the holders at a fixed conversion price of $3.1125 per share. The Subordinated Note Agreement and Convertible Note Agreement contain affirmative and negative covenants that require that the Company maintain certain financial ratios, limit the amount of additional indebtedness, limit the creation or existence of liens, set certain restrictions on acquisitions, mergers and sales of assets and restrict the payment of dividends. At December 31, 2000, the Company was not in compliance with the financial covenants of the Subordinated Note Agreement and Convertible Note Agreement. In addition, the Company has not made $1.9 million in principal and interest payments due to the subordinated note holders in October 2000 and January 2001, because it is restricted from making such payments as long as the Company is in default of the Credit Agreement.
In March 2000, the Company advised its lenders that it was in violation of certain financial covenants of the Credit Agreement. Accordingly, in May 2000, the Company amended the credit facility to cure the covenant violations and to provide additional borrowing availability. As a result of the losses incurred in third and fourth quarters of 2000, the Company has not been in compliance with the financial covenants of the Debt Agreements since June 30, 2000. At December 31, 2000, approximately $45.2 million in senior debt and $15.0 million in subordinated debt were outstanding under the Debt Agreements in addition to approximately $3.5 million in other outstanding subordinated debt. In addition, the Company was not able to make scheduled principal payments under the Credit Agreement in March 2001. Since the Company is in default under these agreements, all amounts outstanding are subject to acceleration and have been classified as current liabilities. The Company has requested waivers of these covenant violations and a forbearance of scheduled principal payments and is negotiating with its lenders to restructure the Debt Agreements. However, these negotiations have not resulted in a forbearance agreement or waivers of the defaults as of April 16, 2001. There can be no assurance that the Company's lenders will consent to the waivers and restructuring necessary to allow the Company to continue to operate. If the Company and the lenders cannot reach an agreement, it may be necessary for the Company to seek protection under Chapter 11 of the Bankruptcy Code.
At December 31, 2000, approximately $1.4 million (net of accumulated amortization of approximately
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
$0.6 million) of debt issuance costs had been capitalized in connection with the issuance of the Debt Agreements.
The Company has issued various subordinated seller notes payable in connection with certain acquisitions ("Subordinated Seller Notes"). These notes bear interest at varying rates ranging from 6.0% to 9.0%, require quarterly payments of interest and principal, and mature at varying dates ranging from June 2000 through June 2002.
The aggregate maturities of long-term debt for each of the next five years subsequent to December 31, 2000, under their original terms, were as follows (in thousands), however, $63.7 million of debt has been classified as current maturities and is subject to acceleration by the holders:
2001.................................... $ 12,501 2002.................................... 36,607 2003.................................... - 2004.................................... - 2005.................................... - Thereafter............................... 15,000 --------- $ 64,108 ========= 5. COMMITMENTS AND CONTINGENCIES:
Lease Commitments
Future minimum lease payments under non-cancelable operating leases with remaining terms of one or more years consisted of the following at December 31, 2000 (in thousands):
2001................................... $ 5,023 2002................................... 4,774 2003................................... 4,083 2004................................... 2,994 2005................................... 2,154 Thereafter............................. 4,257 --------- Total minimum lease obligation......... $ 23,285 =========
The Company has entered into operating leases for various types of office equipment and for its building facilities. Certain building facility leases include rent escalation clauses. Most leases contain purchase and renewal options at fair market rental values.
Litigation
In June 2000, the Company recorded litigation expenses of $1,495,000 resulting from an arbitration award against two subsidiaries of the Company in an arbitration proceeding in Los Angeles, California. The arbitrator found that the subsidiaries had breached a contractual agreement to acquire a dental practice and awarded the plaintiffs actual damages and costs of $442,000. In August 2000, the arbitrator awarded the plaintiffs an additional $666,000 for attorney fees and costs, resulting in a total judgment of $1,108,000 against the Company's subsidiaries. This amount, as well as additional legal expenses incurred by the Company, was included in the litigation expenses recorded in June 2000. None of the judgment amount awarded to the plaintiffs has been paid as of April 16, 2001.
In August 1998, the former owner of certain dental practices acquired by the Company in August 1996, filed a lawsuit against the Company in the 190th District Court of Harris County, Texas. The lawsuit alleged
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
that the Company committed various acts of fraud, securities fraud, conspiracy, breach of contract and misrepresentation concerning the value of the Company's common stock issued in the acquisition of the dental practices. In August 1999, the Company settled the lawsuit for $1.4 million, all of which has been paid.
