Item 1. Business.
We are a provider of care management solutions to the sleep disorder market in the United States. We provide a comprehensive diagnosis and care management solution for patients suffering from sleep disorders.
Going Concern and Management’s Plan
As of December 31, 2012, we had an accumulated deficit of $57.6 million and reported a net loss of $22.4 million for 2012. In addition, we used $4.2 million in cash from operating activities from continuing operations during the year. On March 29, 2013, we signed a definitive purchase agreement with Foundation Surgery Affiliates, LLC and Foundation Surgical Hospital Affiliates, LLC (collectively “Foundation”) for 98.5 million shares of our common stock. We expect the transaction to close in the second quarter of 2013, however there is no assurance the acquisition will close at that time or at all. The closing of the Foundation transaction is subject to the consent of Arvest Bank (our senior lender), Foundation’s senior lender and certain preferred interest holders of Foundation and there is no assurance that these consents will be obtained. For financial reporting purposes, the transaction will be recorded as a reverse merger and Foundation will be considered the accounting acquirer. If the transaction is closed, our primary focus will be the execution of the Foundation business plan which includes operating surgical hospitals and surgery centers. In addition, we anticipate that our existing strategy of providing diagnosis and care management solution for patients suffering from sleep disorders would be significantly curtailed.
There is no assurance that the Foundation transaction will close and we currently do not have sufficient cash on hand and do not expect to generate sufficient cash flow from operations to meet our cash requirements over the next 12 months. Historically, we have been able to raise the capital necessary to fund our operations and growth, but there is no assurance that we will be successful in raising the necessary capital to fund our operations and obligations.
If we are unable to close the Foundation transaction or raise additional funds, we may be forced to substantially scale back operations or entirely cease our operations and discontinue our business. These uncertainties raise substantial doubt regarding our ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.
Company History
We were formed on January 2, 2008, when our predecessor company, Graymark Productions Inc., acquired ApothecaryRx, LLC, and SDC Holdings, LLC, collectively referred to as the “Graymark Acquisition.” For financial reporting purposes, Graymark was deemed acquired by ApothecaryRx, LLC and SDC Holdings, LLC and, accordingly, the historical financial statements prior to December 31, 2007 are those of ApothecaryRx, LLC and SDC Holdings, LLC as adjusted for the effect of the Graymark Acquisition. In conjunction with the Graymark Acquisition, all former operations of Graymark Productions were discontinued. On December 6, 2010, we completed the sale of substantially all of the assets of ApothecaryRx. As a result of the sale of ApothecaryRx’s assets, the related assets, liabilities, results of operations and cash flows of ApothecaryRx have been classified as discontinued operations.
On March 13, 2008, our Board of Directors approved a reverse split of our common stock at a ratio of one-for-five shares. The effective date of the reverse split was April 11, 2008. On January 26, 2011, our Board of Directors approved a reverse stock split in one of five ratios, namely 1 for 2, 3, 4, 5 or 6. On February 1, 2011, we received the consent of a majority of our shareholders for this reverse stock split. On May 18, 2011, our Board of Directors resolved to effect the reverse stock split of our common stock in a ratio of 1-for-4 effective after the close of business on June 3, 2011. We executed the reverse stock split to regain compliance with the continued listing standards of the Nasdaq Capital Market (we were ultimately delisted from the Nasdaq Capital Market on November 2, 2012). The effect of the reverse split reduced our outstanding common stock shares from 34,126,022 to 8,531,506 shares as of the date of the reverse split.
Sleep Management Market
We believe that the market for Sleep Management Solutions is large and growing with no clear market leader. A number of factors support the future growth of this market:
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Large and undiagnosed population of patients that suffer from sleep disorders. There are a substantial number of undiagnosed patients who could benefit from diagnosis and treatment of sleep disorders. There are an estimated 50 million Americans that suffer from chronic, long-term sleep disorders, according to the National Institutes of Health, or NIH. There are over 80 different sleep disorders, including obstructive sleep apnea, or OSA, insomnia, narcolepsy and restless legs syndrome. The primary focus of our business is OSA, which the National Sleep Foundation estimates occur in at least 18 million Americans. Moreover, according to the American College of Physicians, about 80% of persons with sleep apnea go undiagnosed.
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Increasing awareness of diagnosis and treatment options, particularly for OSA. We believe there is an increasing awareness among the U.S. population and physicians in particular about the health risks and the availability and benefits of treatment options for sleep disorders. Of significant importance, OSA can have serious effects on people’s health and personal lives. OSA is known to increase the risk for several serious health conditions, including obesity, high blood pressure, heart disease, stroke, diabetes, depression and sexual dysfunction. Additionally, OSA may result in excessive daytime sleepiness, memory loss, lack of concentration and irritability. OSA and its effects may increase the risk for automobile accidents and negatively affect work productivity and personal relationships. In addition, as physicians become aware of the links between OSA and other serious health conditions, physicians are increasingly referring patients for sleep studies.
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Growth in obesity rates. OSA is found in people of every age and body type, but is most commonly found in the middle-aged, obese population. Obesity is found in approximately 72 million adults in America and is a growing problem in the United States. By 2020, the number of obese Americans is expected to be approximately 103 million. Obesity exacerbates OSA by enlarging the upper airway soft tissue structures and narrowing the airway. Not only does obesity contribute to sleep disorders such as OSA, but sleep disorders can also contribute to obesity. We believe individuals suffering from OSA generally have less energy and ability to exercise or keep a strict diet. Medical studies have also shown that sleep disorders can impair metabolism and disrupt hormone levels, promoting weight gain.
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Large aging population. An aging U.S. population, led by approximately 78 million baby-boomers, is becoming increasingly at risk for OSA. As their soft palates enlarge, their pharyngeal fat pads increase in size and the shape of bony structures around the airway change.
We believe these factors present an opportunity for us because we provide a complete continuum of care for those who suffer from OSA - from initial diagnosis to treatment with a continuous positive airway pressure, or CPAP, device to providing ongoing CPAP supplies and long-term follow-up care.
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The amount being spent on sleep disorder diagnosis and treatment is increasing. A 2010 Frost & Sullivan report estimated the U.S. sleep diagnostic market was $1.4 billion in 2008, and that it will grow to $3.4 billion by 2015 for a compound annual growth rate of 14.3%.
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The sleep diagnostic market is highly fragmented. Our presence as one of the larger overall providers of sleep diagnostic services with 91 total diagnostic and therapy locations, as of March 15, 2013, comprised of 20 independent sleep care centers and 81 hospital sleep diagnostic programs, out of a total we estimate includes 4,000 sleep clinics in the United States, illustrates the level of fragmentation in the market. Only a limited number of companies provide a comprehensive solution which includes initial diagnosis to treatment with a CPAP device and the provision of ongoing CPAP supplies and long-term follow-up care.
The sleep management market is also presenting us and most other non-hospital industry participants with a number of significant challenges that must be overcome to operate this business effectively and profitably.
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Substantial decrease in third party reimbursements. The industry has seen annual reductions in third party reimbursements from both government payers such as Medicare and Medicaid and commercial insurance carriers. In addition, Medicare and Medicaid have begun competitive bidding for certain regions for the therapy services that we provide. Based on the results of this competitive bidding to date, we expect to see additional reimbursement reductions by government payers.
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Increase in home testing. Third party payers are increasingly encouraging patients and physicians to use home sleep testing for diagnosing sleep illnesses. This has had the effect of reducing the volume of patients who use our traditional in-lab sleep diagnostic services, a trend that is accelerating in the market place.
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Lack of Scale. While we have substantially grown our business over the past five years to become the second largest operator of sleep diagnostic labs, we have not yet achieved the scale necessary to profitably operate our business. We have seen numerous other industry participants cease operations due to lack of scale and the other challenges we identify here.
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Difficulties in patient collections. While we have instituted numerous procedures to collect additional amounts from the patient at the point of service, as well as amounts due from patients after service is provided, we still have difficulties collecting a substantial portion of patient receivables on a timely basis.
Our Sleep Management Solution
Our sleep management solution is driven by our clinical approach to managing sleep disorders. Our clinical model is led by our staff of medical directors who are board-certified physicians in sleep medicine, who oversee the entire life cycle of a sleep disorder from initial referral through continuing care management. Our approach to managing the care of our patients diagnosed with OSA is a key differentiator for us. Five key elements support our clinical approach:
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Referral: Our medical directors, who are board-certified physicians in sleep medicine, have forged strong relationships with referral sources, which include primary care physicians, as well as physicians from a wide variety of other specialties and dentists.
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Diagnosis: We own and operate sleep testing clinics that diagnose the full range of sleep disorders including OSA, insomnia, narcolepsy and restless legs syndrome.
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CPAP Device Supply: We sell CPAP devices, which are used to treat OSA.
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Re-Supply: We offer a re-supply program for our patients and other CPAP users to obtain the required components for their CPAP devices that must be replaced on a regular basis.
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Care Management: We provide continuing care to our patients led by our medical directors who are board-certified physicians in sleep medicine and their staff.
Our clinical approach increases the long-term compliance of our patients, and enables us to manage a patient’s sleep disorder care throughout the lifecycle of the disorder, thereby allowing us to generate a long-term, recurring revenue stream. We generate revenues via three primary sources: providing the diagnostic tests and related studies for sleep disorders through our sleep diagnostic centers, the sale of CPAP devices, and the ongoing re-supply of components of the CPAP device that need to be replaced. In addition, as a part of our ongoing care management program, we monitor the patient’s sleep disorder and as the patient’s medical condition changes, we are paid for additional diagnostic tests and studies.
In addition, we believe that our clinical approach to comprehensive patient care provides higher quality of care and achieves higher patient compliance. We believe that higher compliance rates are directly correlated to higher revenue generation per patient compared to our competitors through increased utilization of our patient reorder supply program, or PRSP, and a greater likelihood of full reimbursement from federal payors and those commercial carriers who have adopted federal payor standards.
Referral and Diagnosis
Patients at risk for, or suspected of suffering from, a sleep disorder are referred to one of our sleep clinics by independent physicians, dentists, group practices, or self-referrals. At our independent sleep care centers and hospital sleep diagnostic programs, which we refer to as our sleep clinics, we administer an overnight polysomnogram, or sleep study, to determine if our patients suffer from a sleep disorder. Our medical directors provide a diagnosis and comprehensive report to the referring physician based on analysis of the patient’s sleep study results.
CPAP Device Supply
If the physician determines the patient suffers from OSA following the review of the sleep study results, then the patient is generally prescribed the American Academy of Sleep Medicine’s, or AASM, preferred method of treatment, which is with a CPAP device. Patients return to our clinic for an overnight study to determine the optimal air pressure to prescribe with the CPAP device. Sometimes, both the diagnosis and air pressure study are done in one night. Regulatory restrictions prevent Medicare from making payments to sleep diagnostics centers that sell CPAP devices unless the diagnosis has been made by a medical director who is board-certified in sleep medicine or who meets other specified criteria. All of the sleep studies we conduct, except for those conducted at one of our non-accredited centers, qualify us to receive Medicare reimbursement for the sale of CPAP devices.
Re-supply
In addition to selling CPAP devices to people with OSA, we offer our patient reorder supply program, or PRSP. The PRSP periodically supplies the components of the CPAP device that must be regularly replaced (such as masks, hoses, filters, and other parts) to our patients and other CPAP users. This enables them to better maintain their CPAP devices, increasing the probability of ongoing compliance and a better long-term clinical outcome and providing us with a long-term recurring revenue stream.
Care Management
Our thorough wellness and continuing care program led by our medical staff provides the greatest opportunity for our patients to use their CPAP devices properly and stay compliant. After the initial CPAP device set-up, our clinical staff contacts the patient regularly during the initial six months and each six months thereafter to enhance patient understanding and to ensure the greatest chance for the short- and long-term success for the patient. Most importantly, where we have the program in place, our medical staff has an in-person visit with the patient and their CPAP device approximately 45 days after the initial set-up. The purpose of the visit is to verify initial compliance and to enhance compliance by assuring proper fit and feel of the CPAP device (usually the mask), determining if there are any medical impediments to compliance (such as untreated allergies), and answering any questions about the operation or care of the equipment. We also work closely with the patient’s physicians to aid in their follow-up care and monitoring of the treatment.
Recently, as the public and medical communities have become increasingly aware of the sleep diagnostic and treatment markets, federal and state lawmakers and regulators have taken a greater interest in implementing stricter criteria to ensure a high standard of care. Federal payors, and commercial carriers who have adopted similar standards, will only pay CPAP providers for equipment over a 13-month period in equal installments. Payment is stopped if the CPAP provider cannot document patient compliance levels that meet their established standards within the first 90 days after the initial set-up.
Our Business Strategy
We manage our business as a provider of sleep diagnostic services and care management for sleep disorders towards break-even on an operating cash flow basis, excluding debt service costs. The following are the key elements of our strategy:
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Integrate previous acquisitions and acquire new sleep program management services agreements. We intend to successfully integrate our existing sleep clinics and rationalize our operational and corporate overhead. Our scale allows us to provide central services to our sleep clinics, which create economic synergies across acquired sleep clinics and reduces our operating costs per clinic. When we contract with hospital sleep diagnostic centers we enter into a management agreement to manage the existing sleep center without any purchase price or capital outlay on our part which allows us to increase our therapy business through additional patient referrals without adding to our cost base. We expect to add our care management and ongoing re-supply services to existing high volume diagnostic services to generate additional revenues. We intend to continue to standardize and integrate billing, human resources, purchasing and IT systems, diversify our payor rates across different geographic markets and promote best clinical and operational practices across each of our sleep clinics.
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Drive internal growth. We use marketing initiatives to increase the awareness of sleep disorders and their negative health effects, as well as to promote our comprehensive solution to those that suffer from sleep disorders in the markets we serve. We also use direct marketing representatives to identify strategic hospital and physician group alliances and to market our sleep diagnostic services and care management alternatives to area physicians. We believe that these initiatives, along with a growing, underserved primary target demographic, will increase utilization rates at our sleep clinics and drive revenue growth. We intend to increase referrals from non-traditional sources, including a focus on self-pay customers and corporate customers. We believe that corporate payors in a number of industries, such as trucking and other common carriers, could benefit from the diagnosis and treatment of sleep disorders of their employees. We are also exploring opportunities to establish new billing under arrangements with hospitals in our existing markets to provide enhanced revenue opportunities in our existing facilities. In addition, based on our understanding of and compliance with heightened regulatory requirements, we believe that we will be able to expand our business more easily than other independent sleep care centers.
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Provide Home Sleep Testing Services. As the volume of home sleep testing increases, we intend to implement a program to offer home sleep study equipment and diagnostic review services allowing us to serve this expanding area of sleep diagnostic testing.
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Expand on-going care management and disposable re-supply program. Generally OSA is a long-term chronic disorder, and patients being treated for OSA are generally treated for life. With our comprehensive model of care, ability to improve patient compliance with therapy, and scale, we are able to maintain a long-term, diversified, recurring revenue stream. We provide our patients with an ongoing supply of disposable supplies for their therapy as well as periodic replacement of their CPAP devices. In addition, by virtue of our long-term approach to managing a patient’s sleep disorder, patients periodically undergo additional diagnostic tests and CPAP pressure optimization.
Sleep Clinics and Care Management
We provide a comprehensive diagnosis, and care management solution for the growing population of Americans with sleep disorders. Patients at risk for, or suspected of suffering from, a sleep disorder are referred to one of our sleep clinics by independent physicians, dentists, group practices, or self-referrals that generally come from our reputation in the community and our marketing and advertising efforts. Our sleep clinics typically consist of two to eight bed facilities and are overseen by our medical directors. At our sleep clinics, we administer an overnight polysomnogram, or sleep study, to our patients, which monitors blood oxygen level, heart rate, respiratory function, brain waves, leg movement and other vital signs through small and painless electrical sensors applied to the patient. We compile this information into a detailed sleep report which includes an interpretation of the data and diagnosis by our medical director.
If the physician determines the patient suffers from OSA, the most commonly diagnosed sleep disorder, the patient is generally prescribed the AASM’s preferred method of treatment, which is a CPAP device. A CPAP device is a nasal or facial mask connected by a tube to a small portable airflow generator that delivers compressed air at a prescribed continuous positive pressure. The continuous air pressure acts as a pneumatic splint to keep the patient’s upper airway open and unobstructed, resulting in a smooth breathing pattern and the reduction or elimination of other symptoms associated with OSA, including loud snoring. Patients return to our clinic for an additional study to determine the optimal air pressure to prescribe with the patient’s CPAP device. For certain patients, we may perform a split-night study, with the first half of the night being used to perform the initial diagnosis and the second half of the night being used to determine the optimal air pressure setting for that patient’s CPAP device.
After completion of the sleep study and pressure setting process, the patient can purchase a CPAP device from us. The initial CPAP device set-up for those patients that purchase a CPAP device from us typically occurs at our therapy location close to where the patient received their sleep study or in some cases at the patient’s home. Our clinical staff contacts the patient by phone two days, two weeks, two months, six months and each six months thereafter. We question each patient on their compliance, their product satisfaction and their need for additional supplies. We work with these patients to ensure that they are satisfied with the fit of their mask. Our medical staff has a meeting with each new CPAP device user approximately 45 days after receipt of the device. At that meeting, we download actual patient compliance data from their CPAP device, determine the true compliance to-date and take steps to ensure the greatest chance for long-term success for the patient, including additional medical intervention, if necessary. We believe that this continuing contact with the patient separates us from our competition, helps raise patient compliance and ultimately results in patient satisfaction. We also work closely with the patient’s physician to aid in follow-up care and monitoring of the treatment. In addition to selling CPAP devices to patients with OSA, we offer a program by which patients can routinely receive the components of the CPAP device that must be regularly replaced (such as masks, hoses, filters and other parts). Our patient reorder supply program, or PRSP, is offered through our Nocturna Sleep Therapy business. The PRSP periodically supplies the disposable components of the CPAP system to our patients, which enables them to better maintain their CPAP devices for a better patient outcome and provides us with a long-term recurring revenue stream. Typically there is a need for replacement parts in three or six month increments. We use insurance recommendations to determine the timing on shipments. We believe our PRSP program also assists in the long-term success of our patients. We believe that our compliance monitoring programs exceed industry standard practices. For example, we are not aware of any national competitor for CPAP equipment that has dedicated medical personnel that offer such in-person care. The majority of our competitors ship the CPAP device to the patient’s house with no regularly scheduled in-person contact with dedicated medical staff. We believe that our continuing care management positions us well as federal payors have implemented standards which require proof of CPAP compliance prior to payment beyond three months of treatment, and increasingly, commercial carriers are adopting similar standards.
Sleep Disorders - Obstructive Sleep Apnea
There are over 80 different sleep disorders, including obstructive sleep apnea, or OSA, insomnia, narcolepsy and restless legs syndrome. The most common diagnosis for patients at sleep medicine centers is OSA, a sleep disorder, which the National Sleep Foundation estimates occur in at least 18 million Americans. OSA occurs when the soft tissue in the rear of the throat narrows and repeatedly closes during sleep, causing the body to temporarily stop breathing. Those that suffer from OSA typically have an apnea-hypopnea index, or AHI, which represents the average number of times they stop breathing per hour during the night, of five or more. These frequent episodes can have a serious, deleterious effect on the health and personal lives of those with OSA. OSA is known to increase the risk for obesity, high blood pressure, heart disease, stroke, diabetes, depression and sexual dysfunction, among other negative health conditions. Additionally, OSA may result in excessive daytime sleepiness, memory loss, lack of concentration and irritability, all of which can increase the risk for automobile accidents and negatively affect work productivity and personal relationships.
OSA is most commonly found in obese men over the age of 40, but it can also occur in men and women of all ages and body types. The National Center for Health Statistics, or a NCHS, estimates that in 2009-2010 more than one-third of U.S. adults, or over 78 million people, were obese. According to the Centers for Disease Control and Prevention, or CDC, study obesity-related diseases accounted for over 9% of all U.S. medical spending in 2008, or over $147 billion, roughly double the amount spent in 1998. The rate of obesity in the United States is increasing at an alarming rate. Obesity increases the size of the upper airway soft tissue structures, narrowing the airway and increasing the risk of OSA. Not only does obesity contribute to sleep problems such as sleep apnea, but sleep problems can also contribute to obesity. We believe individuals suffering from OSA generally have less energy and motivation to exercise or keep a healthy diet. Studies have also shown that sleep disorders can impair metabolism and disrupt hormone levels, promoting weight gain. Additionally, an aging American population, led by approximately 78 million baby-boomers, is becoming increasingly at risk for OSA as their soft palates gets longer, their pharyngeal fat pads increase in size and the shape of bony structures around the airway change.
OSA is most commonly treated with the use of a CPAP device, the AASM’s preferred method of treatment. Other treatment alternatives include surgery, which is generally used when non-surgical alternatives fail, oral appliances, which are most commonly used in mild to moderate OSA, or nasal devices.
Sleep Disorder Product Supplier Relationships
We purchase our sleep disorder and CPAP devices from several vendors including: Fisher & Paykell Appliances Limited, Respironics Inc., ResMed Inc., DeVilbiss Healthcare LLC. We maintain a limited inventory of sleep disorder products to lessen the impact of any temporary supply disruption.
Our ability to sell sleep disorder products is restricted by strict federal regulations that prohibit us from diverging from a physician’s prescription. If a physician prescribes a sleep disorder product by name other than one of the products we offer, we are prohibited by federal regulations from substituting a different sleep disorder product.
Sleep Management Solutions Advertising and Promotion
We promote sleep awareness issues and our sleep testing facilities through radio commercials, billboard displays, print media and other marketing efforts. Our clinics also have a strong presence at local health fairs and other public events. We use direct marketing representatives to market to area physicians about our sleep services. Our medical directors are involved in promoting the clinics through local and regional public educational seminars, physician continuing education programs and through individual meetings with referring physicians and hospitals.
Sleep Management Solutions Management Information Systems
We employ an integrated sleep diagnostic and management information system to perform our sleep diagnostic studies. This system provides secure transfer of sleep diagnostic study results and other information from sleep studies to the appropriate physicians and corporate personnel. We also employ an integrated scheduling and medical billing information system which allows for optimal utilization of available beds for sleep studies, optimizes labor scheduling, and streamlines information transfer for insurance and patient billing. We also utilize an enterprise reporting and planning system to track and report both our financial performance and operational metrics, allowing us to provide timely management information on the performance of our sleep centers and overall business.
Sleep Disorder Diagnostic and Care Management Competition
Competition within the sleep disorder diagnostic and care management market is intense. We face competition in each area of our sleep management solutions segment.
Sleep Diagnostics. In the sleep diagnostics business we compete primarily with independent sleep care centers, hospital sleep diagnostic programs and with home testing services. Competition in the sleep diagnostic market is primarily based on market presence and reputation, price, quality, patient or client service, and achieved treatment results. We believe that our services and products compete favorably with respect to these alternatives as we offer patients the option of participating in our clinics as well as resupply and continuing care program, in addition to diagnosis in one of our clinics.
We also compete with providers of home sleep diagnostic tests. In a home sleep test, patients are attached to a portable monitoring device overnight while sleeping in their own bed. We believe that home sleep tests have several limitations compared to overnight sleep tests in a clinic. Home sleep tests are administered in the absence of a trained technician who, when present, is able to correct or make equipment adjustments. In many of our clinics or facilities we have the capabilities to pre-screen patients in a clinic under physician-supervised care, which provides the opportunity to test in the most conducive environment for our patients. Inherent limitations exist in home diagnostics, as the optimal pressure to be prescribed for a CPAP device still must be performed in a clinical setting. We periodically evaluate additional opportunities to expand and improve patient access and care including home testing.
Treatment Alternatives. Currently, the AASM’s preferred method of treatment for OSA is a CPAP device. Alternative treatments for OSA include surgery, oral appliances and nasal devices. In addition, pharmaceuticals may be prescribed for other sleep disorders where they offer a clinical benefit such as for insomnia, narcolepsy and restless legs syndrome.
CPAP Device Supply. We compete with durable medical equipment, or DME, providers, whether national, regional or local when providing CPAP devices. These DME providers include Apria Healthcare and Lincare Holdings. The purchase of a CPAP device is allowed by prescription only. While we believe most DME providers drop ship CPAP devices to the patient’s home, we assist the patient with the set-up of the machine at one of our sleep centers. We work with the patient to ensure proper calibration of the CPAP device as well as proper fit and comfort of the mask.
CPAP Supplies. We compete with DME providers as well as e-commerce web sites for supplying patients with the masks, hoses and filters that must be periodically replaced. We seek to have patients who utilize us for diagnostic and therapy services registered with our patient resupply program, or PRSP, to periodically receive supplies for their CPAP device. We believe that our PRSP provides a convenient way for these patients to obtain their periodic supply.
Intellectual Property
In the course of our operations, we develop trade secrets and trademarks that may assist in maintaining any developed competitive position. When determined appropriate, we may enforce and defend our developed and established trade secrets and trademarks. In an effort to protect our trade secrets, we require certain employees, consultants and advisors to execute confidentiality and proprietary information agreements upon commencement of employment or consulting relationships with us.
Government Regulation
Our operations are and will be subject to extensive federal, state and local regulations. These regulations cover required qualifications, day-to-day operations, reimbursement and documentation of activities. We continuously monitor the effects of regulatory activity on our sleep center operations.
Licensure and Accreditation Requirements
The diagnosis of sleep disorders is a component of the practice of medicine. We engage physicians as independent contractors or employees to provide professional services and serve as medical directors for the sleep centers. The practice of medicine is subject to state licensure laws and regulations. We ensure that our affiliated physicians are appropriately licensed under applicable state law. If our affiliated physicians lose those licenses, our business, financial condition and results of operations may be negatively impacted.
Corporate Practice of Medicine. Generally, state laws prohibit anyone but duly licensed physicians from exercising control over the medical judgments or decisions rendered by other physicians. This is commonly referred to as the “corporate practice of medicine” doctrine. States vary widely in the interpretation of the doctrine. Some states permit a business entity (such as a regular business corporation or limited liability company) to hold, directly or indirectly, contracts for the provision of medical services, including the performance and/or interpretation of diagnostic sleep studies, and to own a medical practice that provides such services, as long as only physicians exercise control over the medical judgments or decisions of other physicians. Other states, including states such as New York, Illinois, Texas and California, have more specific and stringent prohibitions. In such states, the medical practice in which a physician is employed or engaged as an independent contractor must itself be licensed or otherwise qualified to do business as a professional entity (and owned exclusively by physicians who are licensed to practice medicine in the state) or as a licensed diagnostic and treatment facility. Failure to comply with these laws could have material and adverse consequences, including the judicially sanctioned refusal of third-party payors to pay for services rendered, based upon violation of a statute designed to protect the public, as well as civil or criminal penalties. We believe that we are in compliance with the corporate practice of medicine laws in each state in which our sleep centers operate. We do not exercise control over the medical judgments or decisions of our affiliated physicians. While we believe we are in compliance with the requirements of the corporate practice of medicine laws in each state where our sleep centers are located, these laws and their interpretations are continually evolving and may change in the future. Moreover, these laws and their interpretations are generally enforced by state courts and regulatory agencies that have broad discretion in their enforcement.