The Company carries insurance with coverages and coverage limits that it believes to be customary in the dental industry. Although there can be no assurance that such insurance will be sufficient to protect the Company against all contingencies, management believes that its insurance protection is reasonable in view of the nature and scope of the Company's operations.
The Company is from time to time subject to claims and suits arising in the ordinary course of operations. In the opinion of management, the ultimate resolution of such pending legal proceedings will not have a material adverse effect on the Company's financial position, results of operations or liquidity.
6. INCOME TAXES
Significant components of the Company's deferred tax assets (liabilities) were as follows:
Significant components of the provision for income taxes on continuing operations were as follows:
Year Ended December 31, -------------------------------- 1998 1999 2000 -------- ------- -------- (in thousands) Current tax provision (benefit): Federal.......................... $ (70) $ 17 $ 481 State............................ (8) 2 57 -------- ------- -------- Total current................... (78) 19 538 -------- ------- -------- Deferred tax provision (benefit): Federal.......................... 1,403 730 (2,803) State............................ 165 86 (330) -------- ------- -------- Total deferred.................. 1,568 816 (3,133) -------- ------- -------- Provision (benefit) for income taxes......................... 1,490 835 (2,595) ======== ======= ========
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The differences between the statutory federal tax rate and the Company's effective tax rate on continuing operations were as follows:
At December 31, 2000, the Company had net operating loss carryforwards available to reduce future taxable income of approximately $21.8 million, expiring in years from 2016 through 2020.
7. STOCK OPTION PLANS:
The Company grants stock options under the Castle Dental Centers, Inc. Omnibus Stock and Incentive Plan, a stock-based incentive compensation plan (the "Employees' Plan"), and the Non-employee Directors' Stock Option Plan (the "Directors' Plan," together the "Plans") which are described below. The Company recognizes stock-based compensation issued to employees at the intrinsic value between the exercise price of options granted and the fair value of stock for which the options may be exercised. However, pro forma disclosures as if the Company recognized stock-based compensation at the fair-value of the options themselves are presented below.
Under the Employees' Plan, the Company is authorized to issue 1,050,000 shares of Common Stock pursuant to "Awards" granted to officers and key employees in the form of stock options and restricted stock. Under the Directors' Plan, the Company is authorized to issue 150,000 shares of Common Stock to non-employee directors of the Company.
There are 930,400 and 100,000 options granted under the Employees' Plan and the Directors' Plan, respectively, at December 31, 2000. The Compensation Committee administers the Plans. These stock options have contractual terms of 10 years and have an exercise price no less than the fair market value of the stock at grant date. The options vest at varying rates over a four or five-year period, beginning on the first anniversary of the date of grant.
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Following is a summary of the status of the Company's stock options as of December 31, 2000 and the changes during the three-year period then ended:
Number of Weighted Shares of Average Underlying Exercise Options Price ----------- ------------- Outstanding at January 1, 1998.......... 634,250 $ 10.59 Granted................................. 281,750 $ 5.31 Excercised.............................. - - Forfeited............................... (72,600) 11.03 Expired................................. - - --------- ----------- Outstanding at December 31, 1998........ 843,400 $ 8.79 ========= =========== Excercisable at December 31, 1998....... 126,680 $ 10.47 ========= ===========
Granted................................. 252,650 $ 2.57 Excercised.............................. - - Forfeited............................... (52,223) 6.23 Expired................................. (13,727) 8.93 --------- ----------- Outstanding at December 31, 1999........ 1,030,100 $ 7.27 ========= =========== Excercisable at December 31, 1999....... 287,682 $ 9.34 ========= ===========
Granted................................. 62,500 $ 2.91 Excercised.............................. - - Forfeited............................... (34,267) 6.33 Expired................................. (27,933) 4.70 --------- ----------- Outstanding at December 31, 2000........ 1,030,400 $ 7.01 ========= =========== Excercisable at December 31, 2000....... 490,150 $ 8.24 ========= ===========
The fair value of each stock option granted by the Company is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions: dividend yield of 0% for each year; expected volatility of 56.9% for 1998, 67.9% for 1999, and 79.1% for 2000; risk-free interest rates are 4.7% for 1998, 6.1% for 1999 and 6.6% for 2000; and the expected lives of the options average five years.