Fee Splitting. Generally, state laws prohibit a physician from splitting fees derived from the practice of medicine with anyone else. We believe that the management, administrative, technical and other nonmedical services we provide to each of our sleep centers for a service fee does not constitute fee splitting. However, these laws and their interpretations also vary from state to state and are also enforced by state courts and regulatory authorities that have broad discretion in their enforcement.
If our arrangements with our affiliated physicians or our sleep centers are found to violate state laws prohibiting the practice of medicine by general business entities or fee splitting, our business, financial condition and ability to operate in those states could be adversely affected.
With respect to our sleep centers, there has been a trend developing to require facilities that provide sleep diagnostic testing to become accredited by the American Academy of Sleep Medicine (AASM) or The Joint Commission, as well as additional credentialing for physicians diagnosing sleep studies and the licensing of technical personnel to perform diagnostic testing procedures. As of December 31, 2011, 11 of our free standing sleep centers have been accredited by the AASM. We also have one free standing sleep center that is accredited through The Joint Commission. We are actively working on having our remaining sleep centers accredited. Also, Medicare requires that all Durable Medical Equipment (DME) suppliers be accredited. All of our sleep therapy facilities providing DME are accredited by The Joint Commission or by the Accreditation Commission for Healthcare (ACHC).
Medicare and Medicaid
Our sleep centers operate under regulatory and cost containment pressures from federal and state legislation primarily affecting Medicaid and Medicare.
In order to submit claims directly to Medicare for reimbursement, our centers must be enrolled as independent diagnostic testing facilities, or IDTFs. Some of our centers are not enrolled as IDTFs and do not accept Medicare patients for testing. Our centers that are not enrolled as IDTFs may perform sleep studies for Medicare patients if the center enters into a contract with a hospital to perform the studies “under arrangements” for the hospital, in which case the hospital bills Medicare under its own provider number. Enrollment as an IDTF or the performance of services “under arrangements” for hospitals requires compliance with numerous regulations, and the failure to comply with applicable requirements could result in revocation of an IDTF enrollment or the ineligibility of the hospital to obtain reimbursement for services performed on its behalf by one of our centers. Additionally, not all private health plans permit services to be performed by our sleep centers under arrangements for a hospital.
In some locations, we supply CPAP devices and other DME to sleep studies patients who are diagnosed with sleep disorders, as ordered by a physician. Medicare suppliers of DME, prosthetics, orthotics and supplies, or DMEPOS, unless exempt, must be accredited and secure a surety bond.
Medicare generally prohibits a physician who performs a covered medical service from “reassigning” to anyone else the performing physician’s right to receive payment directly from Medicare, except in certain circumstances. We believe we satisfy one or more of the exceptions to this prohibition. Additionally, beginning May 1, 2013, the Centers for Medicare and Medicaid Services (CMS) will deny claims for DME service if the referring physician/provider is not registered in the Provider Enrollment Chain and Ownership System (PECOS). We are verifying all physicians who refer DME services to us are enrolled in PECOS.
The Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective rate adjustments, administrative rulings, executive orders and freezes and funding restrictions, all of which may significantly impact our sleep center operations. Markets where we offer CPAP devices and other DME items are or will be subject to competitive bidding, which has, in some markets and may in other markets, restrict our ability to provide these items to Medicare patients. There is no assurance that payments for sleep testing services and DME under the Medicare and Medicaid programs will continue to be based on current methodologies or even remain similar to present levels. We may be subject to rate reductions as a result of federal or state budgetary constraints or other legislative changes related to the Medicare and Medicaid programs.
We receive reimbursement from government sponsored third-party plans, including Medicaid and Medicare, non-government third-party plans, including managed-care organizations, and also directly from individuals, or private-pay. During 2012, our sleep center payor mix, as a percentage of total sleep center revenues, was approximately 53% commercial insurance, 8% Medicaid/Medicare, 11% private-pay and 28% from hospital contracts. During 2011, our sleep center payor mix, as a percentage of total sleep center revenues, was approximately 56% commercial insurance, 11% Medicaid/Medicare, 10% private-pay and 23% from hospital contracts. Pricing for private-pay patients is based on prevailing regional market rates.
In addition to requirements mandated by federal law, individual states have substantial discretion in determining administrative, coverage, eligibility and reimbursement policies under their respective state Medicaid programs that may affect our sleep center operations.
Fraud and Abuse Laws
We are subject to federal and state laws and regulations governing financial and other arrangements among healthcare providers. Commonly referred to as the Fraud and Abuse laws, these laws prohibit certain financial relationships between pharmacies, physicians, vendors and other referral sources. During the last several years, there has been increased scrutiny and enforcement activity by both government agencies and the private plaintiffs’ bar relating to pharmaceutical marketing practices under the Fraud and Abuse laws. Violations of Fraud and Abuse laws and regulations could subject us to, among other things, significant fines, penalties, injunctive relief, pharmacy shutdowns and possible exclusion from participation in federal and state healthcare programs, including Medicare and Medicaid. Additionally, in its Fiscal Year 2010 Work Plan, the Office of Inspector General of the Department of Health and Human Services identified that it would study the appropriateness of Medicare payments for polysomnography and assess provider compliance with federal program requirements. Changes in healthcare laws or new interpretations of existing laws may significantly affect our business. Some of the Fraud and Abuse Laws that have been applied are discussed below.
Federal and State Anti-Kickback Statutes: The federal anti-kickback statute, Section 1128B(b) of the Social Security Act (42 U.S.C. 1320a-7b(b)), prohibits, among other things, the knowing and willful offer, payment, solicitation or acceptance of remuneration, directly or indirectly, in return for referring an individual to a provider of services for which payment may be made in whole or in part under a federal healthcare program, including the Medicare or Medicaid programs. Remuneration has been interpreted to include any type of cash or in-kind benefit, including the opportunity to participate in investments, long-term credit arrangements, gifts, supplies, equipment, prescription switching fees, or the furnishing of business machines. Several courts have found that the anti-kickback statute is violated if any purpose of the remuneration, not just the primary purpose, is to induce referrals.
Potential sanctions for violations of the anti-kickback statute include felony convictions, imprisonment, substantial criminal fines and exclusion from participation in any federal healthcare program, including the Medicare and Medicaid programs. Violations may also give rise to civil monetary penalties in the amount of $50,000, plus treble damages.
Similarly, many state laws prohibit the solicitation, payment or receipt of remuneration in return for, or to induce, the referral of patients to private as well as government programs. Violation of these anti-kickback laws may result in substantial civil or criminal penalties for individuals or entities and/or exclusion from participating in federal or state healthcare programs.
Although we believe that our relationships with vendors, physicians, and other potential referral sources comply with Fraud and Abuse laws, including the federal and state anti-kickback statutes, the Department of Health and Human Services has acknowledged in its industry compliance guidance that many common business activities potentially violate the anti-kickback statute. There is no assurance that a government enforcement agency, private litigant, or court will not interpret our business relations to violate the Fraud and Abuse laws.
The False Claims Act: Under the False Claims Act, or FCA, civil penalties may be imposed upon any person who, among other things, knowingly or recklessly submits, or causes the submission of false or fraudulent claims for payment to the federal government, for example in connection with Medicare and Medicaid. Any person who knowingly or recklessly makes or uses a false record or statement in support of a false claim, or to avoid paying amounts owed to the federal government, may also be subject to damages and penalties under the FCA.
Furthermore, private individuals may bring “whistle blower” (“qui tam”) suits under FCA, and may receive a portion of amounts recovered on behalf of the federal government. These actions must be filed under seal pending their review by the Department of Justice. Penalties of between $5,500 and $11,000 and treble damages may be imposed for each violation of FCA. Several federal district courts have held that FCA may apply to claims for reimbursement when an underlying service was delivered in violation of other laws or regulations, including the anti-kickback statute.
In addition to FCA, the federal government has other civil and criminal statutes that may be utilized if the Department of Justice suspects that false claims have been submitted. Criminal provisions that are similar to FCA provide that if a corporation is convicted of presenting a claim or making a statement that it knows to be false, fictitious or fraudulent to any federal agency, it may be fined not more than twice any pecuniary gain to the corporation, or, in the alternative, no more than $500,000 per offense. Many states also have similar false claims statutes that impose liability for the types of acts prohibited by FCA. Finally, the submission of false claims may result in termination of our participation in federal or state healthcare programs. Members of management and persons who actively participate in the submission of false claims can also be excluded from participation in federal healthcare programs.
Additionally, some state statutes contain prohibitions similar to and possibly even more restrictive than the FCA. These state laws may also empower state administrators to adopt regulations restricting financial relationships or payment arrangements involving healthcare providers under which a person benefits financially by referring a patient to another person.
We believe that we have sufficient procedures in place to provide for the accurate completion of claim forms and requests for payment. Nonetheless, given the complexities of the Medicare and Medicaid programs, we may code or bill in error and such claims for payment may be treated as false claims by the enforcing agency or a private litigant.
Physician Self-Referral Prohibitions. The federal physician self-referral statute, known as the “Stark” law, prohibits a physician from making a referral of Medicare beneficiaries for certain designated health services, including outpatient prescription drugs and DME (including CPAPs), to any entity with which the physician has a financial relationship, unless there is an exception in the law that allows the referral. Sleep studies are not designated health services unless they are performed under arrangements for a hospital and billed by the hospital. The entity that receives a prohibited referral from a physician may not submit a bill to Medicare for that service. Federal courts have ruled that a violation of the Stark statute, as well as a violation of the federal anti-kickback law described above, can serve as the basis for an FCA suit. Many state laws prohibit physician referrals to entities with which the physician has a financial interest, or require that the physician provide the patient notice of the physician’s financial relationship before making the referral. Violation of the Stark law can result in substantial civil penalties for both the referring physician and any entity that submits a claim for a healthcare service made pursuant to a prohibited referral. We believe that all of our customer arrangements are in compliance with the Stark law. However, these laws could be interpreted in a manner inconsistent with our operations. Federal or state self-referral regulation could impact our arrangements with certain physician investors or independent contractors.
Medicare Anti-Markup Rule. CMS has recently finalized certain anti-markup rules relating to diagnostic tests paid for by the Medicare program. The anti-markup rules are generally applicable where a physician or other supplier bills for the technical component or professional component of a diagnostic test that was ordered by the physician or other supplier (or ordered by a party related to such physician or other supplier through common ownership or control), and the diagnostic test is performed by a physician that does not share a practice with the billing physician or other supplier. If the anti-markup rule applies to a diagnostic test, then the reimbursement provided by Medicare to a billing physician or other supplier for that transaction may be limited. Because our sleep labs bill Medicare for the technical and professional fees of sleep diagnostic tests that are ordered by community physicians or our affiliated physicians, we believe that the anti-markup rule does not apply to the professional services our affiliated physicians perform or the technical services that our sleep labs perform.
Healthcare Information Practices
The Health Insurance Portability and Accountability Act of 1996, or HIPAA, sets forth standards for electronic transactions; unique provider, employer, health plan and patient identifiers; security and electronic signatures as well as privacy protections relating to the exchange of individually identifiable health information. The Department of Health and Human Services, or DHHS, has released several rules mandating compliance with the standards set forth under HIPAA. We believe our sleep centers achieved compliance with DHHS’s standards governing the privacy of individually identifiable health information and DHHS’s standards governing the security of electronically stored health information. In addition, we have fully implemented the required uniform standards governing common healthcare transactions. Finally, we have taken or will take all necessary steps to achieve compliance with other HIPAA rules as applicable, including the standard unique employer identifier rule, the standard healthcare provider identifier rule and the enforcement rule.
HIPAA authorizes the imposition of civil money penalties against entities that employ or enter into contracts with individuals or entities that have been excluded from participation in the Medicare or Medicaid programs. We perform background checks on our affiliated physicians, and we do not believe that we engage or contract with any excluded individuals or entities. However, a finding that we have violated this provision of HIPAA could have a material adverse effect on our business and financial condition.
HIPAA also establishes several separate criminal penalties for making false or fraudulent claims to insurance companies and other non-governmental payors of healthcare services. These provisions are intended to punish some of the same conduct in the submission of claims to private payors as the FCA covers in connection with governmental health programs. We believe that our services have not historically been provided in a way that would place either our clients or ourselves at risk of violating the HIPAA anti-fraud statutes, including those in which we received direct reimbursement because of the reassignment by affiliated physicians to us or those in which we may be considered to receive an indirect reimbursement because of the reassignment by us to hospitals of the right to collect for professional interpretations and technical services.
We continue to evaluate the effect of the HIPAA standards on our business. At this time, we believe that our sleep centers have taken all appropriate steps to achieve compliance with the HIPAA requirements. Moreover, HIPAA compliance is an ongoing process that requires continued attention and adaptation. We do not currently believe that the cost of compliance with the existing HIPAA requirements will be material to our operations; however, we cannot predict the cost of future compliance with HIPAA requirements. Noncompliance with HIPAA may result in criminal penalties and civil sanctions. The HIPAA standards have increased our regulatory and compliance burden and have significantly affected the manner in which our sleep centers use and disclose health information, both internally and with other entities.
In addition to the HIPAA restrictions relating to the exchange of healthcare information, individual states have adopted laws protecting the confidentiality of patient information which impact the manner in which patient records are maintained. Violation of patient confidentiality rights under common law, state or federal law could give rise to damages, penalties, civil or criminal fines and/or injunctive relief. We believe that our sleep center operations are in compliance with federal and state privacy protections. However, an enforcement agency or court may find a violation of state or federal privacy protections arising from our sleep center operations.
Third-Party Reimbursement
The cost of medical care in the United States and many other countries is funded substantially by government and private insurance programs. We receive payment for our products or services directly from these third-party payors and our continued success is dependent upon the ability of patients and their healthcare providers to obtain adequate reimbursement for those products and sleep disorder diagnostic services. In most major markets, our services and supplies are utilized and purchased primarily by patients suffering from obstructive sleep apnea. Patients are generally covered by private insurance. In those cases, the patient is responsible for his or her co-payment portion of the fee and we invoice the patient’s insurance company for the balance. Billings for the products or services reimbursed by third-party payors, including Medicare and Medicaid, are recorded as revenues net of allowances for differences between amounts billed and the estimated receipts from the third-party payors. In hospitals, we contract with the hospital on a “fee for service” basis and the hospital assumes the risk of billing.
The third-party payors include Medicare, Medicaid and private health insurance providers. These payors may deny reimbursement if they determine that a device has not received appropriate FDA clearance, is not used in accordance with approved applications, or is experimental, medically unnecessary or inappropriate. Third-party payors are also increasingly challenging prices charged for medical products and services, and certain private insurers have initiated reimbursement systems designed to reduce healthcare costs. The trend towards managed healthcare and the growth of health maintenance organizations, which control and significantly influence the purchase of healthcare services and products, as well as ongoing legislative proposals to reform healthcare, may all result in lower prices for our products and services. There is no assurance that our sleep disorder products and services will be considered cost-effective by third-party payors, that reimbursement will be available or continue to be available, or that payors’ reimbursement policies will not adversely affect our ability to sell our products and services on a profitable basis, if at all.
Discontinued Operations
On May 10, 2011, we executed an Asset Purchase Agreement (“Agreement”) with Daniel I. Rifkin, M.D., P.C. pursuant to which we sold substantially all of the assets of our subsidiary, Nocturna East, Inc. (“East”) for $2,500,000. In conjunction with the sale of East assets, the Management Services Agreement (“MSA”) under which we provided certain services to the sleep centers owned by Independent Medical Practices (“IMA”) including billing and collections, trademark rights, non-clinical sleep center management services, equipment rental fees, general management services, legal support and accounting and bookkeeping services was terminated. Our decision to sell the assets of East was primarily based on management’s determination that the operations of East no longer fit into our strategic plan of providing a full continuum of care to patients due to significant regulatory barriers that limit our ability to sell CPAP devices and other supplies at the East locations.
On December 6, 2010, we completed the sale of substantially all of the assets of ApothecaryRx’s independent retail pharmacy business to Walgreens. Through ApothecaryRx, we operated independent retail pharmacy stores selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. We had historically grown our pharmacy business by acquiring financially successful independently-owned retail pharmacies from long-term owners that were approaching retirement. The acquired pharmacies successfully maintained market share due to their convenient proximity to healthcare providers and services, high customer service levels, longevity in the community, competitive pricing. Additionally, our independent pharmacies offered supportive services and products such as pharmaceutical compounding, durable medical equipment, and assisted and group living facilities. The pharmacies were located in mid-size, economically-stable communities and we believed that a significant amount of the value of the pharmacies resides in retaining the historical pharmacy name and key staff relationships in the community. Prior to the sale, we owned and operated 18 retail pharmacies located in Colorado, Illinois, Missouri, Minnesota, and Oklahoma.
Employees
As of March 15, 2013, we had 144 full-time and 11 part-time employees at Graymark Healthcare, Inc. and its wholly-owned subsidiaries. Our employees are not represented by a labor union.
Item 1A.
Item 1A. Risk Factors.
If we are unable to close the acquisition of the ambulatory surgery center and surgical hospital businesses of Foundation Healthcare Affiliates or raise additional debt or equity financing we may be unable to continue operations and could be forced to substantially curtail operations or cease operations all together.
On March 29, 2013, we executed a definitive agreement to acquire Foundation Surgery Affiliates, LLC and Foundation Surgical Hospital Affiliates, LLC from Foundation Healthcare, LLC. The ultimate consummation of such transaction is subject to a number of closing conditions and the receipt of third party consents, including from Arvest Bank, our secured lender, as well as secured lenders to and preferred members of certain subsidiaries of Foundation. As of December 31, 2012, we had cash of approximately $0.3 million and for the year then ended, we used $4.2 million of cash flow in operating activities from continuing operations. In November 2012, we executed a subscription agreement with Graymark Investments, LLC (doing business as Oklahoma Health Partners (“OHP”)) in which OHP agreed to purchase 1,444,445 shares of our common stock for $650,000 ($0.45 per share). The proceeds from OHP were used to fund our operations. Including the stock proceeds from OHP, we expect to have enough cash to fund operations into April 2013, but not thereafter. In order to fund our operations, we have taken, and will continue to take, measures to allow us to extend our ability to operate, including increasing the time for payment of our accounts payable and reducing headcount and other operating costs. Due to delays in payments of our accounts payable, certain of our vendors have, from time to time, delayed services or shipment of products to us until payment of owed amounts. If we continue to meaningfully delay payment of our accounts payable, our business may be materially adversely affected by our vendors refusal to provide services or product to us. If we are unable to consummate the Foundation acquisition in a timely manner or raise additional funds, we may be forced to substantially scale back operations or entirely cease operations and discontinue our business.
We have a bank credit facility of approximately $16.7 million and we will not achieve compliance with the Debt Service Coverage Ratio requirements which begin March 31, 2013.
We are party to an amended Loan Agreement with Arvest Bank (the “Arvest Credit Facility”). The Arvest Credit Facility provides for a term loan in the principal amount of $30 million (referred to as the “Term Loan”) and provides an additional credit facility in the principal amount of $15 million (the “Acquisition Line”) for total principal of $45 million. As of December 31, 2012, the outstanding principal amount of the Arvest Credit Facility was $16,735,555. In connection with our sale of the assets of ApothecaryRx to Walgreens, we reduced the outstanding balance on the Arvest Credit Facility by $22 million during 2010. We made additional principal payments of $2.1 million and $3.4 million in 2012 and 2011, respectively. Commencing with the calendar quarter beginning January 1, 2013 and thereafter during the term of the Arvest Credit Facility, based on the latest four rolling quarters, we agreed to continuously maintain a “Debt Service Coverage Ratio” of not less than 1.25 to 1. As of December 31, 2012, our Debt Service Coverage Ratio is less than 1.25 to 1. The Debt Service Coverage Ratio is calculated using the latest four rolling quarters. We are currently developing and executing a combination of strategic, operational and debt reduction strategies aimed at achieving compliance with the Debt Service Coverage Ratio covenant, but we do not expect that we will achieve compliance with the Debt Service Coverage Ratio during 2013 and there is no assurance that Arvest Bank will waive or further delay the requirement.
In the event we receive a notice of default from Arvest Bank and the default is not cured within 10 days following notice of the default by Arvest Bank, Arvest Bank will have the right to declare the outstanding principal and accrued and unpaid interest immediately due and payable. Payment and performance of our obligations under the Arvest Credit Facility are secured by the personal guaranties of certain of our current and former executive officers and one of our greater than 10% stockholders and in general our assets. In addition, in connection with a third amendment to the Arvest Credit Facility in July 2010, we also entered into a Deposit Control Agreement with Arvest Bank covering our accounts at Valliance Bank. Arvest Bank may exercise its rights to give instructions to Valliance Bank under the Deposit Control Agreement only in the event of an uncured default under the Loan Agreement, as amended.
If Arvest Bank accelerates the payment of outstanding principal and interest, we will need to file a current report on Form 8-K with the SEC disclosing the event of default and the acceleration of payment of all principal and interest. In addition, we do not expect to be able to pay all outstanding principal and interest if Arvest Bank accelerates the due dates for such amounts. Since we have granted Arvest Bank a security interest in all of our assets, Arvest Bank could elect to foreclose on such assets as well as to move to enforce the guaranty which is provided by certain of our current and former executive officers and one of our greater than 10% stockholders. If Arvest Bank declares an event of default and/or accelerates the payment of our obligations under the Arvest Credit Facility, then the disclosure of such fact may cause a material decrease in the price of our stock. The declaration of an event of default and the move to foreclose on our assets may cause a material adverse effect on our ability to operate our business in the ordinary course of business as well as a material adverse effect on our liquidity, results of operations and financial position.
We require a significant amount of cash flow from operations and third-party financing to pay our indebtedness, to execute our business plan and to fund our other liquidity needs.
We may not be able to generate sufficient cash flow from operations, and future borrowings may not be available to us under existing loan facilities or otherwise in an amount sufficient to pay our indebtedness, to execute our business plan or to fund our other liquidity needs. We anticipate the need for substantial cash flow to fund future acquisitions, which is our primary growth strategy. In addition, we may need to refinance some or all of our current indebtedness at or before maturity.
We incurred indebtedness with an outstanding balance at December 31, 2012 of approximately $16.7 million to fund the acquisitions of our existing sleep centers. The outstanding principal amounts under the Arvest Bank credit facility and the term loan bear interest at the greater of the Wall Street Journal prime rate or 6%. Further details about this indebtedness can be found in the footnotes to our consolidated financial statements included elsewhere in this report and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
At December 31, 2012, we had total liabilities of approximately $24.2 million. Because of our history of incurring significant losses, there is no assurance that our operating results will provide sufficient funding to pay our liabilities on a timely basis. There is no assurance that we will be able to refinance any of our current indebtedness on commercially reasonable terms or at all. Failure to generate or raise sufficient funds may require us to modify, delay or abandon some of our future business growth strategies or expenditure plans.
We have incurred significant operating losses since our inception and anticipate that we will incur continued losses for the foreseeable future.
We have financed our operations through revenues from operations, as well as the issuance of debt and equity securities and have incurred losses in the past two years. Net losses were $22.4 million in 2012 and $5.9 million in 2011. As of December 31, 2012, we had an accumulated deficit of $57.6 million. While we have instituted a strategy for re-engineering our operations to reduce costs, generate additional revenues, and generate operating cash flow, we continue to incur losses and do not yet generate cash flows from operations. As a result, we expect to continue to incur significant operating losses. Because of the numerous risks and uncertainties associated with our business re-engineering plan, we are unable to predict the extent of any future losses or when we will become profitable, if at all. If we continue to incur losses, we may be unable to continue to operate our business and may need to cease operations entirely.
In January 2013, we closed four of our stand-alone facilities. In addition, in January and February 2013, we were notified of the non-renewal or cancellation of ten hospital contracts. If we decide to close more locations or have more hospital contracts cancelled or not renewed, we may suffer additional losses or be forced to reduce our operations.
On January 7, 2013, we implemented a plan to close four of our sleep diagnostic and therapy facilities. The facilities are located in Oklahoma and Texas and are being closed because the revenue from these facilities has not met expectations and is not adequate to offset the fixed operating costs of these locations. Two of the facilities were operated through January 11, 2013 and the third facility was operated through January 31, 2013. We recorded restructuring charges in connection with the closure of these facilities with respect to the remaining lease obligations for the facilities, severance payments to affected employees and other write-downs. The remaining lease obligations, severance payments and other write-downs were approximately $1.2 million, $0.1 million and $0.1 million, respectively. All cash payments related to the severance costs are expected to be paid during the first quarter of 2013. The cash payments for the remaining lease obligations will continue for the life of the respective leases which extend through January 2018.
During January and February 2013, we were notified of non-renewal or cancellation of 10 hospital contracts. The facilities cancelled or not renewed include: Coryell, Wise, Carrus, Hillcrest, Medical Center of McKinney, Goodall-Witcher, Carroll County, Harrison County, Stewart County and Saunders County. The end dates of these contracts range from January 1, 2013 to March 22, 2013.
Since hospital contracts generally have limited fixed costs, the operating profit and cash flows from these facilities help to support our corporate overhead. If we decide to close more locations or have more hospital contracts cancelled or not renewed, we may suffer additional losses, require more cash to continue operations and be forced to reduce our operations further.
The markets for sleep diagnostic services and sale of related products are highly competitive, and we compete against substantially larger healthcare providers, including hospitals and clinics.
Competition among companies that provide healthcare services and supplies is intense. If we are unable to compete effectively with existing or future competitors, we may be prevented from retaining our existing customers or from attracting new customers, which could materially impair our business. There are a number of companies that currently offer or are in the process of offering services and supplies that compete with our sleep diagnostic and care management services and related product and supplies sales. These competitors may succeed in providing services and products that are more effective, less expensive or both, than those we currently offer or that would render some of our services or supplies obsolete or non-competitive. Some of our competitors may submit lower bids in a competitive bidding process or may be able to accept lower reimbursement rates from third party payors, thus gaining market share in our target markets. Many of our competitors have greater financial, research and development, manufacturing, and marketing resources than we have and may be in a better position than us to withstand the adverse effects on gross margins and profitability caused by price decreases prevalent in this competitive environment.
If third party payors determine that we violate Medicare, Medicaid or other payor reimbursement laws, regulations, or requirements, our revenues may decrease, we may have to restructure our method of billing and collecting Medicare, Medicaid or other payor program payments, respectively, and we could incur substantial defense costs and be subject to fines, monetary penalties and exclusion from participation in government-sponsored programs such as Medicare and Medicaid.
Our operations, including our billing and other arrangements with healthcare providers, are subject to extensive federal and state government regulation and requirements of other third-party payors. Such regulations and requirements include numerous laws directed at payment for services, conduct of operations, preventing fraud and abuse, laws prohibiting general business corporations, such as us, from practicing medicine, controlling physicians’ medical decisions or engaging in some practices such as splitting fees with physicians, laws regulating billing and collection of reimbursement from government programs, such as Medicare and Medicaid, and requirements of other payors. Those laws and requirements may have related rules and regulations that are subject to alternative interpretations and may not provide definitive guidance as to their application to our operations, including our arrangements with hospitals, physicians and professional corporations.
We verify patient benefit eligibility prior to providing services or products. We submit claims for service and products after they have been provided. Claims are supported by required documentation including physician orders. Despite our measures to ensure compliance with Medicare, Medicaid, or other payor billing standards, such third-party payors may disallow, in whole or in part, requests for reimbursement based on determinations that certain amounts are not reimbursable, that the service was not medically necessary, that there was a lack of sufficient supporting documentation, or for other reasons. Incorrect or incomplete documentation and billing information could result in nonpayment, recoupment or allegations of billing fraud.
We are not aware of any inquiry, investigation or notice from any governmental entity or other payor indicating that we are in violation of any of the Medicare, Medicaid or other payor reimbursement laws, regulations, or requirements. We believe we are in substantial compliance with these laws, rules and regulations based upon what we believe are reasonable and defensible interpretations of these laws, rules and regulations. However, such laws and related regulations and regulatory guidance may be ambiguous or contradictory, and may be interpreted or applied by prosecutorial, regulatory or judicial authorities in ways that we cannot predict. If federal or state government officials or other payors challenge our operations or arrangements with third parties that we have structured based upon our interpretation of these laws, rules and regulations, the challenge could potentially disrupt our business operations and we may incur substantial defense costs, even if we successfully defend our interpretation of these laws, rules and regulations. In addition, if the government or other payors successfully challenge our interpretation as to the applicability of these laws, rules and regulations as they relate to our operations and arrangements with third parties, we would potentially incur substantial cost restructuring our billing practice, as well as fines or penalties for non-compliance which could have a material adverse effect on our business, financial condition and results of operations.
In the event regulatory action were to limit or prohibit us from carrying on our business as we presently conduct it or from expanding our operations to certain jurisdictions, we may need to make structural, operational and organizational modifications to our company and/or our contractual arrangements with third-party payors, physicians, or others. Our operating costs could increase significantly as a result. We could also lose contracts or our revenues could decrease under existing contracts. Any restructuring would also negatively impact our operations because our management’s time and attention would be diverted from running our business in the ordinary course.
We are subject to complex rules and regulations that govern our licensing and certification, and the failure to comply with these rules can result in delays in, or loss of, reimbursement for our services or civil or criminal sanctions.
There has been a trend developing to require facilities that provide sleep diagnostic testing and durable medical equipment to become accredited by an approved accreditation organization as well as additional credentialing for physicians diagnosing sleep disorders and the licensing of technical personnel to perform diagnostic testing procedures. As of March 1, 2013, 10 of our free standing sleep centers are accredited by the American Academy of Sleep Medicine, or the AASM. In addition, we have one free standing sleep center that is accredited through The Joint Commission. We are actively pursuing accreditation for our remaining sleep centers. Also, Medicare requires that all Durable Medical Equipment (DME) suppliers be accredited. All of our sleep therapy facilities providing DME were granted accreditation by The Joint Commission or by the Accreditation Commission for Healthcare, or ACHC. During 2010, one of our DME suppliers, somniCare Overland Park, Kansas location, became the first sleep therapy company in America to be accredited by the AASM.
Physicians, physician assistants, nurse practitioners, and respiratory therapists who provide services as part of our operations are required to obtain and maintain certain professional licenses or certifications and are subject to state regulations regarding professional standards of conduct.
Some states also require our free-standing diagnostic testing facilities and DME providers to be licensed by or registered with state authorities such as state departments of health. We believe that we are in compliance with the licensing and registration in applicable states.
Some state laws require that companies dispensing DME and supplies within the state be licensed by the state board of pharmacy. We currently have a pharmacy license for dispensing of durable medical equipment and supplies in applicable states.
The relevant laws and regulations are complex and may be unclear or subject to interpretation. Currently we believe we are in compliance with all requisite regulatory authorities; however, agencies that administer these programs may find that we have failed to comply in some material respects. Failure to comply with these licensing, certification and accreditation laws, regulations and standards could result in our services being found non-reimbursable or prior payments being subject to recoupment, and can give rise to civil or, in extreme cases, criminal penalties.
Government and private insurance plans may further reduce or discontinue healthcare reimbursements, which could result in reductions in our revenue and operating margins.
A substantial portion of the cost of medical care in the United States is funded by managed care organizations, insurance companies, government funded programs, employers and other third-party payors, which are collectively referred to as “third-party plans.” These plans continue to seek cost containment. If this funding were to be reduced in terms of coverage or payment rates or were to become unavailable to our sleep disorder patients, our business will be adversely affected. Furthermore, managed care organizations and insurance companies are evaluating approaches to reduce costs by decreasing the frequency of treatment or the utilization of a medical device or product. These cost containment measures have caused the decision-making function with respect to purchasing to shift in many cases from the physician to the third-party plans or payors, resulting in an increased emphasis on reduced price, as opposed to clinical benefits or a particular product’s features. Efforts by U.S. governmental and private payors to contain costs will likely continue. Because we generally receive payment for our sleep diagnostic services and related products directly from these third-party plans, our business operations are dependent upon our ability to obtain adequate and timely reimbursement for our sleep diagnostic services and related products.
The third-party payors include Medicare, Medicaid and private health insurance providers. These payors may deny reimbursement if they determine that a diagnostic test was not covered under the patient’s plan or performed properly or that a device is not covered under the patient’s plan, is not used in accordance with approved indications, or is unnecessary or deemed to be inappropriate treatment for the patient. For example, federal payors and commercial concerns that have adopted similar standards will only fully reimburse us for a CPAP device if the patient can demonstrate compliance for the first 90 days after the initial set-up. Third-party payors are also increasingly challenging prices charged for medical products and services. There is no assurance that our sleep diagnostic services and the related products will be considered cost-effective by third-party payors, that reimbursement will be available, or that payors’ reimbursement policies will not adversely affect our ability to offer and sell our services and products on a profitable basis, if at all.
Changes in reimbursement levels for sleep diagnostic services and related products continue to reduce our margins and could have a material, adverse effect on our overall operating results.
During the years ended December 31, 2012 and 2011, we were wholly or partially reimbursed by third-party plans, including Medicare and Medicaid, for approximately 61% and 67%, respectively of our revenue from sleep diagnostic services and product sales. The sleep diagnostic revenue reimbursed by third-party plans generally have lower gross margins compared to sales or services paid outside a third-party plan. Increases in the costs of our sleep related products may not be sufficiently offset by increases in reimbursement rates. In addition, continued increases in co-payments by third-party plans may result in decreases in sales and revenue, operating and cash flow losses, and may deplete working capital reserves.
In particular, Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective reimbursement rate adjustments, administrative rulings, executive orders and freezes and funding restrictions, all of which may significantly impact our operations. During the years ended December 31, 2012 and 2011, 8% and 11%, respectively, of our sleep diagnostic revenues were attributable to Medicaid and Medicare reimbursement. Over the last several years, a number of states experiencing budget deficits have moved to reduce Medicaid reimbursement rates as part of healthcare cost containment.
We depend on reimbursements by third-party payors, as well as payments by individuals, which could lead to delays and uncertainties in the reimbursement process.
We receive a substantial portion of our payments for sleep center services and related supplies from third-party payors, including Medicare, Medicaid, private insurers and managed care organizations. The reimbursement process for these third-party payors is complex and can involve lengthy delays. Third-party payors continue their efforts to control expenditures for healthcare, including proposals to revise reimbursement policies. While we recognize revenue when healthcare services are provided, there can be delays before we receive payment. In addition, third-party payors may disallow, in whole or in part, requests for reimbursement based on determinations that certain amounts are not reimbursable under plan coverage, that services provided were not medically necessary, or that additional supporting documentation is necessary. Retroactive adjustments may change amounts realized from third-party payors. These risks may be exacerbated for patients for whom we are out-of-network. We are subject to governmental audits of our reimbursement claims under Medicare and Medicaid and may be required to repay these agencies if a finding is made that we were incorrectly reimbursed. Delays and uncertainties in the reimbursement process may adversely affect accounts receivable, increase the overall costs of collection and cause us to incur additional borrowing costs.
We also may not be paid with respect to co-payments and deductibles that are the patient’s financial responsibility, or in those instances when our facilities provide services to uninsured and underinsured individuals. Amounts not covered by third-party payors are the obligations of individual patients for which we may not receive whole or partial payment. In such an event, our earnings and cash flow would be adversely affected.
Healthcare reform has been enacted into law and could impact the profitability of our business.
The Affordable Care Act, enacted in March 2010, is dramatically altering the U.S. health care system. The law is intended to increase access to health care and health insurance services, increase the quality of care that is provided, and control or reduce health care spending. In addition, health care reform reduces Medicare and Medicaid payments to hospitals and other healthcare providers and bundle payments to hospitals, physicians, and other providers for certain services. We are unable to predict how changes in the law or new interpretations of existing laws may have a dramatic effect on the costs associated with doing business and the amount of reimbursement patients and customers receive both from government and third-party plans or payors. Federal, state and local government representatives will, in all likelihood, continue to review and assess alternative regulations and payment methodologies.
Healthcare reform and enforcement initiatives of federal and state governments may also affect our sales and revenue. These include:
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Significant reductions in spending on Medicare, Medicaid and other government programs;
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changes in programs providing for lower reimbursement rates for the cost healthcare products and services by third-party plans or payors; and
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regulatory changes relating to the approval process for healthcare products and services in general.
There is uncertainty regarding the nature of healthcare reform implementation and whether there will be other changes in the administration of governmental healthcare programs or interpretations of governmental policies or other changes affecting the healthcare system. Recently enacted or future healthcare or budget legislation or other changes, including those referenced above, may materially adversely affect our business resulting in operating and cash flow losses, depletion of working capital reserves and adversely affect our financial condition.
We rely on primary suppliers of sleep related products to sell their products to us on satisfactory terms, and a disruption in our relationship with these suppliers could have a material, adverse effect on our business.
We are dependent on merchandise vendors to provide sleep disorder related products for our resale. Our largest sleep product suppliers are Fisher & Paykel Healthcare, which supplied approximately 32% and 38% of our sleep supplies in the years ended December 31, 2012 and 2011, respectively, and ResMed, Inc., which supplied approximately 35% and 32% of our sleep supplies in the years ended December 31, 2012 and 2011, respectively. In our opinion, if any of these relationships were terminated or if any contracting party were to experience events precluding fulfillment of our needs, we would be able to find a suitable alternative supplier, but possibly not without significant disruption to our business. This could take a significant amount of time and result in a loss of customers and revenue, operating and cash flow losses and may deplete working capital reserves.
We could be subject to professional liability lawsuits, some of which we may not be fully insured against or reserved for, which could adversely affect our financial condition and results of operations.
In recent years, physicians, hospitals and other participants in the healthcare industry have become subject to an increasing number of lawsuits alleging medical malpractice and related legal theories such as negligent hiring, supervision and credentialing, and vicarious liability for acts of their employees or independent contractors. Many of these lawsuits involve large claims and substantial defense costs. We maintain professional liability insurance, which covers third-party claims that may be brought against the physicians and staff that work at our sleep centers, up to a maximum of $3 million, which amount may be insufficient to satisfy all third-party claims that may be brought against our healthcare professionals.
We are dependent upon our ability to recruit and retain physicians who are properly licensed and certified in the specialty of sleep medicine to oversee our sleep centers and provide medical services to our patients.
Our success depends largely upon our ability to recruit and retain physicians who are licensed to practice medicine in the jurisdictions relevant to the sleep diagnostic testing centers. We currently have medical directors who oversee each of our sleep centers, provide sleep study interpretations and consultations to our patients. The loss of one or more medical directors could result in a time-consuming search for a replacement, and could distract our management team from the day-to-day operations of our business. Any change in our relationship with our supervising or interpreting physicians, whether resulting from a dispute between the parties, a change in government regulation, or the loss of contracts with these physicians, could impair our ability to provide services and could have a material adverse affect on our business, financial condition and operations.
In many markets our success is highly dependent upon the continuing ability to recruit and retain qualified sleep specialists to supervise sleep diagnostic testing services and interpret results of such tests for us due to the current shortage of sleep specialists in the medical profession. We face competition for sleep specialists from other healthcare providers, including hospitals and other organizations. The competitive demand for sleep specialists may require us in the future to offer higher compensation in order to secure the services of sleep specialists. As a result, our compensation expense for our affiliated sleep specialists may increase and if we were not able to offset any such increase by increasing our prices, this could have a material adverse effect on our results of operations. An inability to recruit and retain sleep specialists would have a material adverse effect on our ability to maintain accreditation status and would adversely affect our results of operations.
The loss of our accreditation or our inability to obtain accreditation could negatively impact our business and operating results.
There has been a trend developing to require facilities that provide sleep diagnostic testing and equipment to become accredited by a Medicare approved accreditation organization in order to obtain reimbursement for provided such services. It is anticipated that many other government and private payors will follow suit requiring accreditation by certain approved organizations as a condition to reimbursement for sleep testing and treatment services or products. The loss of our accreditation or our inability to obtain accreditation for new facilities or existing facilities not yet accredited could cause us to be unable to provide services to certain accredited institutions, could cause non-compliance with certain of our third party payor contracts, and could cause us to lose our ability to participate in certain government programs such as Medicare, all of which could, in turn, negatively impact our financial condition and results of operations.
If our arrangements with physicians or our patients are found to violate state laws prohibiting the practice of medicine by general business corporations or fee splitting, our business, financial condition and ability to operate in those states could be adversely affected.
The laws of many states, including states in which we engage physicians to perform medical services, prohibit us from exercising control over the medical judgments or decisions of physicians and from engaging in certain financial arrangements, such as splitting professional fees with physicians. These laws and their interpretations vary from state to state and are enforced by state courts and regulatory authorities, each with broad discretion. In states which do not allow us to exercise control over physicians or prohibit certain financial arrangements, we enter into agreements with physicians as independent contractors pursuant to which they render professional medical services. In addition, in some states, we enter into agreements with physicians to deliver professional sleep interpretation services and professional clinic services in exchange for a service fee.
We structure our relationships with physicians in a manner that we believe is in compliance with prohibitions against the corporate practice of medicine and fee splitting. While we have not received notification from any state regulatory or similar authorities asserting that we are engaged in the corporate practice of medicine or that the payment of service fees to us by physicians or to physicians by us constitutes fee splitting, if such a claim were successful we could be subject to substantial civil and criminal penalties and could be required to restructure or terminate the applicable contractual arrangements and our contractual arrangements may be unenforceable in that particular state. A determination that our arrangements with physicians violate state statutes, a change in government regulation, or our inability to successfully restructure these arrangements to comply with these statutes, could eliminate business located in certain states from the market for our services, which would have a material adverse effect on our business, financial condition and operations.
Our failure to comply with government regulations, including broad and complex federal and state fraud and abuse laws, may result in substantial reimbursement obligations, damages, penalties, injunctive relief or exclusion from participation in federal or state healthcare programs.
Our sleep diagnostic, therapy, and supply operations are subject to a variety of complex federal, state and local government laws and regulations targeted at fraud and abuse, including:
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The federal Anti-Kickback Statute, which prohibits persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in cash or in kind: (i) for referring an individual to a person for the provision of an item or service for which payment may be made under federal healthcare programs such as Medicare and Medicaid; or (ii) to induce a person to refer an individual to a person for the provision of an item or service covered under a federal healthcare program, or arrange for or recommend that someone purchase, lease, or order a good, facility, service, or item covered under a federal healthcare program;
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State law equivalents to the federal Anti-Kickback Statute, which may not be limited to government reimbursed items;
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The federal False Claims Act, which prohibits any person from knowingly presenting, or causing to be presented, a false claim for payment to the federal government or knowingly making, or causing to be made, a false statement in order to have a false claim paid. The federal government’s interpretation of the scope of the law has in recent years grown increasingly broad. Most states also have statutes or regulations similar to the federal false claims laws, which apply to items and services reimbursed under Medicaid and other state programs, or, in several states, apply regardless of the payor;
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The Health Insurance Portability and Accountability Act of 1996, or HIPAA, which prohibits fraud on a health benefit plan and false statements. HIPAA created a federal healthcare fraud statute that prohibits knowingly and willfully executing a scheme to defraud any healthcare benefit program, including private payors. Among other things, HIPAA also imposes criminal penalties for knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for healthcare benefits, items or services, along with theft or embezzlement in connection with a healthcare benefits program and willful obstruction of a criminal investigation involving a federal healthcare offense;
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The Stark Law prohibits the referral of Medicare and Medicaid “designated health services” which includes outpatient prescription drugs and durable medical equipment such as CPAP devices and may also include sleep diagnostic testing if the testing is billed by a hospital to Medicare or Medicaid to an entity if the physician or a member of such physician’s immediate family has a “financial relationship” with the entity, unless an exception applies. The Stark Law provides that the entity that renders the “designated health services” may not present or cause to be presented a claim for “designated health services” furnished pursuant to a prohibited referral. A person who engages in a scheme to circumvent the Stark Law’s prohibitions may be fined up to $100,000 for each applicable arrangement or scheme.
In addition, anyone who presents or causes to be presented a claim in violation of the Stark Law is subject to payment denials, mandatory refunds, monetary penalties of up to $15,000 per service, an assessment of up to three times the amount claimed, and possible exclusion from participation in federal healthcare programs; and
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Many state laws prohibit physician referrals to entities with which the physician has a financial interest, or require that the physician provide the patient notice of the physician’s financial relationship before making the referral. State law equivalents to the Stark law may be applicable to different types of services than those that are “designated health services” under the federal law and may have fewer or different exceptions.
In addition to those sanctions described above, violations of these or other government regulations could result in material penalties, including: civil monetary penalties, suspension of payments from government programs, loss of required government certifications, loss of licenses, loss of authorizations to participate in or exclusion from government reimbursement programs (including Medicare and Medicaid programs). Also, violations of federal, state, and common law privacy protections could give rise to significant damages, penalties, or injunctive relief. We believe that our practices are not in violation of the federal anti-kickback statute, false claims laws, HIPAA, the Stark law, or state equivalents, but we cannot assure you that enforcement authorities will not take action against us and, if such action were successful, we could be required to pay significant fines and penalties and change our corporate practices. Such enforcement could have a significant adverse effect on our ability to operate our business and to enforce our contracts with payors and others.
Non-compliance with federal and state anti-kickback laws could affect our business, operations or financial condition.
Various federal and state laws govern financial arrangements among healthcare providers. The federal Anti-Kickback Statute prohibits the knowing and willful offer, payment, solicitation or receipt of any form of remuneration in return for, or with the purpose to induce, the referral of Medicare, Medicaid or other federal healthcare program patients, or in return for, or with the purpose to induce, the purchase, lease or order of items or services that are covered by Medicare, Medicaid or other federal healthcare programs. Similarly, many state laws prohibit the solicitation, payment or receipt of remuneration in return for, or to induce, the referral of patients in private as well as government programs. There is a risk that an investment in our shares or in our subsidiary sleep centers by our affiliated physicians, including the distribution of any profits to our affiliated physicians, referrals for sleep testing or treatment services by physicians who own our securities, the marketing of our affiliated physicians’ services or our compensation arrangements with our affiliated physicians may be considered a violation of these laws. Violation of these anti-kickback laws may result in substantial civil or criminal penalties for individuals or entities and/or exclusion from participating in federal or state healthcare programs. If we are excluded from federal or state healthcare programs, our affiliated physicians who participate in those programs would not be permitted to continue doing business with us. We believe that we are operating in compliance with applicable laws and believe that our arrangements with providers would not be found to violate the anti-kickback laws. However, these laws could be interpreted in a manner inconsistent with our operations.
We have physicians who own non-controlling investment interests in some of our sleep diagnostic testing facilities who also have a referral relationship with our sleep testing or care management services. If the ownership distributions paid to physicians by our testing facilities are found to constitute prohibited payments made to physicians under the federal Anti-kickback Statute, physician self-referral or other fraud and abuse laws, our business may be adversely affected. Over the years, the federal government has published regulations that established “safe harbors” to the federal Anti-Kickback Statute. An arrangement that meets all of the elements of the safe harbor is immunized from prosecution under the federal Anti-Kickback Statute. The failure to satisfy all elements, however, does not necessarily mean the arrangement violates the federal Anti-Kickback Statute. We endeavor to meet safe harbors designed for small entity investments and believe we are in compliance with such laws. However, if we were found to be violation of a federal or state anti-kickback statute, our business, results of operations, and financial condition would be harmed and we would be subject to substantial civil and criminal penalties.
If government laws or regulations change or the enforcement or interpretation of them change, we may be obligated to purchase some or all of the ownership interests of the physicians associated with us.
Changes in government regulation or changes in the enforcement or interpretation of existing laws or regulations could obligate us to purchase at the then fair market value some or all of the ownership interests of the physicians who have invested in our sleep diagnostic facilities. Regulatory changes that could create this obligation include changes that:
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make illegal the referral of Medicare or other patients to our sleep diagnostic facilities by physicians affiliated with us,
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create the substantial likelihood that cash distributions from our sleep diagnostic facilities to our physician partners will be illegal, or
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make illegal the ownership by physicians of their interests in our sleep diagnostic facilities.
From time to time, we may voluntarily seek to increase our ownership interest in one or more of our sleep diagnostic testing facilities, in accordance with any applicable limitations. We may seek to use shares of our common stock to purchase physicians’ ownership interests instead of cash. If the use of our stock is not permitted or attractive to us or the physicians, we may use cash or promissory notes to purchase the physicians’ ownership interests. Our existing capital resources may not be sufficient for the acquisition or the use of cash may limit our ability to use our capital resources elsewhere, limiting our growth and impairing our operations. The creation of these obligations and the possible adverse effect on our affiliation with these physicians could have a material adverse effect on us.
Federal or state self-referral regulations could impact our arrangements with our affiliated physicians.
The federal physician self-referral statute, known as the “Stark” statute, prohibits a physician from making a referral for certain designated health services, including DME such as CPAP devices, to any entity with which the physician has a financial relationship, unless there is an exception in the statute that allows the referral. The entity that receives a prohibited referral from a physician may not submit a bill to Medicare for that service. Many state laws prohibit physician referrals to entities in which the physician has a financial interest, or require that the physician provide the patient notice of the physician’s financial relationship before making the referral. There is a risk that an investment in our shares or in our subsidiary sleep centers by our affiliated physicians, including the distribution of any profits to our affiliated physicians, the use of our equipment by physicians who own our securities, any assistance from healthcare providers in acquiring, maintaining or operating sleep diagnostic testing equipment, the marketing of our affiliated physicians’ services or our compensation arrangements with our affiliated physicians, could be interpreted as a violation of the federal Stark statute or similar state laws, if we were to accept referrals from our affiliated physicians. Violation of the Stark statute can result in substantial civil penalties for both the referring physician and any entity that submits a claim for a healthcare service made pursuant to a prohibited referral. In addition, federal courts have ruled that violations of the Stark statute can be the basis for a legal claim under the Federal False Claims Act. We believe that all of our affiliated physician arrangements are in compliance with the Stark statute. However, these laws could be interpreted in a manner inconsistent with our operations.
Because we submit claims to the Medicare program based on the services we provide, it is possible that a lawsuit could be brought against us under the Federal False Claims Act, and the outcome of any such lawsuit could have a material adverse effect on our business, financial condition and results of operations.
The federal False Claims Act provides, in part, that the federal government may bring a lawsuit against any person whom it believes has knowingly presented, or caused to be presented, a false or fraudulent request for payment from the federal government, or who has made a false statement or used a false record to have a claim approved. Federal courts have ruled that a violation of the anti-kickback provision of the Stark statute can serve as the basis for the federal False Claims Act suit. The federal False Claims Act further provides that a lawsuit brought under that act may be initiated in the name of the United States by an individual who was the original source of the allegations, known as the relator. Actions brought under the federal False Claims Act are sealed by the court at the time of filing. The only parties privy to the information contained in the complaint are the relator, the federal government and the court. Therefore, it is possible that lawsuits have been filed against us that we are unaware of or which we have been ordered by the court not to discuss until the court lifts the seal from the case. Penalties include fines ranging from $5,500 to $11,000 for each false claim, plus three times the amount of damages that the federal government sustained because of the act of the violator.
We believe that we are operating in compliance with the Medicare rules and regulations and, thus, the federal False Claims Act. However, if we were found to have violated certain rules and regulations and, as a result, submitted or caused our affiliated physicians to submit allegedly false claims, any sanctions imposed under the federal False Claims Act could result in substantial fines and penalties or exclusion from participation in federal and state healthcare programs, which could have a material adverse effect on our business and financial condition. If we are excluded from participation in federal or state healthcare programs, our affiliated physicians who participate in those programs could not do business with us.
Federal regulatory and law enforcement authorities have recently increased enforcement activities with respect to Medicare and Medicaid fraud and abuse regulations and other reimbursement laws and regulations, including laws and regulations that govern our activities and the activities of providers of sleep diagnostic testing and durable medical equipment. These increased enforcement activities may have a direct or indirect adverse affect on our business, financial condition and results of operations.
Additionally, some state statutes contain prohibitions similar to and possibly even more restrictive than the federal False Claims Act. These state laws may also empower state administrators to adopt regulations restricting financial relationships or payment arrangements involving healthcare providers under which a person benefits financially by referring a patient to another person. We believe that we are operating in compliance with these laws. However, if we are found to have violated such laws, our business, results of operations and financial condition would be harmed.
Future changes in healthcare regulation are difficult to predict and may constrain or require us to restructure our operations, which could negatively impact our business and operating results.
The healthcare industry is heavily regulated and subject to frequent changes in governing laws and regulations as well as to evolving administrative interpretations. Our business could be adversely affected by regulatory changes at the federal or state level that impose new requirements for licensing, new restrictions on reimbursement for medical services by government programs, new pretreatment certification requirements for patients seeking sleep testing procedures or treatment products, or new limitations on services that can be performed by us. In addition, federal, state and local legislative bodies have adopted and continue to consider medical cost-containment legislation and regulations that have restricted or may restrict reimbursement to entities providing services in the healthcare industry and referrals by physicians to entities in which the physicians have a direct or indirect financial interest or other relationship. For example, Medicare recently adopted a regulation that limits the technical component of the reimbursement for multiple diagnostic tests performed during a single session at medical facilities other than hospitals. Any of these or future reimbursement regulations or policies could limit the number of diagnostic tests ordered and could have a material adverse effect on our business.