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The following table summarizes information about stock options outstanding at December 31, 2000:
Had the compensation cost for the Company's stock-based compensation plans been determined using the fair value of the options, the net income and basic and diluted net income per common share for 1998 would approximate $3.5 million or $0.54 per share; the Company's net income and diluted net income per share for 1999 would approximate $796,000, or $0.12 per share; the Company's net loss and diluted net loss per share for 2000 would approximate $19.5 million, or $3.03 per share.
The effects of applying fair value accounting in this pro forma disclosure are not indicative of future amounts.
8. EARNINGS PER SHARE:
A reconciliation of the denominators of the basic and diluted shares for the computation of net income follows.
December 31, ------------------------------ 1998 1999 2000 ------- ------- -------- (in thousands) Shares Shares-basic (1)................. 6,586 6,825 6,451 Options and warrants............. 22 25 - ----- ----- ----- Shares-diluted................... 6,608 6,850 6,451 ===== ===== =====
- ---------- (1) Includes the weighted average of 407,544 shares of common stock issuable upon the exercise of a conversion right. This conversion right was terminated in January 2000 when the Company acquired the minority interest in its California subsidiary.
Options to purchase an aggregate 616,000 shares of common stock at exercise prices of $10.00 to $13.00 per share were excluded from the calculation of diluted earnings per share for 1998 because their effect would have been antidilutive. Options to purchase an aggregate 604,000 shares of common stock at exercise prices of $6.00 to $13.00 per share were excluded from the calculation of diluted earnings per share for 1999 because their effect would have been antidilutive. Options to purchase an aggregate 1,030,400 shares of common stock at exercise prices of $2.31 to $13.00 per share were excluded from the calculation of basic and diluted loss per share for 2000 because their effect would have been antidilutive.
A warrant to purchase 56,579 shares of common stock at $11.00 per share was excluded from the calculation of diluted earnings per share for 1998 and 1999 because its effect would have been antidilutive. The warrant expired in December 2000.
9. DEFINED CONTRIBUTION PLANS:
In August 1996, the Company adopted a defined contribution plan qualified under Section 401(k) of the Internal Revenue Code of 1986 (the "401(k) Plan"). All permanent employees of the Company are eligible to participate in the 401(k) Plan upon the completion of three months of service. The Company may match contributions made by participants under the Plan each year in an amount determined by the Company on a year-to-year basis. The Company did not make any contributions to the Plan in 1998, 1999, or 2000.
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
10. SUPPLEMENTAL CASH FLOW INFORMATION:
11. CREDIT RISK AND FAIR VALUE OF FINANCIAL INSTRUMENTS:
Credit Risk
The Company grants customers credit in the normal course of business. The Company does not require collateral on the extension of credit. Procedures are in effect to monitor the creditworthiness of customers and appropriate allowances are made to reduce accounts to their net realizable values.
The Company maintains cash balances at various financial institutions. Accounts at each institution are insured up to $100,000 by the Federal Deposit Insurance Corporation. The Company's accounts at these institutions may, at times, exceed the federally insured limits. The Company has not experienced any losses in such accounts.
Financial Instruments
The following estimated fair values of financial instruments have been determined by the Company using available market information and appropriate valuation methodologies.
The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable and the revolving line of credit approximate fair values due to the short-term maturities of these instruments. The carrying amounts of the Company's long-term borrowings as of December 31, 1999 and 2000, respectively, approximate their fair value based on the Company's current incremental borrowing rates for similar type of borrowing arrangements.
Interest Rate Swaps:
Interest expense is subject to fluctuations as interest rates change, specifically U.S. interest rates. To manage this risk, the Company has entered into a swap which involves the exchange of fixed- and floating-rate interest payment obligations without the exchange of the underlying principal amounts, as part of the overall strategy of limiting exposure to fluctuations in U.S. short-term interest rates.
As of December 31, 2000, the Company entered into a swap agreement with a bank to receive variable rate interest payments in exchange for fixed rate interest payments on original notional amounts of $32.0 million. The amounts exchanged are based on the notional amounts multiplied by the difference between the fixed interest rate and variable interest rate in effect. At December 31, 2000, the fixed interest rate applicable to this agreement was 7.37% and the variable rate of interest, based upon a three-month LIBOR rate, was 6.825%. For 2000, the weighted-average variable rate, based upon a three-month LIBOR rate, was 6.78%. The weighted-average variable rates are subject to change over time as LIBOR fluctuates. During 2000, the Company was required to pay $52,000 in payments under the swap agreement. The term of the swap contract expires July 10, 2001.