The Center for Medicare & Medicaid Services, or CMS, recently finalized certain anti-markup rules relating to diagnostic tests paid for by the Medicare program. The anti-markup rules are generally applicable where a physician or other supplier bills for the technical component or professional component of a diagnostic test that was ordered by the physician or other supplier (or ordered by a party related to such physician or other supplier through common ownership or control), and the diagnostic test is performed by a physician who does not share a practice with the billing physician or other supplier. If the anti-markup rule applies to an interpretation, then the reimbursement provided by Medicare to a billing physician or other supplier for that interpretation may be limited. Because our sleep diagnostic testing facilities bill Medicare for the technical and professional fees of sleep diagnostic tests that are ordered by community physicians or our affiliated physicians, we believe that the anti-markup rule does not apply to the professional services our affiliated physicians perform or the technical services that our sleep diagnostic testing facilities perform. However, this rule could be subject to an interpretation that affects the amounts that may be reimbursed by Medicare for professional diagnostic interpretations.
Although we monitor legal and regulatory developments and modify our operations from time to time as the regulatory environment changes, we may not be able to adapt our operations to address every new regulation, and such regulations may adversely affect our business. In addition, although we believe that we are operating in compliance with applicable federal and state laws, our business operations have not been scrutinized or assessed by judicial or regulatory agencies. We cannot assure you that a review of our business by courts or regulatory authorities would not result in a determination that adversely affects our operations or that the healthcare regulatory environment will not change in a way that will restrict our operations.
Non-compliance with state and federal regulations concerning health information practices may adversely affect our business, financial condition or operations, and the cost of compliance may be material.
We collect and use information about individuals and their medical conditions. Numerous federal and state laws and regulations, including the federal Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) and the Health Information Technology For Economic and Clinical Health Act (“HITECH Act”), govern the collection, dissemination, security, use and confidentiality of such patient-identifiable health information. HIPAA sets forth standards for electronic transactions between health plans, providers and clearinghouses; unique provider, employer, health plan and patient identifiers; security and electronic signatures as well as privacy protections relating to the exchange of individually identifiable health information. The Department of Health and Human Services (“DHHS”) has released several rules mandating compliance with the standards set forth under HIPAA. We believe our sleep centers and sleep related products and services achieved compliance with DHHS’s standards governing the privacy of individually identifiable health information and DHHS’s standards governing the security of electronically stored health information. In addition, we have fully implemented the required uniform standards governing common healthcare transactions. Finally, we have taken or will take all necessary steps to achieve compliance with other HIPAA rules as applicable, including the standard unique employer identifier rule, the standard health care provider identifier rule and the enforcement rule. While it is believed that we currently comply with HIPAA, there is some uncertainty of the extent to which the enforcement or interpretation of the HIPAA regulations will affect our business. Continuing compliance and the associated costs with these regulations may have a significant impact on our business operations. Criminal and civil sanctions may be imposed for failing to comply with HIPAA.
In addition to the HIPAA restrictions relating to the exchange of healthcare information, individual states have adopted laws protecting the confidentiality of patient information which impact the manner in which patient records are maintained. Violation of patient confidentiality rights under common law, state or federal law could give rise to damages, penalties, civil or criminal fines and/or injunctive relief. We believe that our sleep center operations are in compliance with federal and state privacy protections. However, an enforcement agency or court may find a violation of state or federal privacy protections arising from our sleep center operations.
The failure to comply with other provisions of HIPAA potentially could result in liability, civil and criminal penalties, and could have a material adverse effect on our business and financial condition.
HIPAA authorizes the imposition of civil money penalties against entities that employ or enter into contracts with individuals or entities that have been excluded from participation in the Medicare or Medicaid programs. We perform background checks on our affiliated physicians, and we do not believe that we engage or contract with any excluded individuals or entities. However, a finding that we have violated this provision of HIPAA could have a material adverse effect on our business and financial condition.
HIPAA also establishes several separate criminal penalties for making false or fraudulent claims to insurance companies and other non-governmental payors of healthcare services. These provisions are intended to punish some of the same conduct in the submission of claims to private payors as the federal False Claims Act covers in connection with governmental health programs. We believe that our services have not historically been provided in a way that would place either our clients or ourselves at risk of violating the HIPAA anti-fraud statutes, including those in which we received direct reimbursement because of the reassignment by affiliated physicians to us or those in which we may be considered to receive an indirect reimbursement because of the reassignment by us to hospitals of the right to collect for professional interpretations and technical services.
We believe that our sleep centers have taken all appropriate steps to achieve compliance with the HIPAA requirements. We do not currently believe that the ongoing cost of compliance with the existing HIPAA requirements will be material to our operations; however, we cannot predict the cost of future compliance with HIPAA requirements.
Our failure to successfully implement our growth plan may adversely affect our financial performance.
We have grown primarily through acquisitions. We intend to continue to grow incrementally through acquisitions with our current focus on acquiring the surgical center and surgical hospital business of Foundation and our historical growth strategy in the sleep disorder market through our comprehensive sleep management care model. As this growth plan is pursued, we may encounter difficulties expanding and improving our operating and financial systems to maintain pace with the increased complexity of the expanded operations and management responsibilities.
The success of our growth strategy will also depend on a number of other factors, including:
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economic conditions;
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competition;
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consumer preferences and purchasing power;
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the ability to attract and retain sleep technicians and physicians;
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financing and working capital requirements;
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the ability to negotiate sleep center leases on favorable terms; and
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the availability of new locations at a reasonable cost.
Even if we succeed in acquiring the surgical center and surgical hospital businesses of Foundation as planned, those acquired facilities may not achieve the projected revenue or profitability levels that we estimate or at all. The failure of our growth strategy may have a material adverse effect on our operating results and financial condition.
Material weaknesses in the design and operation of the internal controls over financial reporting of companies that we acquire could have a material adverse effect on our financial statements.
Our business has primarily grown through the acquisition of existing businesses and in the future we intend to continue to grow our business through the acquisition of existing businesses. When we acquire such existing businesses our due diligence may fail to discover defects or deficiencies in the design and operations of the internal controls over financial reporting of such companies, or defects or deficiencies in the internal controls over financial reporting may arise when we try to integrate the operations of these newly acquired businesses with our own. We can provide no assurances that we will not experience such issues in future acquisitions, the result of which could have a material adverse effect on our financial statements.
The goodwill and other intangible assets acquired pursuant to our acquisitions of sleep centers has become fully-impaired. Goodwill and other intangible assets related to future acquisitions may require additional write-downs and the recognition of additional substantial impairment expense.
At December 31, 2012, we have fully-impaired $21.2 million and $2.1 million in goodwill and other intangible assets, respectively, that were recorded in connection with the acquisitions of our sleep centers during the years 2007 through 2011. We periodically evaluate whether or not to take an impairment charge on our goodwill, as required by the applicable accounting literature. Our evaluation is based on our (i) assessment of current and expected future economic conditions, (ii) trends, strategies and forecasted cash flows at each business unit and (iii) assumptions similar to those that market participants would make in valuing our business units. During the second and fourth quarters of 2012, we determined that the carrying value of goodwill related to our sleep centers exceeded their fair value. In addition, we determined the carrying value of our intangible assets exceeded their fair value. Accordingly, in June 2012 and December 2012, we recorded a noncash impairment charge on goodwill of $3.0 million and $10.7 million, respectively, for a total 2012 impairment charge on goodwill of $13.7 million. In addition, in December 2012, we recorded a noncash impairment charge on intangible assets of $1.1 million. Our evaluation of goodwill and intangible assets completed during 2011 did not identify any impairment.
In the event that we record additional goodwill or other intangibles on future acquisitions and we subsequently determine the goodwill or other intangibles to be impaired for any reason, we will be required to write-down or reduce the value of the goodwill and recognize an impairment expense. The impairment expense may be substantial in amount and adversely affect the results of our operations for the applicable period and may negatively affect the market value of our common stock.
Risks Related to Ownership of Our Common Stock
Our common stock is quoted on the OTCQB, which may limit the liquidity and price of our common stock more than if our common stock quoted or listed on or a national securities exchange.
Our common stock is currently quoted on the OTCQB, an inter-dealer automated quotation system for equity securities not listed on a national securities exchange. Quotation of our common stock on the OTCQB may limit the liquidity and price of our common stock more than if our common stock was quoted or listed on a national securities exchange. Some investors may perceive our common stock to be less attractive because they are traded in the over-the-counter market. In addition, as an OTCQB company, we do not attract the extensive analyst coverage that accompanies companies listed on a national securities exchange. Further, institutional and other investors may have investment guidelines that restrict or prohibit investing in securities traded in the over-the-counter market. In addition, holders of our common stock may face restrictions on the resale of our common stock due to state “blue sky” laws. These factors may have an adverse impact on the trading and price of our common stock.
Our securities are “Penny Stock” and subject to specific rules governing their sale to investors.
The SEC has adopted Rule 15g-9 which establishes the definition of a “penny stock,” for the purposes relevant to us, as any equity security that has a market price of less than $5.00 per share or with an exercise price of less than $5.00 per share, subject to certain exceptions. For any transaction involving a penny stock, unless exempt, the rules require that a broker or dealer approve a person’s account for transactions in penny stocks; and the broker or dealer receive from the investor a written agreement to the transaction, setting forth the identity and quantity of the penny stock to be purchased.
In order to approve a person’s account for transactions in penny stocks, the broker or dealer must obtain financial information and investment experience objectives of the person; and make a reasonable determination that the transactions in penny stocks are suitable for that person and the person has sufficient knowledge and experience in financial matters to be capable of evaluating the risks of transactions in penny stocks.
The broker or dealer must also deliver, prior to any transaction in a penny stock, a disclosure schedule prescribed by the SEC relating to the penny stock market, which, in highlight form sets forth the basis on which the broker or dealer made the suitability determination; and that the broker or dealer received a signed, written agreement from the investor prior to the transaction.
Generally, brokers may be less willing to execute transactions in securities subject to the “penny stock” rules. This may make it more difficult for our shareholders to sell shares of our common stock.
Disclosure also has to be made about the risks of investing in penny stocks in both public offerings and in secondary trading and about the commissions payable to both the broker-dealer and the registered representative, current quotations for the securities and the rights and remedies available to an investor in cases of fraud in penny stock transactions. Finally, monthly statements have to be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stocks.
Investors may experience dilution of their ownership interests because of the future issuance of additional shares of our common stock.
In the future, we may issue additional authorized but previously unissued equity securities, resulting in the dilution of the ownership interests of our present stockholders. We may also issue additional shares of our common stock or other securities that are convertible into or exercisable for common stock in connection with hiring or retaining employees, future acquisitions, future sales of our securities for capital raising purposes, or for other business purposes. The future issuance of any such additional shares of common stock may create downward pressure on the trading price of the common stock. There can be no assurance that we will not be required to issue additional shares, warrants or other convertible securities in the future in conjunction with any capital raising efforts, including at a price (or exercise prices) below the price at which shares of our common stock are currently traded on the OTCQB.
Our current principal stockholders have significant influence over us and they could delay, deter or prevent a change of control or other business combination or otherwise cause us to take action with which you might not agree.
Our executive officers, directors and holders of greater than 5% of our outstanding common stock together beneficially own approximately 55% of our outstanding common stock. As a result, our executive officers, directors and holders of greater than 5% of our outstanding common stock will have the ability to significantly influence all matters submitted to our stockholders for approval, including:
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changes to the composition of our Board of Directors, which has the authority to direct our business and appoint and remove our officers;
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proposed mergers, consolidations or other business combinations; and
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amendments to our certificate of incorporation and bylaws which govern the rights attached to our shares of common stock.
This concentration of ownership of shares of our common stock could delay or prevent proxy contests, mergers, tender offers, open market purchase programs or other purchases of shares of our common stock that might otherwise give you the opportunity to realize a premium over the then prevailing market price of our common stock. The interests of our executive officers, directors and holders of greater than 5% of our outstanding common stock may not always coincide with the interests of the other holders of our common stock. This concentration of ownership may also adversely affect our stock price.
The market price of our common stock may be volatile and this may adversely affect our stockholders.
The price at which our common stock trades may be volatile. The stock market has recently experienced significant price and volume fluctuations that have affected the market prices of securities, including securities of healthcare companies. The market price of our common stock may be influenced by many factors, including:
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our operating and financial performance;
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variances in our quarterly financial results compared to expectations;
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the depth and liquidity of the market for our common stock;
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future sales of common stock or the perception that sales could occur;
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investor perception of our business and our prospects;
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developments relating to litigation or governmental investigations;
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changes or proposed changes in healthcare laws or regulations or enforcement of these laws and regulations, or announcements relating to these matters; or
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general economic and stock market conditions.
In addition, the stock market in general has experienced price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of healthcare companies. These broad market and industry factors may materially reduce the market price of our common stock, regardless of our operating performance. In the past, securities class-action litigation has often been brought against companies following periods of volatility in the market price of their respective securities. We may become involved in this type of litigation in the future. Litigation of this type is often expensive to defend and may divert our management team’s attention as well as resources from the operation of our business.
We do not anticipate paying dividends on our common stock in the foreseeable future and, consequently, your ability to achieve a return on your investment will depend solely on appreciation in the price of our common stock.
We do not pay dividends on our shares of common stock and intend to retain all future earnings to finance the continued growth and development of our business and for general corporate purposes. In addition, we do not anticipate paying cash dividends on our common stock in the foreseeable future. Any future payment of cash dividends will depend upon our financial condition, capital requirements, earnings and other factors deemed relevant by our Board of Directors. Our current credit facility with Arvest Bank restricts our ability to pay dividends, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Arvest Credit Facility.”
Item 1B.
Item 1B. Unresolved Staff Comments.
None
Item 2.
Item 2. Properties.
Facilities
Our corporate headquarters and offices are located in Oklahoma City, Oklahoma. These office facilities consist of approximately 14,900 square feet and are occupied under a lease agreement with City Place, LLC (“City Place”), requiring monthly rental payments of $17,970 plus additional payments for our allocable share of the basic expenses of City Place. The lease agreement with City Place expires on March 31, 2017. Non-controlling interests in City Place are held by Roy T. Oliver, one of our greater than 5% shareholders and affiliates, and Mr. Stanton Nelson, our Chief Executive Officer. We believe that suitable additional or substitute space will be available as needed on reasonable terms.
As of December 31, 2012, we operated 26 free standing sleep clinics and therapy locations in 7 states and 2 administrative outreach locations in 2 states. Most locations are occupied under multiple-year (or long-term) lease arrangements requiring monthly rental payments. The following table presents, as of December 31, 2012, the locations and lease expiration dates of occupancy leases of each sleep center or clinic.
(1) Represents an administrative outreach office location.
(2) Represents a location that includes both a sleep center and a therapy service center.
(3) Location was closed in January 2013, but lease remains in effect.
Item 3.
Item 3. Legal Proceedings.
From time to time, we are subject to claims and suits arising in the ordinary course of our business, including claims for damages for personal injuries. In our management’s opinion, the ultimate resolution of any of these pending claims and legal proceedings will not have a material adverse effect on our financial position or results of operations.
Item 4.
Item 4. Mine Safety Disclosures.
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Market
Our common stock is traded on the OTCQB under the symbol GRMH. Prior to November 2, 2012, our common stock was listed on The Nasdaq Capital Market (“Nasdaq”) under the symbol GRMH. The following table sets forth, during the calendar quarters presented, the high and low sale prices of our common stock as reported by the OTCQB and Nasdaq, respectively:
The share prices listed above have been adjusted to reflect the 1-for-4 reverse stock split effected after the close of business on June 3, 2011. On March 28, 2013, the closing price of our common stock as quoted on OTCQB was $ 0.35.
The market price of our common stock is subject to significant fluctuations in response to, and may be adversely affected by:
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variations in quarterly operating results,
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changes in earnings estimates by analysts,
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developments in the sleep disorder diagnostic and treatment markets,
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announcements of acquisitions, dispositions and other corporate level transactions,
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announcements of financings and other capital raising transactions,
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sales of stock by our larger stockholders,
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announcements and introductions of product or service innovations, and
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general stock market conditions.
Holders of Equity Securities
As of March 15, 2013, we have 93 owners of record of our common stock.
Dividend Policy
Historically, we have not paid dividends on our common stock, and we do not currently intend to pay and you should not expect to receive cash dividends on our common stock. Our dividend policy is to retain earnings to support the expansion of our operations. If we were to change this policy, any future cash dividends will depend on factors deemed relevant by our board of directors. These factors will generally include future earnings, capital requirements, our financial condition contractual restrictions, such as our existing credit facilities. Our existing credit facility restricts our ability to pay dividends without the approval of our lenders. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Arvest Credit Facility.” Furthermore, in the event we issue shares of preferred stock, although unanticipated, no dividends may be paid on our outstanding shares of common stock until all dividends then due on our outstanding preferred stock will have been paid.
Securities Authorized for Issuance under Equity Compensation Plans
The following table sets forth as of December 31, 2012, information related to each category of equity compensation plan approved or not approved by our shareholders, including individual compensation arrangements with our non-employee directors. The equity compensation plan approved by our shareholders is our 2008 Long-Term Incentive Plan. All stock options and rights to acquire our equity securities are exercisable for or represent the right to purchase our common stock.
Unregistered Sales of Equity Securities
All of our unregistered sales of equity securities during 2012 have been previously reported in the Quarterly Reports on Form 10-Q or in a Current Report on Form 8-K.
Repurchases of Equity Securities
During the three months ended December 31, 2012, we did not repurchase any of our equity securities. We do not have any on-going stock repurchase programs.
Item 6.
Item 6. Selected Financial Data.
We are a smaller reporting company as defined in Rule 12b-2 of the Exchange Act and, accordingly, not required to provide the information required by Item 301 of Regulation S-K with respect to Selected Financial Data.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
Graymark Healthcare, Inc. is organized under the laws of the State of Oklahoma and is one of the largest providers of care management solutions to the sleep disorder market based on number of independent sleep care centers and hospital sleep diagnostic programs operated in the United States. We provide a comprehensive diagnosis and care management solutions for patients suffering from sleep disorders.
We provide diagnostic sleep testing services and care management solutions, or SMS, for people with chronic sleep disorders. In addition, we provide therapy services (delivery and set up of CPAP equipment together with training related to the operation and maintenance of CPAP equipment) and the sale of related disposable supplies and components used to maintain the CPAP equipment. Our products and services are used primarily by patients with obstructive sleep apnea, or OSA. Our sleep centers provide monitored sleep diagnostic testing services to determine sleep disorders in the patients being tested. The majority of the sleep testing is to determine if a patient has OSA. A continuous positive airway pressure, or CPAP, device is the American Academy of Sleep Medicine’s, or AASM, preferred method of treatment for obstructive sleep apnea. Our sleep diagnostic facilities also determine the correct pressure settings for patient CPAP devices via titration testing. We sell CPAP devices and disposable supplies to patients who have tested positive for sleep apnea and have had their positive airway pressure determined.
There are non-controlling interests held in some of our testing facilities, typically by physicians located in the geographical area being served by the diagnostic sleep testing facility.
Going Concern and Management’s Plan
As of December 31, 2012, we had an accumulated deficit of $57.6 million and reported a net loss of $22.4 million for 2012. In addition, we used $4.2 million in cash from operating activities from continuing operations during the year. On March 29, 2013, signed a definitive purchase agreement with Foundation Surgery Affiliates, LLC and Foundation Surgical Hospital Affiliates, LLC (collectively “Foundation”) for 98.5 million shares of our common stock. We expect the transaction to close in the second quarter of 2013, however there is no assurance the acquisition will close at that time or at all. The closing of the Foundation transaction is subject to the consent of Arvest Bank (our senior lender), Foundation’s senior lender and certain preferred interest holders of Foundation and there is no assurance that these consents will be obtained. For financial reporting purposes, the transaction will be recorded as a reverse merger and Foundation will be considered the accounting acquirer. If the transaction is closed, our primary focus will be the execution of the Foundation business plan which includes operating surgical hospitals and surgery centers. In addition, we anticipate that our existing strategy of providing diagnosis and care management solution for patients suffering from sleep disorders would be significantly curtailed.
There is no assurance that the Foundation transaction will close and we currently do not have sufficient cash on hand and do not expect to generate sufficient cash flow from operations to meet our cash requirements over the next 12 months. Historically, we have been able to raise the capital necessary to fund our operations and growth, but there is no assurance that we will be successful in raising the necessary capital to fund our operations and obligations.
If we are unable to close the Foundation transaction or raise additional funds, we may be forced to substantially scale back operations or entirely cease our operations and discontinue our business. These uncertainties raise substantial doubt regarding our ability to continue as a going concern. The consolidated condensed financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.
Stock Offerings
On November 12, 2012, we executed a subscription agreement with Graymark Investments, LLC (doing business as Oklahoma Health Partners (“OHP”)) in which OHP agreed to purchase 1,444,445 shares of the Company’s common stock for $650,000 ($0.45 per share). The proceeds from OHP were received on November 13, 2012 and were used to fund our operations.
In June 2011, we completed a public offering of 6,000,000 shares of common stock and warrants exercisable for the purchase of 6,700,000 shares for gross proceeds of $8,400,000 or $1.40 per combination of one share of common stock and a warrant to purchase one share of common stock. The underwriter of the offering received sales commissions of $420,350 (5% of the gross proceeds), a corporate finance fee of $168,140 (2% of the gross proceeds) and a legal and other expense allowance of $116,094 (1.4% of the gross proceeds). In conjunction with the offering, each investor received a warrant to purchase one share of common stock for each share of common stock purchased. The warrants are exercisable for the purchase of one share of common stock for $1.50 beginning June 20, 2011 and on or before June 20, 2016. We incurred $824,603 in expenses directly associated with the offering.
In conjunction with the offering, the underwriter had an option to purchase an additional 700,000 shares of our common stock and warrants to purchase 700,000 shares of our common stock solely to cover over-allotments. The underwriter exercised the full over-allotment option with respect to the warrants in June 2011 in connection with the initial closing and we received $7,000 for the purchase of such warrants. In July 2011, we received $472,600 in gross proceeds from the sale of 340,000 over-allotment shares that the underwriter purchased directly from us. The net proceeds of the over-allotment were $439,518.
In May 2011, we executed subscription agreements with existing accredited investors or their affiliates to sell 1,293,103 shares of our common stock in a private placement. The proceeds of the private placement were approximately $3 million ($2.32 per share). The proceeds included $2 million in cash and $1 million from the conversion of the Valiant Note. In conjunction with the private placement, each investor received a warrant to purchase one share of common stock for each common share purchased pursuant to the subscription agreement. The warrants are exercisable for the purchase of one share of common stock for $1.80 beginning November 4, 2011 and on or before May 4, 2014.
Reverse Stock Split
On January 26, 2011, our Board of Directors approved a reverse stock split in one of five ratios, namely 1 for 2, 3, 4, 5 or 6. On February 1, 2011, we received the consent of a majority of our shareholders for this reverse stock split. On May 18, 2011, our Board of Directors resolved to effect the reverse stock split of our common stock in a ratio of 1-for-4 effective after the close of business on June 3, 2011. We executed the reverse stock split to regain compliance with the continued listing standards of the Nasdaq Capital Market. The Nasdaq Capital Market requires issuers to maintain a $1.00 minimum bid price. In determining a reverse stock split ratio of 1-for-4, the Board of Directors considered the continued listing standards of the Nasdaq Capital Markets, considered a ratio that would allow us to achieve long-term compliance with the listing standards and which allowed us to have a number of outstanding shares to have sufficient trading volume. Our Board of Directors determined that a ratio of 1-for-4 was the best balance of these various factors. The effect of the reverse split reduced our outstanding common stock shares from 34,126,022 to 8,531,506 shares as of the date of the reverse split.
Discontinued Operations
On May 10, 2011, we executed an Asset Purchase Agreement (“Agreement”) with Daniel I. Rifkin, M.D., P.C. pursuant to which we sold substantially all of the assets of our subsidiary, Nocturna East, Inc. (“East”) for $2,500,000. In conjunction with the sale of East assets, the Management Services Agreement (“MSA”) under which we provided certain services to the sleep centers owned by Independent Medical Practices (“IMA”) including billing and collections, trademark rights, non-clinical sleep center management services, equipment rental fees, general management services, legal support and accounting and bookkeeping services was terminated. Our decision to sell the assets of East was primarily based on our determination that the operations of East no longer fit into our strategic plan of providing a full continuum of care to patients due to significant regulatory barriers that limit the our ability to sell CPAP devices and other supplies at the East locations. As a result of the sale of East, the related assets, liabilities, results of operations and cash flows of East have been classified as discontinued operations in the accompanying consolidated financial statements.
On September 1, 2010, we executed an Asset Purchase Agreement, which was subsequently amended on October 29, 2010, (as amended, the “Agreement”) providing for the sale of substantially all of the assets of our subsidiary, ApothecaryRx to Walgreens. ApothecaryRx operated 18 retail pharmacies selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. The final closing of the sale of ApothecaryRx’s assets occurred in December 2010. As a result of the sale of ApothecaryRx’s assets, the remaining assets, and liabilities, results of operations and cash flows of ApothecaryRx have been classified as discontinued operations for financial statement reporting purposes.
Under the Agreement, the consideration for the ApothecaryRx assets purchased and liabilities assumed is $25,500,000 plus up to $7,000,000 for inventory (“Inventory Amount”), but less any payments remaining under goodwill protection agreements and any amounts due under promissory notes which are assumed by buyer (the “Purchase Price”). For purposes of determining the Inventory Amount, the parties agreed to hire an independent valuator to perform a review and valuation of inventory being purchased from each pharmacy location. We received approximately $24.5 million in net proceeds from the sale of assets of which $2.0 million was deposited into an indemnity escrow account (the “Indemnity Escrow Fund”) as previously agreed pursuant to the terms of an indemnity escrow agreement. These proceeds are net of approximately $1.0 million of security deposits transferred to the buyer and the assumption by the buyer of liabilities associated with goodwill protection agreements and promissory notes. We also received an additional $3.8 million for the sale of inventory to Walgreens at 17 of our pharmacies with the inventory for the remaining pharmacy being sold as part of the litigation settlement. We used $22.0 million of the proceeds to pay-down our senior credit facility.
In December 2011 (the 12-month anniversary of the final closing date of the sale of ApothecaryRx), 50% of the remaining funds held in the Indemnity Escrow Fund ($1.0 million) were released, without deduction for any indemnification claims. All remaining funds held in the Indemnity Escrow Fund ($1.0 million) were released in June 2012 (the 18-month anniversary of the final closing date of the sale), without deduction for any indemnification claims.
Business Strategy
We plan to grow our business via organic growth related to our Independent Sleep Care Centers, Hospital Sleep Diagnostic Programs (both increased volumes related to existing management agreements and the execution of new management agreements), therapy services and recurring re-supply fulfillment. We also plan to expand revenues at our existing locations through new billing under arrangements with hospitals in our existing markets. Acquisitions, the opening of new facilities and new management agreement with hospital sleep labs will also be an integral part of our growth strategy going forward. We will seek to acquire business operations that can be rolled into our existing operations as well as additional independent sleep care centers. We will also seek acquisition opportunities related to therapy service and re-supply business operations and new management agreement opportunities in both existing and new markets. We expect all acquisitions to be accretive to our earnings and fully integrated within ninety (90) days of closing.
In addition, we plan to acquire the surgery center and surgical hospital businesses of Foundation Healthcare Affiliates, LLC. On March 29, 2013, we entered into a purchase agreement to acquire these businesses from Foundation. The acquisition is subject to conditions to closing, including the consent of Arvest Bank, our secured lender and the consents or Foundation’s lender and the preferred members of certain of their subsidiaries as well as other customary closing conditions. There is no assurance that we can close this acquisition as planned in the second quarter of 2013 or at all.
On December 12, 2011, we acquired 80% of the Village Sleep Center (“Village”), located in Plano, Texas, for a purchase price of up to $960,000. Under the purchase agreement, we paid $596,000 in cash and withheld $364,000 of the purchase price (“Withheld Funds”) as collateral to secure any obligations the sellers have pursuant to the indemnification clauses of the purchase agreement. The Withheld Funds, less any amounts deducted, shall be paid in two equal installments, not to exceed $182,000. In order to receive the maximum installment payment, the trailing twelve months earnings before interest, taxes, depreciation and amortization (“EBITDA”) for Village for the years ended December 31, 2012 and 2013 must be at least $200,000, respectively. If the EBITDA for 2012 and or 2013 is less than $200,000, the payment of Withheld Funds is reduced by the ratio of actual EBITDA to the required EBITDA of $200,000. We initially estimated the fair value of the contingent consideration or Withheld Funds to be $234,565. We revaluated the contingent consideration based on the actual EBITDA results as of December 31, 2012 and reduced the expected contingent consideration by $90,380.
Impairment of Goodwill and Intangible Assets
As of December 31, 2012, we have fully-impaired our goodwill and intangible assets
Goodwill and other indefinite-lived assets are not amortized, but are subject to impairment reviews annually, or more frequent if necessary. We are required to evaluate the carrying value of goodwill during the fourth quarter of each year and between annual evaluations if events occur or circumstances change that would more likely than not reduce the fair value of the related operating unit below its carrying amount. These circumstances may include without limitation
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a significant adverse change in legal factors or in business climate,
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unanticipated competition, or
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an adverse action or assessment by a regulator.
In evaluating whether goodwill is impaired, we must compare the fair value of the operating unit to which the goodwill is assigned to the operating units carrying amount, including goodwill. The fair value of the operating unit is estimated using a combination of the income, or discounted cash flows, approach and the market approach that utilize comparable companies data. If the carrying amount of the operating unit exceeds its fair value, then the amount of the impairment loss must be measured. The impairment loss would be calculated by comparing the implied fair value of an operating unit to its carrying amount. In calculating the implied fair value of the operating unit goodwill, the fair value of the operating unit will be allocated to all of the other assets and liabilities of that operating unit based on their fair values. The excess of the fair value of an operating unit over the amount assigned to its other assets and liabilities will be the implied fair value of goodwill. An impairment loss will be recognized when the carrying amount of goodwill exceeds its implied fair value.
Based on our sleep study trends and forecasted cash flows, we determined that impairment indicators existed during the second quarter and fourth quarter of 2012. During the second quarter of 2012, the primary factor that drove impairment was our actual volume of sleep studies compared to the volumes that we had projected for 2012. During the fourth quarter of 2012 when we performed our annual impairment review, we noted continued negative trends in its sleep study volumes, coupled with deterioration in the overall sleep diagnostic market. During 2012, the sleep diagnostic market experienced a continued shift to home based testing and continued negative trends in reimbursement levels. Based on assumptions similar to those that market participants would make in valuing the our business, we determined that the carrying value of goodwill and other intangible assets related to our sleep centers exceeded their fair value. Accordingly, in June 2012 and December 2012, we recorded a noncash impairment charge on goodwill of $3.0 million and $10.7 million, respectively, for a total 2012 impairment charge on goodwill of $13.7 million. In addition, in December 2012, we recorded a noncash impairment charge on intangible assets of $1.1 million. Our evaluation of goodwill and indefinite lived intangible assets completed during December 2011 resulted in no impairment.
Operating Statistics:
The following table summarizes our locations as of December 31, 2012 and 2011:
The following table summarizes unit sales and other operating statistics, by quarter, for the years ended December 31, 2012 and 2011:
Results of Operations
The following table sets forth selected results of our operations for the years ended December 31, 2012 and 2011. The following information was derived and taken from our audited financial statements appearing elsewhere in this report.
Comparison of 2012 and 2011
Discussion of Years Ended December 31, 2012 and 2011
Services revenues were flat for 2012 compared with 2011. Our sleep diagnostic services are performed in two environments, our independent diagnostic testing facilities (“IDTF”) and at contracted client locations (“Hospital/Outreach”). For studies performed in our IDTF locations, we generally bill third-party payors for the sleep study. In our hospital and outreach agreements, we are paid a contracted fee per study performed. In our more rural outreach locations, our contracted rates are typically higher due to the additional costs associated with servicing more remote locations. Our urban hospital agreements tend to be at a lower rate due to the reimbursement environment and lower costs to serve.
The flat revenues from sleep diagnostic services during 2012 compared to 2011 was comprised of a $0.6 million increase at our Hospital/Outreach locations which was offset by a $0.3 million decrease at our IDTF locations and a $0.3 million decrease at our clinic locations.
The $0.6 million increase in our Hospital/Outreach location revenue during 2012 compared to 2011 was due to the following:
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We transitioned our Tulsa Midtown IDTF location to a contracted hospital location in May 2011. Through May 2011, the revenue for this location was included in IDTF revenue. For the same period in 2012 revenue from this location is included in our Hospital/Outreach category. This change accounts for $0.2 million of the Hospital/Outreach revenue increase in 2012 compared to 2011.
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Revenue from new hospital agreements that commenced operations since the end of 2011 contributed $0.2 million of the revenue increase in 2012 compared to 2011.
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A decrease in overall average reimbursement per sleep study due to a change in the mix of patients at our existing Hospital/Outreach locations resulted in a decrease of $0.1 million in revenue in 2012 compared to 2011
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An increase in the volume of sleep studies performed at our existing (operating for at least one year) Hospital/Outreach facilities resulted in an increase of $0.3 million in revenue.
The $0.3 million decrease in revenue in 2012 at our IDTF locations compared to 2011 was due to the following:
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We transitioned our Tulsa Midtown IDTF location to a contracted hospital location in May 2011. Through May 2011, the revenue for this location was included in IDTF revenue. For the same period in 2012 revenue from this location is included in our Hospital/Outreach category. This change accounts for $0.1 million of the IDTF revenue decrease in 2012 compared to 2011.
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A decrease in the volume of sleep studies done at our existing IDTF facilities resulted in a $0.9 million decline in revenue in 2012 compared 2011;
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A decrease in the overall average reimbursement per sleep study in our existing IDTF facilities resulted in a $0.2 million decline in revenue during 2012 compared to 2011. The decrease is due to a combination of a change in mix of the locations where studies were performed and the mix of payors at the various locations.
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Revenue from new facilities opened after the third quarter of 2011 (less than a full prior year operating results) resulted in an increase in revenue of $0.9 million in 2012 compared to 2011.
The $0.3 million decline in revenues related to our clinic services were due to the closing of our clinic service locations in Oklahoma City during the fourth quarter of 2011.
Product revenues from our sleep therapy business decreased $0.5 million (a 10.1% decrease) during 2012 compared to 2011. The decrease was due to a $0.7 million reduction in revenue from the initial set-up of CPAP devices, partially offset by a $0.2 million increase in revenue from our re-supply business.
The $0.7 million reduction in CPAP set-up revenues was due to a $0.3 million decrease related to the average revenue per set-up performed which was caused by a change in the mix of payors as well as rate reductions from some payors and a $0.4 million decrease due to lower set-up volumes during 2012 compared to 2011. The increase in re-supply revenue was driven by a $0.1 million increase related to increased volume during 2012 compared to 2011 and a $0.1 million increase in the average reimbursement per re-supply shipment.
Cost of services increased $0.2 million (a 3.7% decrease) to $5.3 million from $5.1 million during 2012 compared to 2011. The increase in cost of services was due to the overall increase in volume during 2012 compared 2011 driven primarily by new facilities opened since the third quarter of 2011.
Cost of services as a percent of service revenue was 42.6% and 40.9% during 2012 and 2011, respectively. The increase in cost of services as a percent of service revenue was primarily due to the shift in our business towards Hospital/Outreach sleep studies which have a lower reimbursement per sleep study compared to our IDTF locations, and as a result has a higher cost of service as a percentage of revenue. In addition, we saw a decline in 2012 of the average reimbursement per sleep study compared to 2011. During 2012, 55% of our sleep studies were performed in an IDTF location compared to 61% in 2011. The higher cost of service percentage in Hospital/Outreach locations is more than offset by the significantly lower operating expense associated with these locations, primarily related to the lack of facility costs.
Cost of sales from our sleep therapy business decreased $0.1 million (an 8.3% decrease) during 2012 compared with 2011. Cost of sales as a percent of product sales was 35.9% and 35.2% during 2012 and 2011, respectively. The decrease in cost of sales compared to 2011 is primarily due to a lower number of set-ups performed in 2012 compared to 2011.
Selling, general and administrative expenses increased $0.3 million (a 2.3% increase) to $14.0 million or 83% of revenue in 2012 from $13.7 million or 79% of revenue during 2011. The increase in selling, general and administrative expenses was primarily due to:
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an increase in central shared service expense of $1.3 million as we added infrastructure and centralized certain operations to our corporate office. The added infrastructure was primarily in the areas of sales, compliance and human resources. In addition, we centralized patient scheduling and benefits verification from field locations to our corporate office;
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an increase in corporate overhead expense of $0.3 million due to non-recurring legal and other expenses related to potential acquisitions;
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a decrease in facility operating expenses of $0.9 million due to a combination of the centralization of patient scheduling and verification as well as reductions in overhead costs due to organizational restructuring of our operations and renegotiation of facility costs at some locations;
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a decrease in operating expenses of $0.4 million due to the closure of our clinic facilities in Oklahoma in the fourth quarter of 2011.
Bad debt expense for 2012 increased $0.5 million (a 61.2% increase) to $1.4 million or 8.5% of revenue from $0.9 million or 5.1% of revenue for 2011. The increase in our bad debt expense occurred in the first half and the fourth quarter of 2012 compared to the same periods in 2011. In the first six months of 2012, we saw growth in our aging categories over 180 days, where our reserve rates are the highest, compared to the first six months of 2011. Additionally, in some of our new locations, physician diagnostic codes were determined to be ineligible for reimbursement by several payors. While we have now addressed the diagnostic coding issue and do not expect it to continue, we incurred higher bad debt expense related to these claims during the first six months of 2012. The combined impact of these items was approximately $0.4 million of the increase compared to 2011. In the fourth quarter, our recurring analysis of historical collection rates indicated a need for a slight increase in our reserve rates some of our aging categories. The impact of the change in reserve rates increased bad debt expense $0.1 million in 2012 compared to 2011.
Impairment of goodwill and intangible assets - during the second and fourth quarters of 2012, we completed impairment reviews of goodwill and other intangible assets. Based on our (i) assessment of current and expected future economic conditions, (ii) trends, strategies and forecasted cash flows at each business unit and (iii) assumptions similar to those that market participants would make in valuing our business units, we determined that the carrying value of goodwill and intangible assets related to our sleep centers exceeded their fair value. Accordingly, we recorded a noncash impairment charges totaling $14.8 million in 2012. Our evaluation of goodwill and indefinite lived intangible assets completed during December 2011 resulted in no impairment losses.
Depreciation and amortization represents the depreciation expense associated with our fixed assets and the amortization attributable to our intangible assets. Depreciation and amortization increased $0.1 million (an 11.1% increase) during 2012 compared to 2011. The increase is primarily due to the incremental depreciation of leasehold improvements and sleep equipment for new sleep labs and leasehold improvements at our corporate office location.
Net other expense represents interest expense on borrowings reduced by interest income earned on cash and cash equivalents. Net other expense decreased $0.2 million (a 15.4% decrease) during 2012 compared with 2011. The decrease is comprised of lower interest expense in 2012 ($0.1 million) due to the payment of principal on our senior debt with Arvest bank and a gain of $0.1 million in 2012 related to adjusting the contingent purchase consideration liability related to the Village Sleep acquisition.
Income from discontinued operations represents primarily the net income (loss) from East and ApothecaryRx. In May 2011 and December 2010, we executed sale substantially all of the assets of East and ApothecaryRx. As a result of the sale of East and ApothecaryRx, the related assets, liabilities, results of operations and cash flows of East and ApothecaryRx have been classified as discontinued operations. In addition, we have discontinued operations related to our discontinued internet sales division and discontinued film operations. The results of East, ApothecaryRx and our other discontinued operations for the years ended December 31, 2012 and 2011 follows:
Noncontrolling interests were allocated approximately $160,000 and $232,000 of net losses during 2012 and 2011. Noncontrolling interests are the equity ownership interests in our SDC Holdings subsidiaries that are not wholly-owned.
Net income (loss) attributable to Graymark Healthcare. Our operations resulted in a net loss of approximately $22.4 million (132% of approximately $17.0 million in net revenues) during 2012, compared to a net loss of approximately $5.9 million (34% of approximately $17.5 million in net revenues) during 2011.
Liquidity and Capital Resources
Generally our liquidity and capital resources needs are funded from operations, loan proceeds and equity offerings. As of December 31, 2012, our liquidity and capital resources included cash and cash equivalents of $0.3 million and a working capital deficit of $20.2 million. As of December 31, 2011, our liquidity and capital resources included cash and cash equivalents of $4.9 million and working capital of $3.9 million. The working capital deficit as of December 31, 2012 includes the impact of classifying our Arvest Credit Facility as current.
Cash used in operating activities from continuing operations was $4.2 million during 2012 compared to $5.0 million during 2011. During 2012, the primary uses of cash from operating activities from continuing operations were cash required to fund losses from continuing operations (net of non-cash adjustments) of $4.9 million, an increase in accounts receivable and other assets totaling $1.4 million. The primary sources of cash from operating activities during 2012 were an increase in accounts payable and accrued liabilities of $2.2 million. During 2011, the primary uses of cash from operating activities from continuing operations were cash required to fund losses from continuing operations (net of non-cash adjustments) of $4.1 million, a net reduction of accounts payable and accrued liabilities totaling $0.2 million, and an increase in accounts receivable and other assets totaling $1.4 million. The primary sources of cash from operating activities during 2011 were a decrease in inventory and other assets of $0.7 million.
Cash provided by discontinued operations during 2012 and 2011 was $0.5 million and $1.2 million, respectively. The cash provided by discontinued operations during 2012 and 2011 was primarily related to $1.0 million received in each year from the release of escrow funds related to the sale of ApothecaryRx.
Net cash used by investing activities from continuing operations during 2012 was $1.0 million and was attributable to the purchase of property and equipment. Net cash used by investing activities in 2011 was approximately $0.7 million which included $0.6 million related to the acquisition of Village Sleep
There were no investing activities from discontinued operations during 2012. Net cash provided by investing activities from discontinued operations during 2011 was $2.5 million. In May 2011, we sold substantially all of the assets of East for $2.5 million.
Net cash used by financing activities from continuing operations during 2012 was approximately $13,000 compared to 2011 when net cash provided by financing activities of $6.3 million. During 2012, we executed a subscription agreement with Graymark Investments, LLC (doing business as Oklahoma Health Partners (“OHP”)) for the purchase of 1,444,445 shares of our common stock for $650,000 ($0.45 per share). During 2012, we received debt proceeds of $1.7 million including $1.5 million in proceeds from notes payable to one of our shareholders. The proceeds of the notes were used to fund our debt payments to Arvest Bank. During 2011, we raised $7.3 million and $2.0 million in a public offering and private placement offering, respectively. During 2011, we received $1.0 million in proceeds from our credit facility with Valiant Investments, LLC which was subsequently repaid with common stock in conjunction with the private placement. During 2012 and 2011, we made debt payments of $2.4 million and $3.9 million, respectively.
As of December 31, 2012, we had an accumulated deficit of $57.6 million and reported a net loss of $22.4 million for 2012. In addition, we used $4.2 million in cash from operating activities from continuing operations during the year. On March 29, 2013, the Company signed a definitive purchase agreement with Foundation Surgery Affiliates, LLC and Foundation Surgical Hospital Affiliates, LLC (collectively “Foundation”) for 98.5 million shares of our common stock. We expect the transaction to close in the second quarter of 2013, however there is no assurance the acquisition will close at that time or at all. The closing of the Foundation transaction is subject to the consent of Arvest Bank (the Company’s senior lender), Foundation’s senior lender and certain preferred interest holders of Foundation and there is no assurance that these consents will be obtained. For financial reporting purposes, the transaction will be recorded as a reverse merger and Foundation will be considered the accounting acquirer. There is no assurance that the Foundation transaction will close and we currently do not have sufficient cash on hand and do not expect to generate sufficient cash flow from operations to meet our cash requirements over the next 12 months. Historically, we have been able to raise the capital necessary to fund our operation and growth, but there is no assurance that we will be successful in raising the necessary capital to fund our operations and obligations. If the Company is unable to close the Foundation transaction or raise additional funds, the Company may be forced to substantially scale back operations or entirely cease its operations and discontinue its business. These uncertainties raise substantial doubt regarding our ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.
Arvest Credit Facility
Effective May 21, 2008, we and each of Oliver Company Holdings, LLC, Roy T. Oliver, The Roy T. Oliver Revocable Trust, Stanton M. Nelson, Vahid Salalati, Greg Luster, Kevin Lewis, Roger Ely and, Lewis P. Zeidner (the “Guarantors”) entered into a Loan Agreement with Arvest Bank (the “Arvest Credit Facility”). The Arvest Credit Facility consolidated the prior loan to our subsidiaries, SDC Holdings and ApothecaryRx in the principal amount of $30 million (referred to as the “Term Loan”) and provided an additional credit facility in the principal amount of $15 million (the “Acquisition Line”) for total principal of $45 million. The Loan Agreement was subsequently amended in January 2009 (the “Amendment”), May 2009, July 2010, December 2010 and March 2012. As of December 31, 2011, the outstanding principal amount of the Arvest Credit Facility was $18.8 million.
Personal Guaranties. The Guarantors unconditionally guarantee payment of our obligations owed to Arvest Bank and our performance under the Loan Agreement and related documents. The initial liability of the Guarantors as a group is limited to $15 million of the last portion or dollars of our obligations collected by Arvest Bank. The liability of the Guarantors under the guaranties initially was in proportion to their ownership of our common stock shares as a group on a several and not joint basis. In conjunction with the employment termination of Mr. Luster, we agreed to obtain release of his guaranty. The Amendment released Mr. Luster from his personal guaranty and the personal guaranties of the other Guarantors were increased, other than the guaranties of Messrs. Salalati and Ely. During 2010, Mr. Oliver and Mr. Nelson assumed the personal guaranty of Mr. Salalati.
Furthermore, the Guarantors agreed to not sell, transfer or otherwise dispose of or create, assume or suffer to exist any pledge, lien, security interest, charge or encumbrance on our common stock shares owned by them that exceeds, in one or an aggregate of transactions, 20% of the respective common stock shares owned at May 21, 2008, except after notice to Arvest Bank. Also, the Guarantors agreed to not sell, transfer or permit to be transferred voluntarily or by operation of law assets owned by the applicable Guarantor that would materially impair the financial worth of the Guarantor or Arvest Bank’s ability to collect the full amount of our obligations.
During 2012, Mr. Oliver paid approximately $1.5 million to Arvest Bank in satisfaction of principal and interest payments that we were required to make. We issued Mr. Oliver notes payable bearing interest at 8% in amounts equal to that paid to Arvest Bank on our behalf. Mr. Oliver’s personal guaranty may be reduced in certain circumstances in an amount equal to such payments. In March 2013, Mr. Oliver paid to Arvest Bank an additional approximately $485,000 in satisfaction of amount we were required to pay and we issued a note in such amount to Mr. Oliver. There can be no assurance that Mr. Oliver will make any such future payments on our behalf. See “Loan Agreements” below.
Maturity Dates. Each advance or tranche of the Acquisition Line will become due on the sixth anniversary of the first day of the month following the date of advance or tranche (the “Tranche Note Maturity Date”). The maturity dates of each tranche of debt under the Acquisition Line range from June 2014 to August 2015. The Term Loan will become due on May 21, 2014.
Interest Rate. The outstanding principal amounts of Acquisition Line and Term Loan bear interest at the greater of the prime rate as reported in the “Money Rates” section of The Wall Street Journal (the “WSJ Prime Rate”) or 6% (“Floor Rate”). Prior to June 30, 2010, the Floor Rate was 5%. The WSJ Prime Rate is adjusted annually, subject to the Floor Rate, then in effect on May 21 of each year of the Term Loan and the anniversary date of each advance or tranche of the Acquisition Line. In the event of our default under the terms of the Arvest Credit Facility, the outstanding principal will bear interest at the per annum rate equal to the greater of 15% or the WSJ Prime Rate plus 5%.
Interest and Principal Payments. Provided we are not in default, the Term Note is payable in quarterly payments of accrued and unpaid interest on each September 1, December 1, March 1, and June 1. Commencing on September 1, 2011, and quarterly thereafter on each December 1, March 1, June 1 and September 1, we are obligated to make equal payments of principal and interest calculated on a seven-year amortization of the unpaid principal balance of the Term Note as of June 1, 2011 at the then current WSJ Prime Rate or Floor Rate, and adjusted annually thereafter for any changes to the WSJ Prime Rate or Floor Rate as provided herein. The entire unpaid principal balance of the Term Note plus all accrued and unpaid interest thereon will be due and payable on May 21, 2014.
Furthermore, each advance or tranche of the Acquisition Line is repaid in quarterly payments of interest only for up to three years and thereafter, principal and interest payments based on a seven-year amortization until the balloon payment on the Tranche Note Maturity Date. We agreed to pay accrued and unpaid interest only at the WSJ Prime Rate or Floor Rate in quarterly payments on each advance or tranche of the Acquisition Line for the first three years of the term of the advance or tranche commencing three months after the first day of the month following the date of advance and on the first day of each third month thereafter. Commencing on the third anniversary of the first quarterly payment date, and each following anniversary thereof, the principal balance outstanding on an advance or tranche of the Acquisition Line, together with interest at the WSJ Prime Rate or Floor Rate on the most recent anniversary date of the date of advance, will be amortized in quarterly payments over a seven-year term beginning on the third anniversary of the date of advance, and recalculated each anniversary thereafter over the remaining portion of such seven-year period at the then applicable WSJ Prime Rate or Floor Rate. The entire unpaid principal balance of the Acquisition Line plus all accrued and unpaid interest thereon will be due and payable on the respective Tranche Note Maturity Date.
Use of Proceeds. All proceeds of the Term Loan were used solely for the funding of acquisition and refinancing of the existing indebtedness and loans, the refinancing of the existing indebtedness owed to Arvest Bank; and other costs we incurred by Arvest Bank in connection with the preparation of the loan documents, subject to approval by Arvest Bank.
The proceeds of the Acquisition Line are to be used solely for the funding of up to 70% of either the purchase price of the acquisition of existing pharmacy business assets or sleep testing facilities or the startup costs of new sleep centers and other costs incurred by us or Arvest Bank in connection with the preparation of the Loan Agreement and related documents, subject to approval by Arvest Bank.
Collateral. Payment and performance of our obligations under the Arvest Credit Facility are secured by the personal guaranties of the Guarantors and in general our assets. If we sell any assets which are collateral for the Arvest Credit Facility, then subject to certain exceptions and without the consent of Arvest Bank, such sale proceeds must be used to reduce the amounts outstanding to Arvest Bank.
Debt Service Coverage Ratio. Based on the latest four rolling quarters, we agreed to continuously maintain a “Debt Service Coverage Ratio” of not less than 1.25 to 1. Debt Service Coverage Ratio is, for any period, the ratio of:
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the net income of Graymark Healthcare (i) increased (to the extent deducted in determining net income) by the sum, without duplication, of our interest expense, amortization, depreciation, and non-recurring expenses as approved by Arvest, and (ii) decreased (to the extent included in determining net income and without duplication) by the amount of minority interest share of net income and distributions to minority interests for taxes, if any, to
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the annual debt service including interest expense and current maturities of indebtedness as determined in accordance with generally accepted accounting principles.
If we acquire another company or its business, the net income of the acquired company and the new debt service associated with acquiring the company may both be excluded from the Debt Service Coverage Ratio, at our option.
Positive EBITDA. Beginning on March 31, 2013, and on the last day of each quarter thereafter, our EBITDA (“earnings before interest, taxes, depreciation and amortization”) must be positive for such immediately ended quarter. “Positive EBITDA” for any period means the net income for that period: (a) plus the following for such period to the extent deducted in calculating such net income, without duplication: (i) interest expense, (ii) all income tax expense; (iii) depreciation and amortization expense; and (iv) non-cash charges constituting intangible impairment charges, equity compensation and fixed asset impairment charges; (b) but, and in all cases, excluding from the calculation of EBITDA: (i) any extraordinary items (as determined in accordance with GAAP); and (ii) onetime or non-recurring gains or losses associated with the sale or disposition of any business, asset, contract or lease.
Compliance with Financial Covenants. As of December 31, 2012, our Debt Service Coverage Ratio was less than 1.25 to 1 which will be the required ratio under our Loan Agreement for each quarterly period beginning after March 31, 2013. In addition, beginning on March 31, 2013, we must have Positive EBITDA (“earnings before interest, taxes, depreciation and amortization”), as defined by Arvest Bank, for the previous three month period. Historically, we have been successful in obtaining default waivers from Arvest Bank, but there is no assurance that Arvest Bank will waive any future defaults.
Default and Remedies. In addition to the general defaults of failure to perform our obligations and those of the Guarantors, collateral casualties, misrepresentation, bankruptcy, entry of a judgment of $50,000 or more, failure of first liens on collateral, default also includes our delisting by OTC Bulletin Board or other similar over-the-counter market. In the event a default is not cured within 10 days or in some case five days following notice of the default by Arvest Bank (and in the case of failure to perform a payment obligation for three times with notice), Arvest Bank will have the right to declare the outstanding principal and accrued and unpaid interest immediately due and payable.