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
12. RELATED PARTY TRANSACTIONS:
The Company maintains a management services agreement with one of the Company's affiliated dental practices in Texas pursuant to which the sole shareholder of the affiliated dental practice, a member of the Board of Directors of the Company, receives an annual salary of $100,000 to take actions necessary to maintain the dental license for the affiliated dental practice in the state of Texas, for as long as he holds such license and is the sole shareholder of the practice. Such compensation arrangement was negotiated between the shareholder and previously unaffiliated investors in the Company. In 1995, in connection with the Company's acquisition of the assets of the shareholder's dental practice, the Company entered into a deferred compensation agreement with the shareholder pursuant to which the Company agreed to pay the shareholder $2.6 million in 20 quarterly installments of $131,500, beginning March 1996. As of December 31, 2000, there was $131,500 payable to the shareholder under the terms of the deferred compensation agreement.
At December 31, 1999 and 2000, certain executive officers of the Company had outstanding loans in the aggregate amount of $307,000 and $67,500, respectively, from the Company. The Company forgave $265,000 in loans to its former president and chief operating officer at December 31, 2000. These loans are repayable over varying periods ranging from one to five years and bear interest at rates ranging from zero to six percent.
A director of the Company is a Managing Director of The GulfStar Group, Inc. ("GulfStar"), which has provided investment banking and advisory services to the Company. The Company paid $183,000 during 1998 in investment banking fees to GulfStar. The Company made no payments to Gulfstar during 1999 and 2000.
A director of the Company is a Managing Director of Pecks Management Partners Ltd., the investment advisor to investors who own an aggregate of 913,243 shares of Company common stock. Pursuant to the provisions of the Stockholders Agreement dated January 30, 2000, for so long as certain ownership thresholds are maintained with respect to the common stock, the investors have the contractual right to nominate one member of the Company's Board of Directors.
The Company entered into a lease agreement with Goforth, Inc., a company owned by the Company's chairman of Board of Directors (the "Affiliate"). The Company has agreed to pay the Affiliate a minimum guaranteed rental of $12,000 per month through December 2000 and $13,200 per month from January 2001 through January 2006 for rental of a dental center. The Company has also agreed to pay additional rent of approximately $1,600 per month for insurance, taxes and common area maintenance. The Company paid $174,000 under this agreement during 1998, 1999 and 2000.
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
13. ASSET IMPAIRMENT
The $3.6 million asset impairment results primarily from the closing of six dental offices in Florida, Texas and California, a charge to reflect the impairment in the value of fixed assets for eleven under-performing dental offices, and the write-off of related intangible assets and long-term receivables associated with certain acquisitions. As a result, the Company reduced intangible assets by approximately $1.2 million, leasehold improvements and equipment by approximately $1.7 million, and other assets by approximately $0.7 million.
14. QUARTERLY FINANCIAL DATA (UNAUDITED):
______________ (1) Earnings per share are computed independently for each of the quarters presented. Therefore, the sum of the quarterly earnings per share does not equal the total computed for the year due to stock transactions that occurred.
CASTLE DENTAL CENTERS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
15. OPERATING SEGMENTS:
Financial information is provided below for each of the Company's operating regions. The Company measures the performance of its regional operations primarily based on net patient revenues and operating income. There are no inter-regional revenues. The Company's primary measure of profit by which it formulates decisions and communicates to investors and analysts is net income and earnings per share. Financial information internally reported for the Company for the years ended December 31, 1998, 1999 and 2000 is as follows:
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Castle Dental Centers, Inc.:
Our report on the financial statements of Castle Dental Centers, Inc. is included on page of this Form 10-K. In connection with our audits of such financial statements, we have also audited the related financial statement schedule listed in item 14(a) in this Form 10-K.
In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included herein.
PricewaterhouseCoopers LLP
Houston, Texas April 16, 2001
S-1
CASTLE DENTAL CENTERS, INC.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
___________ (1) Acquired allowances for uncollectible accounts of affiliated dental practices.
(2) Adjustments to patient accounts that are charged to the allowance for doubtful accounts.
S-2
_____________ * Incorporated herein by reference to the Company's Registration Statement on Form S-1 (registration number 333-1335)