Deposit Account Control Agreement. Effective June 30, 2010, we entered into a Deposit Control Agreement (“Deposit Agreement”) with Arvest Bank and Valliance Bank covering the deposit accounts that we have at Valliance Bank. The Deposit Agreement requires Valliance Bank to comply with instructions originated by Arvest Bank directing the disposition of the funds held by us at Valliance Bank without our further consent. Without Arvest Bank’s consent, we cannot close any of our deposit accounts at Valliance Bank or open any additional accounts at Valliance Bank. Arvest Bank may exercise its rights to give instructions to Valliance Bank under the Deposit Agreement only in the event of an uncured default under the Loan Agreement, as amended.
Loan Agreements
On August 31, 2012, December 31, 2012 and March 1, 2013, the Company executed promissory notes with Mr. Roy T. Oliver in the amount of $1,184,808, $351,710 and $485,082, respectively, for a total of $2,021,600. The interest rate on the notes is 8% and the maturity date of the notes is June 30, 2013. All principal and interest outstanding are due on the maturity date. Mr. Oliver is one of the Company’s greater than 5% shareholders and affiliates. The promissory notes are subordinate to the Company’s credit facility with Arvest Bank. The Company used the proceeds from the notes to fund its payment obligations to Arvest Bank.
On March 16, 2011, we entered into a Loan Agreement with Valiant Investments, LLC, an entity owned and controlled by Mr. Oliver, of up to $1 million. We used the loan proceeds to fund our working capital needs. We fully advanced the loan during the third quarter of 2011 and in May 2011, we repaid the loan with common stock as part of our private placement offering. On March 11, 2011, we received the consent of Arvest to obtain this loan and requirements for payments of interest and principal on this loan.
Financial Commitments
We do not have any material capital commitments during the next 12 months; however, we have contractual commitments of $20.9 million for payments on our indebtedness, operating lease payments and other long-term liabilities. Although we have not entered into any definitive arrangements for obtaining additional capital resources, either through long-term lending arrangements or equity offering, we continue to explore various capital resource alternatives to replace our long-term bank indebtedness.
Our future commitments under contractual obligations by expected maturity date at December 31, 2012 are as follows:
(1) Includes principal and interest obligations.
(2) Represents contingent purchase consideration on our acquisition of Village Sleep Center in December 2011.
Off-Balance Sheet Arrangements
We had no material off-balance sheet arrangements (as defined in Item 303(a) (4) of Regulation S-K) as of December 31, 2012 and 2011.
CRITICAL ACCOUNTING POLICIES
The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and include amounts based on management’s prudent judgments and estimates. Actual results may differ from these estimates. Management believes that any reasonable deviation from those judgments and estimates would not have a material impact on our consolidated financial position or results of operations. To the extent that the estimates used differ from actual results, however, adjustments to the statement of earnings and corresponding balance sheet accounts would be necessary. These adjustments would be made in future statements. Some of the more significant estimates include revenue recognition, allowance for contractual adjustments and doubtful accounts, and goodwill and intangible asset impairment. We use the following methods to determine our estimates:
Revenue recognition - Sleep center services and product sales are recognized in the period in which services and related products are provided to customers and are recorded at net realizable amounts estimated to be paid by customers and third-party payors. Insurance benefits are assigned to us and, accordingly, we bill on behalf of our customers. For our sleep diagnostic business and acquired sleep therapy business, we estimate the net realizable amount based primarily on the contracted rates stated in the contracts we have with various payors or for payors without contracts, historic payment trends. In addition, we calculate on a monthly basis, the actual payments received from all payors at each location to determine if an incremental contractual reserve is necessary and if so, the amount of that reserve. We do not anticipate any future changes to this process. In our historic sleep therapy business, the business has been predominantly out-of-network and as a result, we have not used contract rates to determine net revenue for its payors. For this portion of the business, we perform a monthly analysis of actual reimbursement from each third party payor for the most recent 12-months. In the analysis, we calculate the percentage actually paid by each third party payor of the amount billed to determine the applicable amount of net revenue for each payor. The key assumption in this process is that actual reimbursement history is a reasonable predictor of the future reimbursement for each payor at each facility. We expect to transition our historic sleep therapy business to the same process currently used for our sleep diagnostic business in 2013. This change in process and assumptions for the historic sleep therapy business is not expected to have a material impact on future operating results.
For certain sleep therapy and other equipment sales, reimbursement from third-party payors occur over a period of time, typically 10 to 13 months. We recognize revenue on these sales as payments are earned over the payment period stipulated by the third-party payor.
We have established an allowance to account for contractual adjustments that result from differences between the amount billed and the expected realizable amount. Actual adjustments that result from differences between the payment amount received and the expected realizable amount are recorded against the allowance for contractual adjustments and are typically identified and ultimately recorded at the point of cash application or when otherwise determined pursuant to our collection procedures. Revenues are reported net of such adjustments.
Due to the nature of the healthcare industry and the reimbursement environment in which we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time products or services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on our operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded.
The patient and their third party insurance provider typically share in the payment for our products and services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the number of out-of-network patients, we are not certain of the full amount of patient responsibility at the time of service. We estimate amounts due from patients prior to service and attempt to collect those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.
Cost of Services and Sales - Cost of services includes technician labor required to perform sleep diagnostics, fees associated with scoring and interpreting the results of the sleep study and disposable supplies used in providing sleep diagnostics. Cost of sales includes the acquisition cost of sleep therapy products sold. Costs of services are recorded in the time period the related service is provided. Cost of sales is recorded in the same time period that the related revenue is recognized. If the revenue from the sale is recognized over a specified period, the product cost associated with that sale is recognized over that same period. If the revenue from a product sale is recognized in one period, the cost of sale is recorded in the period the product was sold.
Accounts Receivable - Accounts receivable are reported net of allowances for contractual adjustments and doubtful accounts. The majority of our accounts receivable is due from private insurance carriers, Medicare and Medicaid and other third-party payors, as well as from customers under co-insurance and deductible provisions.
Third-party reimbursement is a complicated process that involves submission of claims to multiple payors, each having its own claims requirements. Adding to this complexity, a significant portion of our historical therapy business has been out-of-network with several payors, which means we do not have defined contracted reimbursement rates with these payors. For this reason, our systems report this revenue at a higher gross billed amount, which we adjusted to an expected net amount based on historic payments. As we continue to move more of our business to in-network contracting, the level of reserve related to contractual allowances is expected to decrease. In some cases, the ultimate collection of accounts receivable subsequent to the service dates may not be known for several months. As these accounts age, the risk of collection increases and the resulting reserves for bad debt expense reflect this longer payment cycle. We have established an allowance to account for contractual adjustments that result from differences between the amounts billed to customers and third-party payors and the expected realizable amounts. The percentage and amounts used to record the allowance for doubtful accounts are supported by various methods including current and historical cash collections, contractual adjustments, and aging of accounts receivable.
We offer payment plans of up to three months to patients for amounts due from them for the sales and services we provide. The minimum monthly payment amount is calculated based on the down payment and the remaining balance divided by three months.
Accounts are written-off as bad debt using a specific identification method. For amounts due from patients, we utilize a collections process that includes distributing monthly account statements. For patients that are not on a payment plan, collection efforts including collection letters and collection calls begin once the balance of the claim becomes the patient responsibility. If the patient is on a payment program, these efforts begin within 30 days of the patient failing to make a planned payment. Beginning in the fourth quarter of 2012, all patient responsibility accounts are forwarded to a contracted Extended Business Office (“EBO”). The EBO prepares and mails all patient account statements and follows up with patients via phone calls and letters to collect amounts due prior to them being turned over for collection. For our diagnostic patients, we submit patient receivables to an outside collection agency if the patient has failed to pay 120 days following service or, if the patient is on a payment plan, they have failed to make two consecutive payments. For our therapy patients, patient receivables are submitted to an outside collection agency if payment has not been received between 180 and 240 days following service depending on the service provided and circumstances of the receivable or, if the patient is on a payment plan, they have failed to make two consecutive payments. It is our policy to write-off as bad debt all patient receivables at the time they are submitted to an outside collection agency. If funds are recovered by our collection agency, the amounts previously written-off are accounted for as a recovery of bad debt. For amounts due from third party payors, it is our policy to write-off an account receivable to bad debt based on the specific circumstances related to that claim resulting in a determination that there is no further recourse for collection of a denied claim from the denying payor.
Included in accounts receivable are earned but unbilled receivables. Unbilled accounts receivable represent charges for services delivered to customers for which invoices have not yet been generated by the billing system. Prior to the delivery of services or equipment and supplies to customers, we perform certain certification and approval procedures to ensure collection is reasonably assured and that unbilled accounts receivable is recorded at net amounts expected to be paid by customers and third-party payors. Billing delays, ranging from several weeks to several months, can occur due to delays in obtaining certain required payor-specific documentation from internal and external sources, interim transactions occurring between cycle billing dates established for each customer within the billing system and new sleep centers awaiting assignment of new provider enrollment identification numbers. In the event that a third-party payor does not accept the claim for payment, the customer is ultimately responsible.
A summary of the Days Sales Outstanding (“DSO”) and management’s expectations follows:
Diagnostic DSO increased in 2012 compared to 2011 due to a combination of changes in our billing agreements at certain locations to a provider based arrangement with hospitals. Although these agreements improve our net revenue per sleep study, they also increase the DSO for the impacted sites due to added time to process claims and reconcile collections. Therapy DSO improved as we implemented processes to improve collections at the time of service, enacted tighter credit requirements for patients in our resupply program, and increased our focus on collecting required billing documentation which shortened the time between the date service was provided and the payor was billed. In the first quarter of 2013, we have implemented additional programs including contracting with an extended business office to focus on patient collections and new verification of benefits tools designed to continue the improvement in our collections for patient amounts due at the time of service. We expect these new programs to improve DSO particularly in the diagnostic business and to have some impact on our therapy business as well.
Goodwill and Intangible Assets - Goodwill is the excess of the purchase price paid over the fair value of the net assets of the acquired business. Goodwill and other indefinite-lived intangible assets are not amortized, but are subject to annual impairment reviews, or more frequent reviews if events or circumstances indicate there may be an impairment of goodwill.
Intangible assets other than goodwill which include customer relationships, customer files, covenants not to compete, trademarks and payor contracts are amortized over their estimated useful lives using the straight line method. The remaining lives range from three to fifteen years. We evaluate the recoverability of identifiable intangible assets whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.
Recently Adopted and Recently Issued Accounting Guidance
Adopted Guidance
On January 1, 2012, we adopted changes issued by the Financial Accounting Standards Board (FASB) to conform existing guidance regarding fair value measurement and disclosure between GAAP and International Financial Reporting Standards. These changes both clarify the FASB’s intent about the application of existing fair value measurement and disclosure requirements and amend certain principles or requirements for measuring fair value or for disclosing information about fair value measurements. The clarifying changes relate to the application of the highest and best use and valuation premise concepts, measuring the fair value of an instrument classified in a reporting entity’s shareholders’ equity, and disclosure of quantitative information about unobservable inputs used for Level 3 fair value measurements. The amendments relate to measuring the fair value of financial instruments that are managed within a portfolio; application of premiums and discounts in a fair value measurement; and additional disclosures concerning the valuation processes used and sensitivity of the fair value measurement to changes in unobservable inputs for those items categorized as Level 3, a reporting entity’s use of a nonfinancial asset in a way that differs from the asset’s highest and best use, and the categorization by level in the fair value hierarchy for items required to be measured at fair value for disclosure purposes only. Other than the additional disclosure requirements, the adoption of these changes had no impact on our consolidated financial statements.
In July 2011, the FASB issued “Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities” (ASU 2011-07), which requires certain healthcare organizations that perform services for patients for which the ultimate collection of all or a portion of the amounts billed or billable cannot be determined at the time services are rendered to present all bad debt expense associated with patient service revenue as an offset to the patient service revenue line item in the statement of operations. The ASU also requires qualitative disclosures about our policy for recognizing revenue and bad debt expense for patient service transactions and quantitative information about the effects of changes in the assessment of collectability of patient service revenue. This ASU is effective for fiscal years beginning after December 15, 2011, and was adopted by us on January 1, 2012. This ASU applies to health care entities that recognize significant amounts of patient service revenue at the time services are rendered even though it has not assessed the patient’s ability to pay. We evaluate the collectability of payments at the time of service for substantially all of its business and as a result, we have determined that the reporting provisions in the ASU do not apply to us.
In September 2011, the FASB issued changes to the testing of goodwill for impairment. These changes provide an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the fair value of a reporting unit is less than its carrying amount. Such qualitative factors may include the following: macroeconomic conditions; industry and market considerations; cost factors; overall financial performance; and other relevant entity-specific events. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the existing two-step quantitative impairment test, otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, go directly to the two-step quantitative impairment test. These changes became effective us for any goodwill impairment test performed on January 1, 2012 or later. The adoption of these changes did not have a material impact on our consolidated financial statements.
On January 1, 2011, we adopted changes issued by FASB to revenue recognition for multiple-deliverable arrangements. These changes require separation of consideration received in such arrangements by establishing a selling price hierarchy (not the same as fair value) for determining the selling price of a deliverable, which will be based on available information in the following order: vendor-specific objective evidence, third-party evidence, or estimated selling price; eliminate the residual method of allocation and require that the consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method, which allocates any discount in the arrangement to each deliverable on the basis of each deliverable’s selling price; require that a vendor determine its best estimate of selling price in a manner that is consistent with that used to determine the price to sell the deliverable on a standalone basis; and expand the disclosures related to multiple-deliverable revenue arrangements. The adoption of these changes had no impact on our consolidated financial statements, as we do not currently have any such arrangements with our customers.
On January 1, 2011, we adopted changes issued by the FASB to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose, in the reconciliation of fair value measurements using significant unobservable inputs (Level 3), separate information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). The adoption of these changes had no impact on our consolidated financial statements.
On January 1, 2011, we adopted changes issued by the FASB to the disclosure of pro forma information for business combinations. These changes clarify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. Also, the existing supplemental pro forma disclosures were expanded to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The adoption of these changes had no impact on our consolidated financial statements.
Issued Guidance
In July 2012, the FASB issued changes to the testing of indefinite-lived intangible assets for impairment, similar to the goodwill changes issued in September 2011. These changes provide an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the fair value of an indefinite-lived intangible asset is less than its carrying amount. Such qualitative factors may include the following: macroeconomic conditions; industry and market considerations; cost factors; overall financial performance; and other relevant entity-specific events. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the existing two-step quantitative impairment test, otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the two-step quantitative impairment test. These changes become effective for us for any indefinite-lived intangible asset impairment test performed on January 1, 2013 or later, although early adoption is permitted. Upon adoption of these changes, we plan to proceed directly to the two-step quantitative test for our indefinite-lived intangible assets. As these changes should not affect the outcome of the impairment analysis of an indefinite-lived intangible asset, we have determined these changes will not have an impact on our consolidated financial statements.
In December 2011, the FASB issued changes to the disclosure of offsetting assets and liabilities. These changes require an entity to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The enhanced disclosures will enable users of an entity’s financial statements to understand and evaluate the effect or potential effect of master netting arrangements on an entity’s financial position, including the effect or potential effect of rights of setoff associated with certain financial instruments and derivative instruments. These changes become effective for us on January 1, 2013. Other than the additional disclosure requirements, management has determined that the adoption of these changes will not have an impact on our consolidated financial statements.
Cautionary Statement Relating to Forward Looking Information
We have included some forward-looking statements in this section and other places in this report regarding our expectations. These forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, levels of activity, performance or achievements, or industry results, to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Some of these forward-looking statements can be identified by the use of forward-looking terminology including “believes,” “expects,” “may,” “will,” “should” or “anticipates” or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategies that involve risks and uncertainties. You should read statements that contain these words carefully because they:
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discuss our future expectations;
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contain projections of our future operating results or of our future financial condition; or
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state other “forward-looking” information.
We believe it is important to discuss our expectations; however, it must be recognized that events may occur in the future over which we have no control and which we are not accurately able to predict. Readers are cautioned to consider the specific business risk factors described in the report and not to place undue reliance on the forward-looking statements contained herein, which speak only as of the date hereof. We undertake no obligation to publicly revise forward-looking statements to reflect events or circumstances that may arise after the date of this report.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
We are a smaller reporting entity as defined in Rule 12b-2 of the Exchange Act and as such, are not required to provide the information required by Item 305 of Regulation S-K with respect to Quantitative and Qualitative Disclosures about Market Risk.
Item 8.
Item 8. Financial Statements and Supplementary Data.
Our financial statements which are prepared in accordance with Regulation S-X are set forth in this report beginning on page
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We are a smaller reporting entity as defined in Rule 12b-2 of the Exchange Act and as such, are not required to provide the information required by Item 302 of Regulation S-K with respect to Supplementary Financial Information.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
On October 30, 2012, Eide Bailly LLP, the Company’s independent accountant (“Eide Bailly”), informed the Company that, effective on the earlier of November 19, 2012 or the date on which the Company files its Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2012, Eide Bailly was resigning as the independent registered public accounting firm of the Company. Eide Bailly communicated to the Company that their decision to resign is a reflection of their evaluation of available resources to continue to serve as the Company’s auditor and the current and future direction of its SEC/PCAOB practice. On December 21, 2012, the Audit Committee of the Company’s Board of Directors engaged Hein & Associates LLP as the Company’s independent registered public accounting firm for the year ending December 31, 2012.
During 2012 and 2011, there were no disagreements concerning matters of accounting principle or financial statement disclosure between us and our independent accountants of the type requiring disclosure hereunder.
Item 9A.
Item 9A. Controls and Procedures.
Disclosure Controls and Procedures
Our management, with the participation of our Principal Executive Officer and Principal Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2012. Our Principal Executive Officer and Principal Financial Officer are responsible primarily for establishing and maintaining disclosure controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the U.S. Securities and Exchange Commission. The controls and procedures are those defined in Rules 13a-15 or 15d-15 under the Securities Exchange Act of 1934. These controls and procedures are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based on such evaluations, our Principal Executive Officer and Principal Financial Officer concluded that, as of December 31, 2012, our disclosure controls and procedures were effective.
Internal Controls over Financial Reporting
Furthermore, our Principal Executive Officer and Principal Financial Officer are responsible for the design and supervision of our internal controls over financial reporting as defined in Rule 13a-15 of the Securities Exchange Act of 1934. These internal controls over financial reporting are then effected by and through our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. These policies and procedures
(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets;
(2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
(3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.
Our Principal Executive Officer and Principal Financial Officer, conducted their evaluation using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework. Based upon their evaluation of the effectiveness of our internal controls over financial reporting as of December 31, 2012, management, including our Principal Executive Officer and Principal Accounting Officer, concluded that our internal controls over financial reporting were effective as of December 31, 2012, and reported to our auditors and the audit committee of our board of directors that no changes had occurred in our internal control over financial reporting during the last fiscal quarter that have materially affected or are reasonably likely to materially affect our internal control over financial reporting. In conducting their evaluation of our internal controls over financial reporting, these executive officers did not discover any fraud that involved management or other employees who have a significant role in our disclosure controls and procedures and internal controls over financial reporting. Furthermore, there were no significant changes in our internal controls over financial reporting, or other factors that could significantly affect our internal controls over financial reporting subsequent to the date of their evaluation.
Changes in Internal Control over Financial Reporting
No changes in our internal controls occurred during the fourth fiscal quarter of 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
The information required by this item is incorporated herein by reference to our Proxy Statement for our annual shareholders’ meeting (the “2013 Proxy Statement”).
Item 11.
Item 11. Executive Compensation.
The information required by this item is incorporated herein by reference to the 2013 Proxy Statement.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this item is incorporated herein by reference to the 2013 Proxy Statement.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The information required by this item is incorporated herein by reference to the 2013 Proxy Statement.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by this item is incorporated herein by reference to the 2013 Proxy Statement.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a) Exhibits:
+ Filed herewith.
* Management contract or compensatory plan or arrangement.
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.
GRAYMARK HEALTHCARE, INC.
(Registrant)
By:
/S/ STANTON NELSON
Stanton Nelson
Chief Executive Officer
Date: April 1, 2013
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.
Each person whose signature appears below in so signing also makes, constitutes and appoints Stanton Nelson, Mark R. Kidd and Grant A. Christianson, and each of them, his true and lawful attorney-in-fact, with full power of substitution, for him in any and all capacities, to execute and cause to be filed with the Securities and Exchange Commission any and all amendments to this Form 10-K, with exhibits thereto and other documents in connection therewith, and hereby ratifies and confirms all that said attorney-in-fact or his substitute or substitutes may do or cause to be done by virtue hereof.
Exhibit Index
+ Filed herewith.
* Management contract or compensatory plan or arrangement.
GRAYMARK HEALTHCARE, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Audit Committee, Board of Directors,
and Shareholders
Graymark Healthcare, Inc.
We have audited the accompanying consolidated balance sheet of Graymark Healthcare, Inc. and subsidiaries (the “Company”) as of December 31, 2012, and the related consolidated statements of operations, shareholders’ equity (deficit) and cash flows for the year then ended. 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 audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial consolidated statements referred to above present fairly, in all material respects, the financial position of Graymark Healthcare, Inc. and subsidiaries as of December 31, 2012, and the results of their operations and their cash flows for the year then ended, in conformity with U.S. generally accepted accounting principles.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has suffered significant losses from operations, anticipates additional losses in the next year and had insufficient working capital as of December 31, 2012 to fund the anticipated losses. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ Hein & Associates LLP
Denver, Colorado
April 1, 2013
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Audit Committee, Board of Directors,
and Shareholders of Graymark Healthcare, Inc.
Oklahoma City, Oklahoma
We have audited the accompanying consolidated balance sheet of Graymark Healthcare, Inc. (the “Company”) as of December 31, 2011, and the related consolidated statements of operations, shareholders’ equity and cash flows for the year then ended. Graymark Healthcare, Inc.’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Graymark Healthcare, Inc. as of December 31, 2011, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
/s/ Eide Bailly LLP
Greenwood Village, Colorado
April 9, 2012
GRAYMARK HEALTHCARE, INC.
Consolidated Balance Sheets
As of December 31, 2012 and 2011
See Accompanying Notes to Consolidated Financial Statements
GRAYMARK HEALTHCARE, INC.
Consolidated Statements of Operations
For the Years Ended December 31, 2012 and 2011
See Accompanying Notes to Consolidated Financial Statements
GRAYMARK HEALTHCARE, INC.
Consolidated Statements of Shareholders’ Equity (Deficit)
For the Years Ended December 31, 2012 and 2011
See Accompanying Notes to Consolidated Financial Statements
GRAYMARK HEALTHCARE, INC.
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2012 and 2011
See Accompanying Notes to Consolidated Financial Statements
GRAYMARK HEALTHCARE, INC.
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2012 and 2011
Note 1 - Nature of Business
Graymark Healthcare, Inc. (the “Company”) is organized under the laws of the state of Oklahoma and is a provider of care management solutions to the sleep disorder market based in the United States. The Company provides a comprehensive diagnosis and care management solution for patients suffering from sleep disorders.
The Company provides diagnostic sleep testing services and care management solutions for people with chronic sleep disorders. In addition, the Company sells equipment and related supplies and components used to treat sleep disorders. The Company’s products and services are used primarily by patients with obstructive sleep apnea, or OSA. The Company’s sleep centers provide monitored sleep diagnostic testing services to determine sleep disorders in the patients being tested. The majority of the sleep testing is to determine if a patient has OSA. A continuous positive airway pressure, or CPAP, device is the American Academy of Sleep Medicine’s (“AASM”) preferred method of treatment for obstructive sleep apnea. The Company’s sleep diagnostic facilities also determine the correct pressure settings for patient treatment with positive airway pressure. The Company sells CPAP devices and disposable supplies to patients who have tested positive for sleep apnea and have had their positive airway pressure determined. There are noncontrolling interests held in some of the Company’s testing facilities, typically by physicians located in the geographical area being served by the diagnostic sleep testing facility.
In May 2011 and December 2010, the Company executed the sale of substantially all of the assets of the Company’s subsidiaries, Nocturna East, Inc. (“East”) and ApothecaryRx, LLC (“ApothecaryRx”), respectively. East operated the Management Services Agreement (“MSA”) under which the Company provided certain services to the sleep centers owned by Independent Medical Practices (“IMA”) including billing and collections, trademark rights, non-clinical sleep center management services, equipment rental fees, general management services, legal support and accounting and bookkeeping services. ApothecaryRx operated 18 retail pharmacy stores selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. As a result of the sale of East and ApothecaryRx, the related assets, liabilities, results of operations and cash flows of East and ApothecaryRx have been classified as discontinued operations in the accompanying consolidated financial statements.
Note 2 - Basis of Presentation
Going Concern and Management’s Plan - As of December 31, 2012, the Company had an accumulated deficit of $57.6 million and reported a net loss of $22.4 million for 2012. In addition, the Company used $3.6 million in cash from operating activities from continuing operations during the year. On March 29, 2013, the Company signed a definitive purchase agreement with Foundation Surgery Affiliates, LLC and Foundation Surgical Hospital Affiliates, LLC (collectively “Foundation”) for 98.5 million shares of the Company’s common stock. Management expects the transaction to close in the second quarter of 2013, however there is no assurance the acquisition will close at that time or at all. The closing of the Foundation transaction is subject to the consent of Arvest Bank (the Company’s senior lender), Foundation’s senior lender and certain preferred interest holders of Foundation and there is no assurance that these consents will be obtained. For financial reporting purposes the transaction will be recorded as a reverse merger and Foundation will be considered the accounting acquirer. If the transaction is closed, the Company’s primary focus will be the execution of the Foundation business plan which includes operating surgical hospitals and surgery centers. In addition, management anticipates that the Company’s existing strategy of providing diagnosis and care management solution for patients suffering from sleep disorders would be significantly curtailed.
There is no assurance that the Foundation transaction will close and the Company currently does not have sufficient cash on hand and does not expect to generate sufficient cash flow from operations to meet its cash requirements over the next 12 months. Historically, management has been able to raise the capital necessary to fund the operation and growth of the Company, but there is no assurance that the Company will be successful in raising the necessary capital to fund the Company’s operations and obligations.
As noted in Note 9 - Borrowings, the Company’s Debt Service Coverage Ratio is less than 1.25 to 1 which will be the required ratio under the Company’s loan agreement with Arvest Bank for each quarterly period beginning after March 31, 2013. In addition, beginning on March 31, 2013, the Company must have Positive EBITDA (“earnings before interest, taxes, depreciation and amortization”), as defined by Arvest Bank, for the previous three month period. Since the Debt Service Coverage Ratio becomes effective in less than 12 months and it is unlikely that we will initially meet the requirement, the associated debt with Arvest Bank has been classified as current in the accompanying consolidated balance sheets as of December 31, 2012. Historically, the Company has been successful in obtaining default waivers from Arvest Bank, but there is no assurance that Arvest Bank will waive any future defaults.
If the Company is unable to close the Foundation transaction or raise additional funds, the Company may be forced to substantially scale back operations or entirely cease its operations and discontinue its business. These uncertainties raise substantial doubt regarding the Company’s ability to continue as a going concern. The consolidated condensed financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.
Reverse Stock Split - On June 3, 2011, the Company executed a reverse stock split of the Company’s common stock in a ratio of 1-for-4. The effect of the reverse split reduced the Company’s outstanding common stock shares from 34,126,022 to 8,531,506 shares as of the date of the reverse split. The accompanying consolidated financial statements give effect to the reverse split as of the first date presented.
Note 3 - Summary of Significant Accounting Policies
Consolidation - The accompanying consolidated financial statements include the accounts of Graymark Healthcare, Inc. and its wholly owned, majority owned and controlled subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
Reclassifications - Certain amounts presented in prior years have been reclassified to conform to the current year’s presentation. Such reclassifications had no effect on net loss.
Use of estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management of the Company to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Revenue recognition - Sleep center services and product sales are recognized in the period in which services and related products are provided to customers and are recorded at net realizable amounts estimated to be paid by customers and third-party payors. Insurance benefits are assigned to the Company and, accordingly, the Company bills on behalf of its customers. For its sleep diagnostic business and acquired sleep therapy business, the Company estimates the net realizable amount based primarily on the contracted rates stated in the contracts the Company has with various payors or for payors without contracts, historic payment trends. In addition, the Company calculates on a monthly basis, the actual payments received from all payors at each location to determine if an incremental contractual reserve is necessary and if so, the amount of that reserve. The Company does not anticipate any future changes to this process. In the Company’s historic sleep therapy business, the business has been predominantly out-of-network and as a result, the Company has not used contract rates to determine net revenue for its payors. For this portion of the business, the Company performs a monthly analysis of actual reimbursement from each third party payor for the most recent 12-months. In the analysis, the Company calculates the percentage actually paid by each third party payor of the amount billed to determine the applicable amount of net revenue for each payor. The key assumption in this process is that actual reimbursement history is a reasonable predictor of the future reimbursement for each payor at each facility. The Company expects to transition its historic sleep therapy business to the same process currently used for its sleep diagnostic business in 2013. This change in process and assumptions for the Company’s historic sleep therapy business is not expected to have a material impact on future operating results.
For certain sleep therapy and other equipment sales, reimbursement from third-party payors occurs over a period of time, typically 10 to 13 months. The Company recognizes revenue on these sales as payments are earned over the payment period stipulated by the third-party payor.
The Company has established an allowance to account for contractual adjustments that result from differences between the amount billed and the expected realizable amount. Actual adjustments that result from differences between the payment amount received and the expected realizable amount are recorded against the allowance for contractual adjustments and are typically identified and ultimately recorded at the point of cash application or when otherwise determined pursuant to the Company’s collection procedures. Revenues in the accompanying consolidated financial statements are reported net of such adjustments.
Due to the nature of the healthcare industry and the reimbursement environment in which the Company operates, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time products or services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on the Company’s operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded.
The patient and their third party insurance provider typically share in the payment for the Company’s products and services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the number of out-of-network patients, the Company is not certain of the full amount of patient responsibility at the time of service. The Company estimates amounts due from patients prior to service and increase collection of those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.
During the years ended December 31, 2012 and 2011, the Company’s revenue payor mix was as follows:
Cost of Services and Sales - Cost of services includes technician labor required to perform sleep diagnostics, fees associated with interpreting the results of the sleep study and disposable supplies used in providing sleep diagnostics. Cost of sales includes the acquisition cost of sleep therapy products sold. Costs of services are recorded in the time period the related service is provided. Cost of sales is recorded in the same time period that the related revenue is recognized. If the sale is paid for over a specified period, the product cost associated with that sale is recognized over that same period. If the product is paid for in one period, the cost of sale is recorded in the period the product was sold.
Cash and cash equivalents - The Company considers all highly liquid temporary cash investments with an original maturity of three months or less to be cash equivalents. Certificates of deposit with original maturities of more than three months are also considered cash equivalents if there are no restrictions on withdrawing funds from the account.
Restricted cash - As of December 31, 2012 and December 31, 2011, the Company had long-term restricted cash of approximately $236,000 included in other assets in the accompanying condensed consolidated balance sheets. This amount is pledged as collateral to the Company’s senior bank debt and bank line of credit.
Accounts receivable - The majority of the Company’s accounts receivable is due from private insurance carriers, Medicare/Medicaid and other third-party payors, as well as from patients relating to deductible and coinsurance and deductible provisions of their health insurance policies.
Third-party reimbursement is a complicated process that involves submission of claims to multiple payors, each having its own claims requirements. Adding to this complexity, a significant portion of the Company’s historic therapy business has been out-of-network with several payors, which means the Company does not have defined contracted reimbursement rates with these payors. For this reason, the Company’s systems report this revenue at a higher gross billed amount, which the Company adjusts to an expected net amount based on historic payments. As the Company continues to move more of its business to in-network contracting, the level of reserve related to contractual allowances is expected to decrease. In some cases, the ultimate collection of accounts receivable subsequent to the service dates may not be known for several months. As these accounts age, the risk of collection increases and the resulting reserves for bad debt expense reflect this longer payment cycle. The Company has established an allowance to account for contractual adjustments that result from differences between the amounts billed to customers and third-party payors and the expected realizable amounts. The percentage and amounts used to record the allowance for doubtful accounts are supported by various methods including current and historical cash collections, contractual adjustments, and aging of accounts receivable.
The Company offers payment plans of up to three months to patients for amounts due from them for the sales and services the Company provides. The minimum monthly payment amount is calculated based on the down payment and the remaining balance divided by three months.
Accounts are written-off as bad debt using a specific identification method. For amounts due from patients, the Company utilizes a collections process that includes distributing monthly account statements. For patients that are not on a payment plan, collection efforts including collection letters and collection calls begin once the balance of the claim becomes the patient responsibility. If the patient is on a payment program, these efforts begin within 30 days of the patient failing to make a planned payment. Beginning in the fourth quarter of 2012, all patient responsibility accounts are forwarded to a contracted Extended Business Office (“EBO”). The EBO prepares and mails all patient account statements and follows up with patients via phone calls and letters to collect amounts due prior to them being turned over for collection. For diagnostic patients, the Company submits patient receivables to an outside collection agency if the patient has failed to pay 120 days following service or, if the patient is on a payment plan, they have failed to make two consecutive payments. For therapy patients, patient receivables are submitted to an outside collection agency if payment has not been received between 180 and 240 days following service depending on the service provided and circumstances of the receivable or, if the patient is on a payment plan, they have failed to make two consecutive payments. It is the Company’s policy to write-off as bad debt all patient receivables at the time they are submitted to an outside collection agency. If funds are recovered by a collection agency, the amounts previously written-off are accounted for as a recovery of bad debt. For amounts due from third party payors, it is the Company’s policy to write-off an account receivable to bad debt based on the specific circumstances related to that claim resulting in a determination that there is no further recourse for collection of a denied claim from the denying payor.
For the years ended December 31, 2012 and 2011, the amounts the Company collected in excess of recorded contractual allowances were approximately $52,000 and $81,000, respectively.
As of December 31, 2012 and 2011, accounts receivable are reported net of allowances for contractual adjustments and doubtful accounts as follows:
The activity in the allowances for contractual adjustments and doubtful accounts for the years ending December 31, 2012 and 2011 follows:
The aging of the Company’s accounts receivable, net of allowances for contractual adjustments and doubtful accounts as of December 31, 2012 and 2011 follows:
In addition to the aging of accounts receivable shown above, management relies on other factors to determine the collectability of accounts including the status of claims submitted to third party payors, reason codes for declined claims and an assessment of the Company’s ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan.
Included in accounts receivable are earned but unbilled receivables of approximately $179,000 and $205,000 as of December 31, 2012 and 2011, respectively. Unbilled accounts receivable represent charges for services delivered to customers for which invoices have not yet been generated by the billing system. Prior to the delivery of services or equipment and supplies to customers, the Company performs certain certification and approval procedures to ensure collection is reasonably assured and that unbilled accounts receivable is recorded at net amounts expected to be paid by customers and third-party payors. Billing delays can occur due to delays in obtaining certain required payor-specific documentation from internal and external sources, interim transactions occurring between cycle billing dates established for each customer within the billing system and new sleep centers awaiting assignment of new provider enrollment identification numbers. In the event that a third-party payor does not accept the claim for payment, the customer is ultimately responsible.
As of December 31, 2012, approximately 9% of the Company’s accounts receivable is from Medicare and Medicaid programs and another 50% is due from major insurance companies. The Company has not experienced losses due to the inability of these major insurance companies to meet their financial obligations and does not foresee that this will change in the near future.
Inventories - Inventories are stated at the lower of cost or market and include the cost of products acquired for sale. The Company accounts for inventories using the first in-first out method of accounting for substantially all of its inventories.
Property and equipment - Property and equipment is stated at cost and depreciated using the straight line method to depreciate the cost of various classes of assets over their estimated useful lives. At the time assets are sold or otherwise disposed of, the cost and accumulated depreciation are eliminated from the asset and depreciation accounts; profits and losses on such dispositions are reflected in current operations. Fully depreciated assets are written off against accumulated depreciation. Expenditures for major renewals and betterments that extend the useful lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred.
The estimated useful lives of the Company’s property and equipment are as follows:
Goodwill and Intangible Assets - Goodwill and other indefinite-lived intangible assets are not amortized, but are subject to annual impairment reviews, or more frequent reviews if events or circumstances indicate there may be an impairment of goodwill.
Intangible assets other than goodwill which include customer relationships, customer files, covenants not to compete, trademarks and payor contracts are amortized over their estimated useful lives using the straight line method. The remaining lives range from three to five years. The Company evaluates the recoverability of identifiable intangible asset whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.
Noncontrolling Interests - Noncontrolling interests in the results of operations of consolidated subsidiaries represents the noncontrolling shareholders’ share of the income or loss of the various consolidated subsidiaries. The noncontrolling interests in the consolidated balance sheet reflect the original investment by these noncontrolling shareholders in these consolidated subsidiaries, along with their proportional share of the earnings or losses of these subsidiaries less distributions made to these noncontrolling interest holders.
Advertising Costs - Advertising and sales promotion costs are expensed as incurred. Advertising expense for 2012 and 2011, included in continuing operations, was approximately $89,000 and $131,000, respectively.
Acquisition Costs - Acquisition costs are charged directly to expense when incurred.
Legal Issues - For asserted claims and assessments, liabilities are recorded when an unfavorable outcome of a matter is deemed to be probable and the loss is reasonably estimable. Management determines the likelihood of an unfavorable outcome based on many factors such as the nature of the matter, available defenses and case strategy, progress of the matter, views and opinions of legal counsel and other advisors, applicability and success of appeals processes, and the outcome of similar historical matters, among others. Once an unfavorable outcome is deemed probable, management weighs the probability of estimated losses, and the most reasonable loss estimate is recorded. If an unfavorable outcome of a matter is deemed to be reasonably possible, then the matter is disclosed and no liability is recorded. With respect to unasserted claims or assessments, management must first determine that the probability that an assertion will be made is likely, then, a determination as to the likelihood of an unfavorable outcome and the ability to reasonably estimate the potential loss is made. Legal matters are reviewed on a continuous basis or sooner if significant changes in matters have occurred to determine if a change in the likelihood of an unfavorable outcome or the estimate of a loss is necessary.
Income Taxes - The Company recognizes deferred tax assets and liabilities for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. In the event the Company determines that the deferred tax assets will not be realized in the future, the valuation adjustment to the deferred tax assets is charged to earnings in the period in which the Company makes such a determination.
The Company uses a two-step process to evaluate a tax position. The first step is to determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including the resolution of any related appeals or litigation based on the technical merits of that position. The second step is to measure a tax position that meets the more-likely-than-not threshold to determine the amount of benefit to be recognized in the financial statements. A tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.
Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent period in which the threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not criteria should be de-recognized in the first subsequent financial reporting period in which the threshold is no longer met. The Company reports tax-related interest and penalties as a component of income tax expense.
Based on all known facts and circumstances and current tax law, the Company believes that the total amount of unrecognized tax benefits as of December 31, 2012, is not material to its results of operations, financial condition or cash flows. The Company also believes that the total amount of unrecognized tax benefits as of December 31, 2012, if recognized, would not have a material effect on its effective tax rate. The Company further believes that there are no tax positions for which it is reasonably possible, based on current tax law and policy that the unrecognized tax benefits will significantly increase or decrease over the next 12 months producing, individually or in the aggregate, a material effect on the Company’s results of operations, financial condition or cash flows.
Loss per share - Basic loss per share is computed by dividing net loss by the weighted average number of common shares outstanding for the period. Diluted loss per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted during the period. Dilutive securities having an anti-dilutive effect on diluted earnings (loss) per share are excluded from the calculation.
The dilutive potential common shares on options and warrants are calculated in accordance with the treasury stock method, which assumes that proceeds from the exercise of all options and warrants are used to repurchase common stock at market value. The amount of shares remaining after the proceeds are exhausted represents the potential dilutive effect of the securities.
The following securities were not included in the computation of diluted earnings (loss) per share from continuing operations or discontinued operations as their effect would be anti-dilutive:
Concentration of credit risk - The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risk. There were no cash deposits in excess of FDIC limits as of December 31, 2012 or 2011.
Stock options - The Company accounts for its stock option grants using the modified prospective method. Under the modified prospective method, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is the vesting period.
Recently Adopted and Recently Issued Accounting Guidance
Adopted Guidance
On January 1, 2012, the Company adopted changes issued by the Financial Accounting Standards Board (FASB) to conform existing guidance regarding fair value measurement and disclosure between GAAP and International Financial Reporting Standards. These changes both clarify the FASB’s intent about the application of existing fair value measurement and disclosure requirements and amend certain principles or requirements for measuring fair value or for disclosing information about fair value measurements. The clarifying changes relate to the application of the highest and best use and valuation premise concepts, measuring the fair value of an instrument classified in a reporting entity’s shareholders’ equity, and disclosure of quantitative information about unobservable inputs used for Level 3 fair value measurements. The amendments relate to measuring the fair value of financial instruments that are managed within a portfolio; application of premiums and discounts in a fair value measurement; and additional disclosures concerning the valuation processes used and sensitivity of the fair value measurement to changes in unobservable inputs for those items categorized as Level 3, a reporting entity’s use of a nonfinancial asset in a way that differs from the asset’s highest and best use, and the categorization by level in the fair value hierarchy for items required to be measured at fair value for disclosure purposes only. Other than the additional disclosure requirements, the adoption of these changes had no impact on the Company’s consolidated financial statements.
In July 2011, the FASB issued “Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities” (ASU 2011-07), which requires certain healthcare organizations that perform services for patients for which the ultimate collection of all or a portion of the amounts billed or billable cannot be determined at the time services are rendered to present all bad debt expense associated with patient service revenue as an offset to the patient service revenue line item in the statement of operations. The ASU also requires qualitative disclosures about the Company’s policy for recognizing revenue and bad debt expense for patient service transactions and quantitative information about the effects of changes in the assessment of collectability of patient service revenue. This ASU is effective for fiscal years beginning after December 15, 2011, and was adopted by the Company on January 1, 2012. This ASU applies to health care entities that recognize significant amounts of patient service revenue at the time services are rendered even though it has not assessed the patient’s ability to pay. The Company evaluates the collectability of payments at the time of service for substantially all of its business and as a result, the Company has determined that the reporting provisions in the ASU do not apply to the Company.
In September 2011, the FASB issued changes to the testing of goodwill for impairment. These changes provide an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the fair value of a reporting unit is less than its carrying amount. Such qualitative factors may include the following: macroeconomic conditions; industry and market considerations; cost factors; overall financial performance; and other relevant entity-specific events. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the existing two-step quantitative impairment test, otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, go directly to the two-step quantitative impairment test. These changes became effective for the Company for any goodwill impairment test performed on January 1, 2012 or later. The adoption of these changes did not have a material impact on the Company’s consolidated financial statements.
On January 1, 2011, the Company adopted changes issued by FASB to revenue recognition for multiple-deliverable arrangements. These changes require separation of consideration received in such arrangements by establishing a selling price hierarchy (not the same as fair value) for determining the selling price of a deliverable, which will be based on available information in the following order: vendor-specific objective evidence, third-party evidence, or estimated selling price; eliminate the residual method of allocation and require that the consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method, which allocates any discount in the arrangement to each deliverable on the basis of each deliverable’s selling price; require that a vendor determine its best estimate of selling price in a manner that is consistent with that used to determine the price to sell the deliverable on a standalone basis; and expand the disclosures related to multiple-deliverable revenue arrangements. The adoption of these changes had no impact on the Company’s consolidated financial statements, as the Company does not currently have any such arrangements with its customers.
On January 1, 2011, the Company adopted changes issued by the FASB to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose, in the reconciliation of fair value measurements using significant unobservable inputs (Level 3), separate information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). The adoption of these changes had no impact on the Company’s consolidated financial statements.
On January 1, 2011, the Company adopted changes issued by the FASB to the disclosure of pro forma information for business combinations. These changes clarify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. Also, the existing supplemental pro forma disclosures were expanded to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The adoption of these changes had no impact on the Company’s consolidated financial statements.
Issued Guidance
In July 2012, the FASB issued changes to the testing of indefinite-lived intangible assets for impairment, similar to the goodwill changes issued in September 2011. These changes provide an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the fair value of an indefinite-lived intangible asset is less than its carrying amount. Such qualitative factors may include the following: macroeconomic conditions; industry and market considerations; cost factors; overall financial performance; and other relevant entity-specific events. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the existing two-step quantitative impairment test, otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the two-step quantitative impairment test. These changes become effective for the Company for any indefinite-lived intangible asset impairment test performed on January 1, 2013 or later, although early adoption is permitted. Upon adoption of these changes, management plans to proceed directly to the two-step quantitative test for the Company’s indefinite-lived intangible assets. As these changes should not affect the outcome of the impairment analysis of an indefinite-lived intangible asset, management has determined these changes will not have an impact on the Company’s consolidated financial statements.
In December 2011, the FASB issued changes to the disclosure of offsetting assets and liabilities. These changes require an entity to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The enhanced disclosures will enable users of an entity’s financial statements to understand and evaluate the effect or potential effect of master netting arrangements on an entity’s financial position, including the effect or potential effect of rights of setoff associated with certain financial instruments and derivative instruments. These changes become effective for the Company on January 1, 2013. Other than the additional disclosure requirements, management has determined that the adoption of these changes will not have an impact on the Company’s consolidated financial statements.
Note 4 - Acquisitions
On December 12, 2011, the Company acquired 80% of the Village Sleep Center (“Village”), located in Plano, Texas, for a purchase price of up to $960,000. Under the purchase agreement, the Company paid $596,000 in cash and withheld $364,000 of the purchase price (“Withheld Funds”) as collateral to secure any obligations the sellers have pursuant to the indemnification clauses of the purchase agreement. The Withheld Funds, less any amounts deducted, shall be paid in two equal installments, not to exceed $182,000. In order to receive the maximum installment payment, the trailing twelve months earnings before interest, taxes, depreciation and amortization (“EBITDA”) for Village for the years ended December 31, 2012 and 2013 must be at least $200,000, respectively. If the EBITDA for 2012 and or 2013 is less than $200,000, the payment of Withheld Funds will be reduced by the ratio of actual EBITDA to the required EBITDA of $200,000. The Company initially determined the fair value of the contingent consideration or Withheld Funds to be $234,565. The actual EBITDA for Village during the twelve months ended December 31, 2012 was $39,564. Based on Village’s actual EBITDA for 2012 and the projected EBITDA for 2013, the Company revalued the contingent consideration and determined the fair value to be $144,185. The change in contingent consideration of $90,380 was recorded as a gain and is included in other income in the accompanying consolidated statements of operations.
The acquisition of Village was based on management’s belief that the Village location will solidify the Company’s market presence in the Plano area.
The Village acquisition was recorded by allocating the cost of the acquisition to the assets acquired, including intangible assets and liabilities assumed based on their estimated fair values at the acquisition date. The excess of the cost of the acquisitions over the net amounts assigned to the fair value of the assets acquired, net of liabilities assumed, was recorded as goodwill, none of which is tax deductible. As of December 31, 2011, management completed a valuation of the fair value of the assets acquired and liabilities assumed in the Village acquisition. The purchase allocation for the Village acquisition was as follows:
During 2011, the Company recorded expenses of approximately $69,000 related to costs incurred in the acquisition of Village. The acquisition costs were primarily related to legal and professional fees and other costs incurred in performing due diligence.
The amounts of Village’s revenues and earnings included in the Company’s consolidated statements of operations for the year ended December 31, 2011 were approximately $27,000. It was impracticable for Company to obtain adequate financial information, from Village’s previous facility manager, to prepare pro forma revenue and earnings information for Village for 2011.
Note 5 - Discontinued Operations
On May 10, 2011, the Company executed an Asset Purchase Agreement (“Agreement”) with Daniel I. Rifkin, M.D., P.C. pursuant to which the Company sold substantially all of the assets of the Company’s subsidiary, Nocturna East, Inc. (“East”) for $2,500,000. In conjunction with the sale of East assets, the Management Services Agreement (“MSA”) under which the Company provided certain services to the sleep centers owned by Independent Medical Practices (“IMA”) including billing and collections, trademark rights, non-clinical sleep center management services, equipment rental fees, general management services, legal support and accounting and bookkeeping services was terminated. The Company’s decision to sell the assets of East was primarily based on management’s determination that the operations of East no longer fit into the Company’s strategic plan of providing a full continuum of care to patients due to significant regulatory barriers that limit the Company’s ability to sell CPAP devices and other supplies at the East locations. As a result of the sale of East, the related assets, liabilities, results of operations and cash flows of East have been classified as discontinued operations in the accompanying consolidated financial statements.
On September 1, 2010, the Company executed an Asset Purchase Agreement, which was subsequently amended on October 29, 2010, (as amended, the “Agreement”) providing for the sale of substantially all of the assets of the Company’s subsidiary, ApothecaryRx (the “ApothecaryRx Sale”). ApothecaryRx operated 18 retail pharmacy stores selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. The final closing of the sale of ApothecaryRx assets occurred in December 2010. As a result of the sale of ApothecaryRx, the related assets, liabilities, results of operations and cash flows of ApothecaryRx have been classified as discontinued operations in the accompanying consolidated financial statements.
Under the Agreement, the consideration for the ApothecaryRx assets purchased and liabilities assumed is $25,500,000 plus up to $7,000,000 for inventory (“Inventory Amount”), but less any payments remaining under goodwill protection agreements and any amounts due under promissory notes which are assumed by buyer (the “Purchase Price”). For purposes of determining the Inventory Amount, the parties agreed to hire an independent valuator to perform a review and valuation of inventory being purchased from each pharmacy location; the independent valuator valued the Inventory Amount at approximately $3.8 million. The resulting total Purchase Price was $29.3 million. Of the Purchase Price, $2,000,000 was deposited in an escrow fund (the “Indemnity Escrow Fund”) pursuant to the terms of an indemnity escrow agreement. All proceeds from the sale of ApothecaryRx were deposited in a restricted account at Arvest Bank. Of the proceeds, $22,000,000 was used to reduce outstanding obligations under the Company’s credit facility with Arvest Bank.
In December 2011 (the 12-month anniversary of the final closing date of the sale of ApothecaryRx), 50% of the remaining funds ($1,000,000) held in the Indemnity Escrow Fund were released, without deduction for any pending claims for indemnification. All remaining funds held in the Indemnity Escrow Fund ($1,000,000) were released in June 2012 (the 18-month anniversary of the final closing date of the sale), without deduction for any pending claims for indemnification.
The operating results of East, ApothecaryRx and the Company’s other discontinued operations (discontinued internet sales division and discontinued film operations) are summarized below:
As noted above, the Company’s other discontinued operations generated net loss of ($34,791) and ($43,298) during the years ended December 31, 2012 and 2011, respectively. During the year ended December 31, 2012, other discontinued operations included a loss from the Company’s discontinued internet sales channel of $34,219 and a loss from the Company’s discontinued film operations of $572. During the year ended December 31, 2011, other discontinued operations included a loss from the Company’s discontinued internet sales channel of ($44,430) which was offset by income from the Company’s discontinued film operations of $1,132.
The balance sheet items for East, ApothecaryRx and the Company’s other discontinued operations as of December 31, 2012 and 2011 are summarized below:
Note 6 - Other Assets
On October 1, 2012 the Company entered into a purchase agreement to acquire 100% of the membership interests of Midwest Sleep Specialists (“MSS”) located in Kansas City, Missouri, for a purchase price of $720,000. The membership interests of MSS are currently held by Dr. Steven Hull, the Company’s Chief Medical Officer. Under the agreement, the purchase price will be paid in semi-monthly installments of $15,000 commencing on October 18, 2012 and ending on September 30, 2014 (the “Transfer Date”). Under the agreement, the membership interests will not be transferred to the Company until the final payment is made on the Transfer Date. Prior to the Transfer Date, the Company does not have any control over the operation of MSS. In addition, the Company is not obligated to continue to make the semi-monthly payments and may rescind the agreement at any time. As a result, the Company will not record the MSS purchase until the Transfer Date. As of December 31, 2012, the Company has paid cumulative semi-monthly payments of $90,000 which is included in other assets in the accompanying consolidated balance sheets.
Note 7 - Property and Equipment
Following are the components of property and equipment included in the accompanying consolidated balance sheets as of December 31, 2012 and 2011:
Depreciation expense for the years ended December 31, 2012 and 2011 was $1,076,903 and $961,612 respectively.
Note 8 - Goodwill and Other Intangibles
Changes in the carrying amount of goodwill during the years ended December 31, 2012 and 2011 were as follows:
As of December 31, 2012, the Company has fully-impaired $21.2 million of goodwill resulting from business acquisitions. Goodwill and intangibles assets with indefinite lives must be tested for impairment at least once a year. Carrying values are compared with fair values, and when the carrying value exceeds the fair value, the carrying value of the impaired asset is reduced to its fair value. The Company tests goodwill and indefinite-lived intangible assets for impairment on an annual basis in the fourth quarter or more frequently if management believes indicators of impairment exist. The performance of the test involves a two-step process. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. The Company generally determines the fair value of its reporting units using the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the Company performs the second step of the impairment test to determine the amount of impairment loss. The second step of the impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill.
Based on the Company’s sleep study trends and forecasted cash flows, management determined that impairment indicators existed during the second quarter and fourth quarter of 2012. During the second quarter of 2012, the primary factor that drove impairment was the Company’s actual volume of sleep studies compared to the volumes that had been projected for 2012. During the fourth quarter of 2012 when the Company performs its annual impairment review, the Company noted continued negative trends in its sleep study volumes, coupled with deterioration in the overall sleep diagnostic market. During 2012, the sleep diagnostic market experienced a continued shift to home based testing and continued negative trends in reimbursement levels. Based on assumptions similar to those that market participants would make in valuing the Company’s business, the Company determined that the carrying value of goodwill and other intangible assets related to the Company’s sleep centers exceeded their fair value. Accordingly, in June 2012 and December 2012, the Company recorded a noncash impairment charge on goodwill of $3.0 million and $10.7 million, respectively, for a total 2012 impairment charge on goodwill of $13.7 million. In addition, in December 2012, the Company recorded a noncash impairment charge on intangible assets of $1.1 million. The Company’s evaluation of goodwill and intangible assets completed during 2011 resulted in no impairment losses.
Changes in the carrying amount of intangible assets during the years ended December 31, 2012 and 2011 were as follows:
Intangible assets as of December 31, 2012 and 2011 include the following:
(1) The carrying value is net of accumulated impairment charges.
Amortization expense for the years ended December 31, 2012 and 2011 was $157,039 and $149,123, respectively
Note 9 - Borrowings
The Company’s borrowings as of December 31, 2012 and 2011 are as follows:
(1) Effective rate as of December 31, 2012
On August 31, 2012 and December 31, 2012, the Company executed promissory notes with Mr. Roy T. Oliver in the amount of $1,184,808 and $351,710 for a total of $1,536,518. The interest rate on the notes is 8% and the maturity date of the notes is June 30, 2013. All principal and interest outstanding are due on the maturity date. Mr. Oliver is one of the Company’s greater than 5% shareholders and affiliates. The promissory notes are subordinate to the Company’s credit facility with Arvest Bank. The Company used the proceeds from the notes to fund its payment obligations to Arvest Bank.
In May 2008 and as amended in May 2009 and July 2010, the Company entered into a loan agreement with Arvest Bank consisting of a $30 million term loan (the “Term Loan”) and a $15 million line of credit to be used for future acquisitions (the “Acquisition Line”); collectively referred to as the “Credit Facility.” In December 2010 and as amended in April 2012, August 2012 and October 2012, the Company entered into an Amended and Restated Loan Agreement covering the Credit Facility. The Term Loan was used by the Company to consolidate certain prior loans to the Company’s subsidiaries SDC Holdings LLC (“SDC Holdings”) and ApothecaryRx LLC. The Term Loan and the Acquisition Line bear interest at the greater of the prime rate as reported in the Wall Street Journal or the floor rate of 6%. The rate on the Term Loan is adjusted annually on May 21. The rate on the Acquisition Line is adjusted on the anniversary date of each advance or tranche. The Term Loan matures on May 21, 2014 and requires quarterly payments of interest only. Commencing on September 1, 2011, the Company became obligated to make quarterly payments of principal and interest calculated on a seven-year amortization based on the unpaid principal balance on the Term Loan as of June 1, 2011. Each advance or tranche of the Acquisition Line will become due on the sixth anniversary of the first day of the month following the date of the advance or tranche. Each advance or tranche is repaid in quarterly payments of interest only for three years and thereafter, quarterly principal and interest payments based on a seven-year amortization until the balloon payment on the maturity date of the advance or tranche. The Credit Facility is collateralized by substantially all of the Company’s assets and is personally guaranteed by certain of our current and former executive officers and Mr. Roy T. Oliver, one of our greater than 5% stockholders and affiliates. The liability of the guarantors as a group is limited to $15 million on a several and not joint basis. The Company has also agreed to maintain certain financial covenants including a Debt Service Coverage Ratio of not less than 1.25 to 1, as defined.
As of December 31, 2012, the Company’s Debt Service Coverage Ratio is less than 1.25 to 1 which will be the required ratio under the Company’s loan agreement with Arvest Bank for each quarterly period beginning after March 31, 2013. In addition, beginning on March 31, 2013, the Company must have Positive EBITDA (“earnings before interest, taxes, depreciation and amortization”), as defined by Arvest Bank, for the previous three month period. Since the Debt Service Coverage Ratio becomes effective in less than 12 months and it is unlikely that we will initially meet the requirement, the associated debt with Arvest Bank has been classified as current in the accompanying condensed consolidated balance sheets as of December 31, 2012. Historically, the Company has been successful in obtaining default waivers from Arvest Bank, but there is no assurance that Arvest Bank will waive any future defaults.
In connection with the third amendment to the Arvest Credit Facility in June 2010, the Company also entered into a Deposit Control Agreement with Arvest Bank covering the Company’s accounts at Valliance Bank. Arvest Bank may exercise its rights to give instructions to Valliance Bank under the Deposit Control Agreement only in the event of an uncured default under the loan agreement, as amended.
The Company has entered into a note payable for the purchase of sleep diagnostic equipment. The balance owed at December 31, 2012 of $137,972 bears interest at a fixed rate of 6%. The Company is required to make monthly payments of principal and interest totaling $12,479. The note matures in December 2013.
The Company has entered into a note payable to a bank to supplement the working capital needs of its individual sleep centers. The amount owed under this note at December 31, 2012 of $56,100 bears interest at a fixed rate of 6.0%. The Company is required to make monthly payments of principal and interest totaling $2,704. The note matures in January 2015.
The Company has entered various notes payable for the purchase of vehicles totaling $13,547 at December 31, 2012. Under the terms of the notes, the Company is required to make monthly principal and interest payments totaling $2,221. The notes mature on various dates from January 2013 to December 2013 and bear interest at fixed rates ranging from 2.9% to 3.9%.
The Company has entered into various capital leases for the purchase of equipment totaling $138,385 at December 31, 2012. Under the terms of the lease, the Company is required to make monthly principal and interest payments totaling $5,284. The leases mature on various dates from January 2015 to February 2015 and bear interest at fixed rates ranging from 8.2% to 11.6%.
At December 31, 2012, future maturities of long-term debt were as follows:
Note 10 - Commitments and Contingencies
Legal Issues
The Company is exposed to asserted and unasserted legal claims encountered in the normal course of business. Management believes that the ultimate resolution of these matters will not have a material adverse effect on the operating results or the financial position of the Company. During the year ended December 31, 2011, the Company incurred $160,000 in settlement expenses related to its ongoing asserted and unasserted legal claims. During the year ended December 31, 2012, the Company did not incur any costs in settlement expenses related to its ongoing asserted and unasserted legal claims.
Operating Leases
The Company leases all of the real property used in its business for office space and sleep testing facilities under operating lease agreements. Rent is expensed consistent with the terms of each lease agreement over the term of each lease. In addition to minimum lease payments, certain leases require reimbursement for common area maintenance and insurance, which are expensed when incurred.
The Company’s rental expense for operating leases in 2012 and 2011 was $1,436,526 and $1,605,474, respectively.
Following is a summary of the future minimum lease payments under operating leases as of December 31, 2012:
Significant Supplier
The Company is dependent on merchandise vendors to provide sleep disorder related products for resale. The Company’s largest sleep product supplies are Fisher & Paykel Healthcare, which supplied approximately 32% and 38% of the Company’s sleep supplies in the years ended December 31, 2012 and 2011, respectively, and ResMed, Inc., which supplied approximately 35% and 32% of the Company’s sleep supplies in the years ended December 31, 2012 and 2011, respectively. In management’s opinion, if any of these relationships were terminated or if any contracting party were to experience events precluding fulfillment of the Company’s needs, the Company would be able to find a suitable alternative supplier, but possibly not without significant disruption to the Company’s business. This could take a significant amount of time and result in a loss of customers and revenue, operating and cash flow losses and may deplete working capital reserves.
Note 11 - Income Taxes
The income tax provision for the years ended December 31, 2012 and 2011 consists of:
The Company has accrued interest and penalties of approximately $159,000 at December 31, 2012 and 2011 related to the late filing of certain tax returns. The accrued interest and penalties are included in accrued liabilities in the accompanying consolidated balance sheets.
Deferred income tax assets and liabilities as of December 31, 2012 and 2011 are comprised of:
The change in the Company’s valuation allowance on deferred tax assets during the years ended December 31, 2012 and 2011 follows:
The Company’s effective income tax rate for continuing operations differs from the U.S. Federal statutory rate as follows:
At December 31, 2012, the Company had federal and state net operating loss carryforwards of approximately $34.2 million expiring at various dates through 2027. Approximately $3,012,000 of the Company’s net operating loss carryforwards are subject to an annual limitation of approximately $218,000.
The amount of income taxes the Company pays is subject to ongoing examinations by federal and state tax authorities. To date, there have been no reviews performed by federal or state tax authorities on any of the Company’s previously filed returns. The Company’s 2005 and later tax returns are still subject to examination.
Note 12 - Capital Structure
On November 12, 2012, the Company executed a subscription agreement with Graymark Investments, LLC (doing business as Oklahoma Health Partners (“OHP”)) in which OHP agreed to purchase 1,444,445 shares of the Company’s common stock for $650,000 ($0.45 per share). The proceeds from OHP were received on November 13, 2012 and used to fund the operations of the Company.
On November 5, 2012, the Company’s shareholders gave the Company’s board of directors the authority to amend the Company’s Restated Certificate of Incorporation to effect a reverse stock split in a ratio to be determined by the Board. The primary reason for obtaining shareholder approval for the reverse split was increase the per share market price of the Company’s common stock in order to maintain the $1.00 minimum per share requirement for continued listing on The NASDAQ Capital Market. On November 2, 2012, the Company was notified by NASDAQ that the Company’s common stock would be delisted from The NASDAQ Capital Market, effective at the open of business on Tuesday, November 6, 2012. As a result of the delisting by NASDAQ, on November 6, 2012, the Company’s Board elected to not affect the reverse stock split.
In June 2011, the Company completed a public offering of 6,000,000 shares of common stock and warrants exercisable for the purchase of 6,700,000 shares for gross proceeds of $8,400,000 or $1.40 per combination of one share of common stock and a warrant to purchase one share of common stock. The underwriter of the offering received sales commissions of $420,350 (5% of the gross proceeds), a corporate finance fee of $168,140 (2% of the gross proceeds) and a legal and other expense allowance of $116,094 (1.4% of the gross proceeds). In conjunction with the offering, each investor received a warrant to purchase one share of common stock for each share of common stock purchased. The amount received for the warrants has been included in additional paid-in capital in the accompanying consolidated balance sheets. The warrants are exercisable for the purchase of one share of common stock for $1.50 beginning June 20, 2011 and on or before June 20, 2016. The Company incurred $883,271 in expenses directly associated with the offering. These expenses have been reflected as a reduction in additional paid-in capital in the accompanying consolidated balance sheets.
In conjunction with the offering, the underwriter had an option to purchase an additional 700,000 shares of the Company’s common stock and warrants to purchase 700,000 shares of the Company’s common stock solely to cover over-allotments. The underwriter exercised the full over-allotment option with respect to the warrants in conjunction with the initial closing in June 2011 and the Company received $7,000 for the purchase of such warrants. In July 2011, the Company received $472,600 in gross proceeds from the sale of 340,000 shares of common stock upon the exercise of a portion of the over-allotment shares by the underwriter. The net proceeds of the over-allotment were $439,518.
In May 2011, the Company executed subscription agreements with existing accredited investors or their affiliates to sell 1,293,103 shares of the Company’s common stock in a private placement. The proceeds of the private placement were approximately $3 million ($2.32 per share). The proceeds included $2 million in cash and $1 million from the conversion of a note payable to Valiant Investments, LLC. In conjunction with the private placement, each investor received a warrant to purchase one share of common stock for each common share purchased pursuant to the subscription agreement. The warrants are exercisable for the purchase of one share of common stock for $1.80 beginning November 4, 2011 and on or before May 4, 2014.
On January 26, 2011, the Company’s Board of Directors approved a reverse stock split in one of five ratios, namely 1 for 2, 3, 4, 5 or 6. On February 1, 2011, the Company received the consent of a majority of our shareholders for this reverse stock split. On May 18, 2011, the Company’s Board of Directors resolved to effect the reverse stock split of our common stock in a ratio of 1-for-4 effective after the close of business on June 3, 2011. The Company executed the reverse stock split to regain compliance with the continued listing standards of the Nasdaq Capital Market. The effect of the reverse split reduced the Company’s outstanding common stock shares from 34,126,022 to 8,531,506 shares as of the date of the reverse split.
Note 13 - Stock Options, Grants and Warrants
The Company has adopted the 2008 Long-Term Incentive Plan (the “Incentive Plan”). The Incentive Plan consists of three separate stock incentive plans, a Non-Executive Officer Participant Plan, an Executive Officer Participant Plan and a Non-Employee Director Participant Plan. Except for administration and the category of employees eligible to receive incentive awards, the terms of the Non-Executive Officer Participant Plan and the Executive Officer Participant Plan are identical. The Non-Employee Director Plan has other variations in terms and only permits the grant of nonqualified stock options and restricted stock awards. Each incentive award will be pursuant to a written award agreement. The number of shares of common stock authorized and reserved under the Incentive Plan is 2,750,000.
The fair value of each option and warrant grant is estimated on the date of grant using the Black-Scholes option pricing model. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables. These variables include the expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. Given the Company’s limited trading history and lack of employee option exercise history, the Company has included the assumptions and variables of similar companies in the determination of the actual variables used in the option pricing model. The Company bases the risk-free interest rate used in the option pricing model on U.S. Treasury zero-coupon issues. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore an expected dividend yield of zero is used in the option pricing model.
The assumptions used to value the option and warrant grants are as follows:
Information with respect to stock options and warrants outstanding follows:
The fair value of the 330,000 and 255,000 options issued in 2012 and 2011 was estimated to be approximately $62,000 and $69,000, respectively. The fair value of the 75,000 warrants issued in 2012 was estimated to be approximately $14,000. The value of the options and warrants is recorded as compensation expense or, in the case of non-employee third parties, as professional services expense over the requisite service period which equals the vesting period of the options and warrants. Compensation expense related to stock options was approximately $33,000 and $44,000 during 2012 and 2011, respectively. Professional services expense related to warrants was approximately $14,000 during 2012. There was no professional services expense related to warrants in 2011.
During 2011, in conjunction with a public stock offering, the Company issued warrants for the purchase of 6,700,000 shares of common stock at an exercise price of $1.50. The warrant agreement contains an anti-dilution provision that requires the exercise price and number of shares exercisable under the warrants to be adjusted in certain instances including when the Company issues an equity security at a price less than $1.50. During 2012, the Company granted 479,315 additional warrants under this provision and adjusted the exercise price from $1.50 to $1.40. The total amount of money the Company would receive under the exercise of the warrants did not change.
The options and warrants outstanding and options and warrants exercisable as of December 31, 2012 and 2011 had no intrinsic value. The intrinsic value is calculated as the difference between the market value and exercise price of the shares.
Information with respect to the Company’s restricted stock awards follows:
During 2012 and 2011, the Company issued 125,000 and 225,000, respectively, restricted stock grant awards to certain key employees and directors. The fair value of the restricted stock grant awards was approximately $53,000 and $255,000, respectively, and was calculated by multiplying the number of restricted shares issued times the closing share price on the date of issuance. The value of the stock grants is recorded as compensation over the requisite service period which equals vesting period of the stock award. During 2012 and 2011, the Company recorded compensation expense related to stock grant awards of approximately $119,000 and $275,000, respectively. As of December 31, 2012 and 2011, the Company has unrecognized compensation expense associated with the stock grants, options and warrants of approximately $111,000 and $145,000, respectively.
Note 14 - Fair Value Measurements
Fair value is the price that would be received from the sale of an asset or paid to transfer a liability (i.e., an exit price) in the principal or most advantageous market in an orderly transaction between market participants. In determining fair value, the accounting standards established a three-level hierarchy that distinguishes between (i) market data obtained or developed from independent sources (i.e., observable data inputs) and (ii) a reporting entity’s own data and assumptions that market participants would use in pricing an asset or liability (i.e., unobservable data inputs). Financial assets and financial liabilities measured and reported at fair value are classified in one of the following categories, in order of priority of observability and objectivity of pricing inputs:
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Level 1 - Fair value based on quoted prices in active markets for identical assets or liabilities.
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Level 2 - Fair value based on significant directly observable data (other than Level 1 quoted prices) or significant indirectly observable data through corroboration with observable market data. Inputs would normally be (i) quoted prices in active markets for similar assets or liabilities, (ii) quoted prices in inactive markets for identical or similar assets or liabilities or (iii) information derived from or corroborated by observable market data.
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Level 3 - Fair value based on prices or valuation techniques that require significant unobservable data inputs. Inputs would normally be a reporting entity’s own data and judgments about assumptions that market participants would use in pricing the asset or liability.
The fair value measurement level for an asset or liability is based on the lowest level of any input that is significant to the fair value measurement. Valuation techniques should maximize the use of observable inputs and minimize the use of unobservable inputs.
Recurring Fair Value Measurements: The carrying value of the Company’s financial assets and financial liabilities is their cost, which may differ from fair value. The carrying value of cash held as demand deposits, money market and certificates of deposit, accounts receivable, short-term borrowings, accounts payable and accrued liabilities approximated their fair value. At December 31, 2012, the fair value of the Company’s debt was determined to be $10 million. The fair value of the Company’s debt was valued using Level 3 inputs. At December 31, 2011, the fair value of the Company’s long-term debt, including the current portion approximated its carrying value.
Nonrecurring Fair Value Measurements:
Business Acquisition - In December 2011, the Company acquired 80% of the Village Sleep Center (“Village”), located in Plano, Texas, for a purchase price of $960,000. Under the purchase agreement, the Company paid $596,000 in cash and withheld $364,000 of the purchase price (“Withheld Funds”) as collateral to secure any obligations the sellers have pursuant to the indemnification clauses of the purchase agreement. The Withheld Funds, less any amounts deducted, shall be paid in two equal installments, not to exceed $182,000. In order to receive the maximum installment payment, the trailing twelve months earnings before interest, taxes, depreciation and amortization (“EBITDA”) for Village for the years ended December 31, 2012 and 2013 must be at least $200,000, respectively. If the EBITDA for 2012 and or 2013 is less than $200,000, the payment of Withheld Funds will be reduced by the ratio of actual EBITDA to the required EBITDA of $200,000. The Company determined the fair value of the contingent consideration or Withheld Funds on the transaction date to be $234,565. The actual EBITDA for Village during the twelve months ended December 31, 2012 was $39,564. Based on Village’s actual EBITDA for 2012 and the projected EBITDA for 2013, the Company revalued the contingent consideration and determined the fair value to be $144,185. The change in contingent consideration of $90,380 was recorded as a gain and is included in other income in the accompanying consolidated statements of operations.
Goodwill and Intangible Assets - Goodwill and intangible assets are tested for possible impairment as of the beginning of the fourth quarter of each year. During 2012, the Company determined that impairment indicators existed during the second quarter of 2012. As a result, the Company tested goodwill and intangible assets twice during 2012. The impairment tests during the second and fourth quarters of 2012 resulted in impairment charges of $3.0 million and $11.7 million, respectively, for a total impairment charge of $14.7 million. During 2011, the review determined there was no impairment of goodwill or indefinite-lived assets
These nonrecurring fair value measurements were developed using significant unobservable inputs (Level 3). The primary valuation technique used was an income methodology based on management’s estimates of forecasted cash flows for each business unit, with those cash flows discounted to present value using rates commensurate with the risks of those cash flows. Assumptions used by management were similar to those that would be used by market participants performing valuations of these business units and were based on analysis of current and expected future economic conditions and the updated strategic plan for each business unit.
The fair value measurements for the Company’s assets measured at fair value on a nonrecurring basis as of December 31, 2012 and 2011 follows:
Note 15 - Related Party Transactions
On October 1, 2012 the Company entered into a purchase agreement to acquire 100% of the membership interests of Midwest Sleep Specialists (“MSS”) located in Kansas City, Missouri, for a purchase price of $720,000. The membership interests of MSS are currently held by Dr. Steven Hull, the Company’s Chief Medical Officer. Under the agreement, the purchase price will be paid in semi-monthly installments of $15,000 commencing on October 18, 2012 and ending on September 30, 2014 (the “Transfer Date”). Under the agreement, the membership interests will not be transferred to the Company until the final payment is made on the Transfer Date. Prior to the Transfer Date, the Company does not have any control over the operation of MSS. In addition, the Company is not obligated to continue to make the semi-monthly payments and may rescind the agreement at any time. As a result, the Company will not record the MSS purchase until the Transfer Date. As of December 31, 2012, the Company has paid cumulative semi-monthly payments of $90,000 which is included in other assets in the accompanying consolidated balance sheets.
On October 1, 2012 the Company entered into a management services agreement with MSS to provide certain administrative staffing and other support to the back office operations of MSS. MSS is owned by Dr. Steven Hull, our Chief Medical Officer. The term of the management services agreement is five years and renews automatically for successive five year periods unless either party provides 90 day written notice of termination. Additionally, the management services agreement will automatically terminate upon the Transfer Date. The Company has received approximately $64,000 in management fees since October 1, 2012 under this agreement. Prior to the current agreement, the Company provided similar services to MSS under other arrangements. Under the previous arrangements, the total management fees received from MSS during 2012 and 2011 were approximately $298,000 and $323,000, respectively.
On August 31, 2012 and December 31, 2012, the Company executed promissory notes with Mr. Roy T. Oliver in the amount of $1,184,808 and $351,710 for a total of $1,536,518. The interest rate on the notes is 8% and the maturity dates of the notes are June 30, 2013. All principal and interest outstanding are due on the maturity date. Mr. Oliver is one of the Company’s greater than 5% shareholders and affiliates. The promissory notes are subordinate to the Company’s credit facility with Arvest Bank. The Company used the proceeds from the notes to fund its payment obligations to Arvest Bank.
On March 16, 2011, the Company executed a promissory note with Valiant Investments, LLC in the amount of $1,000,000. The interest rate on the note was 6% and the maturity date of the note was August 1, 2011. Valiant Investments, LLC is controlled by Mr. Roy T. Oliver, one of the Company’s greater than 5% shareholders and affiliates. The promissory note is subordinate to the Company’s credit facility with Arvest Bank. In May 2011, the Valiant Note was converted to common stock in conjunction with a private placement stock offering. During 2011, the Company incurred approximately $5,000 in interest expense on the Valiant Note.
As of December 31, 2012 and 2011, the Company had approximately $33,000 and $4.3 million on deposit at Valliance Bank. Valliance Bank is controlled by Mr. Roy T. Oliver, one of the Company’s greater than 5% shareholders and affiliates. In addition, the Company is obligated to Valliance Bank under a sleep center capital note totaling approximately $56,000 and $84,000 at December 31, 2012 and 2011, respectively. The interest rates on the notes are fixed at 6%. Non-controlling interests in Valliance Bank are held by Mr. Stanton Nelson, the Company’s chief executive officer and Mr. Joseph Harroz, Jr., one of the Company’s directors. Mr. Nelson and Mr. Harroz also serve as directors of Valliance Bank.
In March 2012, the Company executed a lease agreement with City Place, LLC (“City Place”) for the Company’s new corporate headquarters and offices. Under the lease agreement, the Company pays monthly rent of $17,970 through June 30, 2014; $0.00 from July 1, 2014 to January 31, 2015 and $17,970 from February 1, 2015 to March 31, 2017 plus additional payments for allocable basic expenses of City Place; the lease expires on March 31, 2017. As part of the lease agreement, City Place paid $450,000 to offset a portion of the costs the Company incurred to build-out the office space. Non-controlling interests in City Place are held by Roy T. Oliver, one of the Company’s greater than 5% shareholders and affiliates, and Mr. Stanton Nelson, the Company’s Chief Executive Officer. During 2012, the Company incurred approximately $70,000 in lease expense under the terms of the lease.
The Company’s previous corporate headquarters and offices were occupied under a month to month lease with Oklahoma Tower Realty Investors, LLC, requiring monthly rental payments of approximately $7,000. Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates, controls Oklahoma Tower Realty Investors, LLC (“Oklahoma Tower”). During 2012 and 2011, the Company incurred approximately $21,000 and $84,000, respectively, in lease expense under the terms of the lease. In addition, during 2012 and 2011, the Company paid Oklahoma Tower approximately $42,000 and $37,000, respectively, for employee parking under a month to month agreement. Mr. Stanton Nelson, the Company’s chief executive officer, owns a non-controlling interest in Oklahoma Tower Realty Investors, LLC.
Note 16 - Subsequent Events
Management evaluated all activity of the Company and concluded that no subsequent events have occurred that would require recognition in the consolidated financial statements or disclosure in the notes to the consolidated financial statements, except the following:
On March 29, 2013, the Company signed a definitive purchase agreement with Foundation Surgery Affiliates, LLC and Foundation Surgical Hospital Affiliates, LLC (collectively “Foundation”) for 98.5 million shares of the Company’s common stock. Management expects the transaction to close in the second quarter of 2013, however there is no assurance the acquisition will close at that time or at all. The closing of the Foundation transaction is subject to the consent of Arvest Bank (the Company’s senior lender), Foundation’s senior lender and certain preferred interest holders of Foundation and there is no assurance that these consents will be obtained. For financial reporting purposes the transaction will be recorded as a reverse merger and Foundation will be considered the accounting acquirer.
On March 1, 2013, the Company executed a promissory note with Mr. Roy T. Oliver in the amount of $485,082. The interest rate on the notes is 8% and the maturity date of the note is June 30, 2013. All principal and interest outstanding are due on the maturity date. Mr. Oliver is one of the Company’s greater than 5% shareholders and affiliates. The promissory note is subordinate to the Company’s credit facility with Arvest Bank. The Company used the proceeds from the note to fund its payment obligation to Arvest Bank.
On January 7, 2013, the Company implemented a plan to close four of its sleep diagnostic and therapy facilities. The facilities are located in Oklahoma and Texas and are being closed because the revenue from these facilities has not met expectations and is not adequate to offset the fixed operating costs of these locations. Two of the facilities were operated through January 11, 2013 and two of the facilities were operated through January 31, 2013. The Company recorded restructuring charges in connection with the closure of these facilities with respect to the remaining lease obligations for the facilities, severance payments to affected employees and other write-downs. The remaining lease obligations, severance payments and other write-downs were approximately $1.1 million, $0.1 million and $0.1 million, respectively. All cash payments related to the severance costs are expected to be paid during the first quarter of 2013. The cash payments for the remaining lease obligations will continue for the life of the respective leases which extend through January 2018.
Note 17 - Supplemental Cash Flow Information
Cash payments for interest and income taxes and certain noncash investing and financing activities for the years ended December 31, 2012 and 2011 follows: