##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004, OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____ TO _____.
 Commission File No.: 001-13457 ORTHODONTIC CENTERS OF AMERICA, INC.  Delaware
    
    72-1278948(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification No.)
 3850 N. Causeway Boulevard, Suite 800
Metairie, Louisiana 70002
(504) 834-4392     Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES þ     NOo Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).  YESþ     NOo At May 12, 2004 there were approximately 50,097,000 outstanding shares of the
Registrants Common Stock, $.01 par value per share.




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ORTHODONTIC CENTERS OF AMERICA, INC. TABLE OF CONTENTS PagePART I.
    
    FINANCIAL INFORMATION
    
    
    3ITEM 1.
    
    CONSOLIDATED FINANCIAL STATEMENTS
    
    
    3Condensed Consolidated Balance Sheets 
March 31, 2004 (Unaudited and December 31, 2003)
    
    
    3Condensed Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) 
Three months ended March 31, 2004 and 2003 (Unaudited)
    
    
    4Condensed Consolidated Statements of Cash Flows 
Three months ended March 31, 2004 and 2003 (Unaudited)
    
    
    5Notes to Condensed Consolidated Financial Statements  March 31, 2004 (Unaudited)
    
    
    6ITEM 2.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
    
    
    17ITEM 3.
    
    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    33ITEM 4.
    
    CONTROLS AND PROCEDURES
    
    
    33PART II.
    
    OTHER INFORMATION
    
    
    34ITEM 1.
    
    LEGAL PROCEEDINGS
    
    
    34ITEM 6.
    
    EXHIBITS AND REPORTS ON FORM 8-K
    
    
    36EX-31.1  SECTION 302 CERTIFICATION OF THE CEOEX-31.2  SECTION 302 CERTIFICATION OF THE CFOEX-32.1  SECTION 906 CERTIFICATION OF THE CEOEX-32.2  SECTION 906 CERTIFICATION OF THE CFO
  FORWARD-LOOKING STATEMENTS Certain statements contained in this Report may not be based on historical
facts and are forward looking statements within the meaning of Section 27A of
the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. These forward-looking statements may be
identified by reference to a future period(s) or by the use of forward looking
terminology, such as anticipate, estimate, believe, expect, foresee,
may, would, could or will. These forward-looking statements include,
without limitation, statements regarding patient revenue, critical accounting
policies, net operating loss carryforwards and income tax liability, effects of
changes in accounting, amounts payable to affiliated practices under incentive
programs, liquidity, capital resources, cash needs, buy-outs of Service
Agreements, transitions of affiliated practices, pending litigation,
advancement of funds to affiliated practices, recoverability of assets related
to certain practices, updates to internal controls, repayment of outstanding
indebtedness, capital expenditures for development of de novocenters,
investment activities, stock repurchases, deferred tax assets, future growth
and operating results. We caution you not to place undue reliance on these
forward-looking statements, in that they involve certain risks and
uncertainties that could cause actual results to differ materially from
anticipated results. These risks and uncertainties include potential adverse
changes in the Companys financial results and condition, disruption of the
Companys relationships with its affiliated practices or loss of a significant
number of the Companys affiliated practices, failure or delay in integrating
OrthAlliances affiliated practices, adverse outcomes of litigation pending
against the Company and OrthAlliance, competition, inability to effectively
manage an increasing number of affiliated practices, changes in the general
economy of the United States and the specific markets in which the Company
operates, difficulties in staffing and managing foreign offices, foreign
currency exchange fluctuations and other risks relating to international
expansion and the Companys foreign operations, changes in the Companys
operating or expansion strategy, inability of the Company to attract and retain
qualified management, personnel and affiliated practitioners, inability of the
Company to effectively market its services and those of its affiliated
practices, changes in regulations affecting the Companys business, and other
factors identified in the Companys Annual Report on Form 10-K for the year
ended December 31, 2003, other filings with the Securities and Exchange
Commission or in other public announcements by the Company. We undertake no
obligation to update these forward-looking statements to reflect events or
circumstances that occur after the date of this Report.




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PART I. FINANCIAL INFORMATION 
 ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS 
 Orthodontic Centers of America, Inc.
Condensed Consolidated Balance Sheets
(in thousands, except share amounts) March 31,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    11,345
    
    
    $
    7,391Patient receivables, net of allowance for uncollectible amounts of $8,197 at March 31, 2004
    
    
    122,968
    
    
    
    Current portion of service fees receivable, net of allowance for uncollectible
amount of $8,382 at December 31, 2003
    
    
    
    
    
    
    96,720Current
portion of advances to practitioners, net of allowance for uncollectible
amounts of $0 at March 31, 2004 and $1,438 at December 31, 2003
    
    
    10,519
    
    
    
    16,544Deferred income taxes
    
    
    38,836
    
    
    
    43,346Supplies inventory
    
    
    13,197
    
    
    
    13,726Prepaid expenses and other assets
    
    
    4,106
    
    
    
    4,979Total current assets
    
    
    200,971
    
    
    
    182,706Financed practice-related expense portion of service fees receivable
    
    
    
    
    
    
    51,558Advances to affiliated practices, less current portion, net of allowance for uncollectible
amounts of $2,214 at December 31, 2003
    
    
    
    
    
    
    12,921Property, equipment and improvements, net
    
    
    90,760
    
    
    
    89,458Assets associated with non-performing practices, net of allowance for uncollectible amounts of
$2,249 at March 31, 2004 and $2,256 at December 31, 2003
    
    
    31,979
    
    
    
    26,682Deferred tax assets, net
    
    
    16,492
    
    
    
    Identifiable intangible assets, net
    
    
    
    
    
    
    201,163Goodwill
    
    
    290,445
    
    
    
    87,641Other assets
    
    
    14,251
    
    
    
    13,547TOTAL ASSETS
    
    $
    644,898
    
    
    $
    665,676LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    6,699
    
    
    $
    8,985Accrued salaries and other accrued liabilities
    
    
    12,785
    
    
    
    13,977Service fee prepayments
    
    
    
    
    
    
    1,157Deferred revenue
    
    
    92,279
    
    
    
    Amounts
payable to practitioners
    
    
    8,392
    
    
    
    5,373Current
portion of notes payable to practitioners
    
    
    2,397
    
    
    
    2,122Current portion of long-term debt
    
    
    8,333
    
    
    
    8,333Total current liabilities
    
    
    130,885
    
    
    
    39,947Deferred income tax liability, net
    
    
    
    
    
    
    41,268Notes
payable to practitioners, less current portion
    
    
    3,338
    
    
    
    4,050Long-term debt, less current portion
    
    
    85,640
    
    
    
    87,724Shareholders equity:Preferred stock, $.01 par value: 10,000,000 shares authorized; no shares outstanding
    
    
    
    
    
    
    Common stock, $.01 par value: 100,000,000 shares authorized; approximately 51,353,000
shares issued and outstanding at March 31, 2004 and 51,341,000 shares issued and
outstanding at December 31, 2003
    
    
    530
    
    
    
    513Additional paid-in capital
    
    
    218,654
    
    
    
    218,530Retained earnings
    
    
    222,555
    
    
    
    289,976Accumulated other comprehensive loss
    
    
    (491
    )
    
    
    (119
    )Less cost of approximately 1,256,000 shares of treasury stock at March 31, 2004 and
December 31, 2003
    
    
    (16,213
    )
    
    
    (16,213
    )Total shareholders equity
    
    
    425,035
    
    
    
    492,687TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    644,898
    
    
    $
    665,676
 See accompanying notes to condensed consolidated financial statements. 3




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Orthodontic Centers of America, Inc.
Condensed Consolidated Statements of Income (Loss) and Comprehensive Income (Loss)
(in thousands, except per share data) Three months endedMarch 31,2004
        
        2003(Unaudited)Patient revenue
        
        $
        110,898
        
        
        $
        Fee revenue
        
        
        
        
        
        
        100,639Direct expenses:Amounts retained
            by practitioners
        
        
        32,693
        
        
        
        Salaries and benefits
        
        
        27,236
        
        
        
        29,301Clinical supplies
            and lab fees
        
        
        9,148
        
        
        
        10,596Rent
        
        
        7,180
        
        
        
        9,503Marketing and advertising
        
        
        5,248
        
        
        
        6,242Total direct expenses
        
        
        81,505
        
        
        
        55,642General and administrative
        
        
        12,940
        
        
        
        12,949Depreciation
        
        
        3,791
        
        
        
        3,532Amortization
        
        
        190
        
        
        
        2,426Asset Impairments
        
        
        
        
        
        
        703Operating income
        
        
        12,472
        
        
        
        25,387Interest expense,
            net
        
        
        (1,165
        )
        
        
        (1,429
        )Non-controlling interest
            in subsidiary
        
        
        94
        
        
        
        (14
        )Income before income
            taxes and cumulative effect of change in accounting principle
        
        
        11,401
        
        
        
        23,944Income taxes
        
        
        4,161
        
        
        
        9,039Income before cumulative
            effect of change in accounting principle
        
        
        7,240
        
        
        
        14,905Cumulative effect
            of change in accounting principle, net of income tax benefit
        
        
        (74,661
        )
        
        
        Net income (loss)
        
        $
        (67,421
        )
        
        $
        14,905Net income (loss) per
            share:Basic before cumulative
            effect of change in accounting principle
        
        $
        0.14
        
        
        $
        0.30Cumulative effect
            of change in accounting principle, net of income tax benefit, per
            share
        
        
        (1.49
        )
        
        
        Basic
        
        $
        (1.35
        )
        
        $
        0.30Diluted before cumulative
            effect of change in accounting principle
        
        $
        0.14
        
        
        $
        0.30Cumulative effect
            of change in accounting principle, net of income tax benefit, per
            share
        
        
        (1.49
        )Diluted
        
        $
        (1.35
        )
        
        $
        0.30Weighted average
            shares outstanding:Basic
        
        
        50,070
        
        
        
        50,197Diluted
        
        
        50,070
        
        
        
        50,402Comprehensive income
            (loss):Net income (loss)
        
        $
        (67,421
        )
        
        $
        14,905Other comprehensive
            loss:Foreign currency
            translation adjustment
        
        
        (372
        )
        
        
        (210
        )Comprehensive income
            (loss)
        
        $
        (67,793
        )
        
        $
        14,695See accompanying notes to condensed consolidated financial statements.
 4




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Orthodontic Centers of America, Inc.
Condensed Consolidated Statements of Cash Flows
(in thousands) Three months endedMarch 31,2004
    
    2003(Unaudited)Operating activities:Net income (loss)
    
    $
    (67,421
    )
    
    $
    14,905Adjustments to reconcile net income (loss) to net cash provided by
operating activities:Cumulative effect of change in accounting principle, net of
income tax benefit
    
    
    74,661
    
    
    
    Provision for bad debt expense
    
    
    348
    
    
    
    644Depreciation and amortization
    
    
    3,981
    
    
    
    5,958Asset impairments
    
    
    
    
    
    
    703Deferred income taxes
    
    
    4,510
    
    
    
    8,887Changes in operating assets and liabilities:Patient receivables
    
    
    (5,363
    )
    
    
    Service fees receivable
    
    
    
    
    
    
    (11,886
    )Deferred revenue
    
    
    3,219
    
    
    
    Service fee prepayments
    
    
    
    
    
    
    (2,447
    )Accounts payable and other current liabilities
    
    
    (3,477
    )
    
    
    (4,268
    )Amounts
payable to practitioners
    
    
    3,019
    
    
    
    Other
    
    
    1,197
    
    
    
    388Net cash provided by operating activities
    
    
    14,674
    
    
    
    12,884Investing activities:Purchases of property, equipment and improvements
    
    
    (5,093
    )
    
    
    (4,349
    )Advances to
practitioners, net
    
    
    (1,512
    )
    
    
    (300
    )Notes receivable
    
    
    (499
    )
    
    
    (1,172
    )Other
    
    
    (864
    )
    
    
    (286
    )Net cash used in investing activities
    
    
    (7,968
    )
    
    
    (6,107
    )Financing activities:Repayment of
notes payable to practitioners
    
    
    (438
    )
    
    
    (2,628
    )Repayment of long-term debt
    
    
    (2,083
    )
    
    
    (109,640
    )Proceeds from long-term debt
    
    
    
    
    
    
    109,900Issuance of common stock
    
    
    141
    
    
    
    405Net cash used in financing activities
    
    
    (2,380
    )
    
    
    (1,963
    )Effect of exchange rate changes on cash and cash equivalents
    
    
    (372
    )
    
    
    (210
    )Change in cash and cash equivalents
    
    
    3,954
    
    
    
    4,604Cash and cash equivalents at beginning of period
    
    
    7,391
    
    
    
    7,522Cash and cash equivalents at end of period
    
    $
    11,345
    
    
    $
    12,126Supplemental cash flow information:Cash paid during period for:Interest
    
    $
    1,192
    
    
    $
    1,392Income taxes
    
    $
    300
    
    
    $
    77Supplemental disclosures of non-cash investing and financing activities:Notes payable and common stock issued to obtain Service Agreements
    
    $
    
    
    
    $
    284
 See accompanying notes to condensed consolidated financial statements. 5




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Orthodontic Centers of America, Inc.
Notes to Condensed Consolidated Financial Statements (Unaudited)
March 31, 2004 1. DESCRIPTION OF BUSINESS Orthodontic Centers of America, Inc. and its wholly- and majority-owned
subsidiaries (OCA) provide business services to orthodontic and pediatric
dental practices in 46 states and four foreign markets. References to the
Company are to OCA and the entities required to be consolidated pursuant to
FIN 46R (as defined below), unless the context otherwise requires. OCA provides purchasing, financial, marketing and administrative services
under service, consulting and management service agreements (Service
Agreements). OCA provides services to orthodontic and pediatric dental
practices operated by orthodontists and pediatric dentists and/or their
wholly-owned professional entities (Affiliated Practices). OCA does not hold
any ownership interest in the Affiliated Practices and does not employ the
orthodontists or other practitioners in the Affiliated Practices. The patients
who are parties to patient contracts with Affiliated Practices are the patients
of the Affiliated Practices, not OCA. OCA does not practice orthodontics or
other forms of dentistry, and is prohibited from doing so by the laws of each
jurisdiction in which it operates. OCA generally affiliates with an existing orthodontic or pediatric dental
practice by entering into a Service Agreement and acquiring substantially all
of the non-professional assets of the practice or professional corporation. OCA
obtains the exclusive right to provide business operations, financial,
marketing and administrative services to the Affiliated Practice during the
term of the Service Agreement. The Service Agreements generally provide that
the professional corporation or entity is responsible for providing orthodontic
or pediatric dental services and for employing all orthodontists or pediatric
dentists. The terms of the Service Agreements range from 20 to 40 years, with
most ranging from 20 to 25 years. In many cases, the Affiliated Practice has
the option to terminate the Service Agreement after a certain number
of years (typically seven) as
prescribed in the Service Agreement. If the Affiliated Practice terminates its
affiliation with OCA, it generally is required to pay OCA for the tangible and
intangible assets associated with the practice at their current book value or
sell the Affiliated Practices interests in the practice to another licensed
orthodontist or pediatric dentist. The following table provides information about the Affiliated Practices: Number of Affiliated PracticesAs of March 31, 2004
        
        As of March 31, 2003Location
        
        Orthodontic
        
        Pediatric
        
        Total
        
        Orthodontic
        
        Pediatric
        
        TotalUnited States
        
        
        294
        
        
        
        28
        
        
        
        322
        
        
        
        309
        
        
        
        29
        
        
        
        338Japan
        
        
        28
        
        
        
        
        
        
        
        28
        
        
        
        24
        
        
        
        
        
        
        
        24Mexico
        
        
        7
        
        
        
        
        
        
        
        7
        
        
        
        4
        
        
        
        
        
        
        
        4Puerto Rico
        
        
        2
        
        
        
        1
        
        
        
        3
        
        
        
        2
        
        
        
        
        
        
        
        2Spain
        
        
        3
        
        
        
        
        
        
        
        3
        
        
        
        3
        
        
        
        
        
        
        
        3Total
        
        
        334
        
        
        
        29
        
        
        
        363
        
        
        
        342
        
        
        
        29
        
        
        
        371
 The total number of Affiliated Practices at March 31, 2004 and 2003
excludes 61 and 50 practices, respectively, that are parties to Service
Agreements but were engaged in litigation with OCA or its subsidiary,
OrthAlliance, Inc., and had ceased paying service fees as of such respective
dates. The total number of Affiliated Practices at March 31, 2004 and 2003
includes 40 and 29 other practices, respectively, that were parties to Service
Agreements and were not engaged in litigation with OCA or
OrthAlliance but had ceased paying service fees as of such respective
dates. The Company had generally 6




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ceased to record patient revenue and fee
revenue with respect to each of these practices as of the respective dates
(Non-Performing Practices). Therefore, at March 31, 2004, there were a total
of 101 Non-Performing Practices for which the Company had generally ceased to
record patient revenue, and at March 31, 2003, there were a
total of 79 Non-Performing Practices for which the Company had generally ceased to record
fee revenue. See Note 5 for further discussion. 2. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. The year-end condensed consolidated balance sheet
was derived from the audited financial statements, but does not include all of
the information and footnotes required by generally accepted accounting
principles in the United States for financial statements. In the opinion of
management, all normal and recurring adjustments, except for the
adjustments resulting from the adoption of FIN 46 as defined below, considered necessary for a fair presentation have
been included. While all available information has been considered, actual
amounts could differ from those estimates. Operating results for the three
month period ended March 31, 2004 are not necessarily indicative of the results
that may be expected for the year ending December 31, 2004. For further
information, refer to the consolidated financial statements and footnotes
thereto included in OCAs Annual Report on Form 10-K for the year ended
December 31, 2003. Reclassifications Certain reclassifications have been made to prior periods in order to
conform to the current period presentation. This primarily relates to
reclassification of Assets associated with non-performing practices. See Note 5. Adoption of New Accounting Standard Effective January 1, 2004, OCA was required to, and did, adopt the
provisions of Financial Accounting Standards Board (FASB) Interpretation No.
46R, Consolidation of Variable Interest Entities  an Interpretation of ARB
No. 51 (FIN 46R). FIN 46R was issued by the FASB on December 24, 2003 and
replaced Interpretation No. 46 (FIN 46), which was issued in January 2003.
FIN 46R requires the consolidation of variable interest entities (VIE), as
defined in FIN 46R, when an enterprise absorbs a majority of the VIEs expected
losses, receives a majority of the VIEs expected residual returns, or both, as
a result of ownership, contractual or other financial interests in the VIE. OCA has evaluated its contractual and economic relationships with its
Affiliated Practices in light of FIN 46R, and has concluded that the Affiliated
Practices are VIEs for purposes of FIN 46R. OCA has also concluded that it is
the primary beneficiary of the Affiliated Practices for purposes of FIN 46R, in
that OCA absorbs a majority of the VIEs expected losses, receives a majority
of the VIEs expected residual returns, or both, as a result of contractual or
other financial interests in the Affiliated Practices. Accordingly, effective
January 1, 2004, OCA is consolidating the assets, liabilities, equity and
financial results of the Affiliated Practices (other than the Non-Performing
Practices) in the Companys consolidated financial statements. The Company was
not required to consolidate the Affiliated Practices for financial reporting
purposes prior to January 1, 2004, in accordance with Emerging Issues Task
Force (EITF) Issue No. 97-2. The Companys adoption of FIN 46R and consolidation of the Affiliated
Practices for financial reporting purposes does not change the legal and
contractual relationships between OCA and the Affiliated Practices. OCA does
not hold any ownership interest in the Affiliated Practices and does not employ
the orthodontists or other practitioners in the Affiliated Practices. The
patients who are parties to patient contracts with Affiliated Practices are the
patients of the Affiliated Practices, not OCA. OCA does not practice
orthodontics or other forms of dentistry, and is prohibited from doing so by
the laws of each jurisdiction in which the Company operates. In connection with the Companys consolidation of the Affiliated Practices
for financial reporting purposes effective January 1, 2004, the Company now
presents patient revenues and patient receivables 7




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associated with the activities of its Affiliated Practices in its consolidated financial
statements. Services fees and service fees receivable are eliminated
upon consolidation of the Affiliated Practices. In addition, due to
consolidation under FIN 46R, the Company will be presenting in its
consolidated statements of income (loss) the amounts retained by
practitioners under its
Service Agreements. The consolidation rules of FIN 46R and Accounting
Research Bulletin No. 51, Consolidated Financial
Statements, will result in a change in our accounting for
excess distributions to affiliated practices that are consolidated
under FIN 46R, as well as identifiable intangible assets and
goodwill. Due to the consolidation of Affiliated Practices and
resulting
presentation of patient revenue in the Companys consolidated
statements of income (loss), the Companys accounting policy for
revenue recognition will now be reflective of the Affiliated
Practices services performed to their patients rather than the
services the Company performs on
behalf of and for the Affiliated Practices. The Companys new
accounting policies effective January 1, 2004 are summarized
following the analysis of the impact of FIN 46R below. The table below provides the impact to the Companys condensed
consolidated balance sheet at January 1, 2004, including elimination of
intercompany transactions, as a result of the Companys adoption of FIN 46R (in
thousands): OCA
        
        Impact ofBalance Sheet
        
        Adopting FIN 46R
        
        ConsolidatedCash and cash equivalents
        
        $
        7,391
        
        
        $
        
        
        
        $
        7,391Patient receivables,
            net
        
        
        
        
        
        
        117,942
        (a)
        
        
        117,942Current portion of
            service fees receivable, net
        
        
        96,720
        
        
        
        (96,720
        ) (a)
        
        
        Current portion of
            advances to practitioners, net
        
        
        16,544
        
        
        
        (7,526
        ) (b)
        
        
        9,018Other current assets
        
        
        62,051
        
        
        
        
        
        
        
        62,051Total current assets
        
        
        182,706
        
        
        
        13,696
        
        
        
        196,402Financed practice-related
            expense portion of service fees receivable
        
        
        51,558
        
        
        
        (51,558
        ) (a)
        
        
        Advances
to practitioners, less current portion, net
        
        
        12,921
        
        
        
        (12,921
        ) (b)
        
        
        Assets associated
            with non-performing practices
        
        
        26,682
        
        
        
        4,624
        
        
        
        31,306Deferred income taxes
        
        
        
        
        
        
        41,420
        
        
        
        41,420Property, equipment
            and improvements, net
        
        
        89,458
        
        
        
        
        
        
        
        89,458Identifiable intangible
            assets, net
        
        
        201,163
        
        
        
        (201,163
        ) (c)
        
        
        Goodwill
        
        
        87,641
        
        
        
        202,804
        (b)
        
        
        290,445Other assets
        
        
        13,547
        
        
        
        
        
        
        
        13,547Total assets
        
        $
        665,676
        
        
        $
        (3,098
        )
        
        $
        662,578Accounts payable
        
        $
        8,985
        
        
        $
        
        
        
        $
        8,985Accrued salaries
            and other current liabilities
        
        
        13,977
        
        
        
        
        
        
        
        13,977Amounts payable to
            practitioners
        
        
        5,373
        
        
        
        
        
        
        
        5,373Service fee prepayments
        
        
        1,157
        
        
        
        (1,157
        ) (d)
        
        
        Deferred revenue
        
        
        
        
        
        
        89,060
        (d)
        
        
        89,060Current portion of
            debt and notes payable
        
        
        10,455
        
        
        
        
        
        
        
        10,455Total current liabilities
        
        
        39,947
        
        
        
        87,903
        
        
        
        127,850Deferred income tax
            liability
        
        
        41,268
        
        
        
        (16,340
        )
        
        
        24,928Notes payable to
            practitioners, less current
        
        
        4,050
        
        
        
        
        
        
        
        4,050Long-term debt
        
        
        87,724
        
        
        
        
        
        
        
        87,724Shareholders
            equity
        
        
        492,687
        
        
        
        (74,661
        ) (e)
        
        
        418,026Total liabilities
            and shareholders equity
        
        $
        665,676
        
        
        $
        (3,098
        )
        
        $
        662,578
 The following discusses the more significant adjustments on certain line
items of the Companys condensed balance sheet as a result of
adopting FIN 46R: 8




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(a) Patient
    Receivables and Service Fee Receivables. Effective January 1,
    2004, the Company records patient receivables in its consolidated balance
    sheets. Patient receivables represent amounts patients owe Affiliated Practices,
    as calculated under the Companys revenue recognition policy, as discussed
    below. They reflect amounts yet to be received after being recognized as patient
    revenue. These amounts are expected to be collected within twelve months.
    Because the Company now consolidates Affiliated Practices, the Company no
    longer records service fees receivable in its consolidated balance sheets,
    including the current and financed practice-related expense portion of service
    fees receivable. (b) Advances
    to Affiliated Practices and Amounts Payable to Affiliated Practices.Effective
    January 1, 2004, the Company does not record in its consolidated balance
    sheets cash advances to Affiliated Practices against future distributions.
    Because the Company now consolidates Affiliated Practices, at January 1,
    2004, the Company made the following adjustments with respect to advances
    to Affiliated Practices: (A) eliminated advances to Affiliated Practices
    that related to cash advances to Affiliated Practices against future distributions,
    (B) reclassified advances related to amounts due under Service Agreements
    with Non-Performing Practices to assets associated with Non-Performing Practices
    (which are reflected in Other assets in the table above), and
    (C) eliminated advances to Affiliated Practices related to amounts due
    under Service Agreements. The Company will continue to record receivables
    and payables related to short-term differences between amounts distributed
    as monthly or biweekly draws to practitioners and the amounts that
    the practitioners are entitled to retain under their Service Agreements,
    until those amounts are trued up. (c) Goodwill
    and Identifiable Intangibles. Pursuant to the consolidation provisions
    of FIN 46R, effective January 1, 2004, the Company accounts for affiliations
    with practices as business combinations and therefore was required to reclassify
    identifiable intangible assets related to Service Agreements as goodwill. Prior
    to the Companys adoption of FIN 46R, it recorded these amounts as identifiable
    intangible assets and amortized these assets. Also, as of January 1,
    2004, the Company reclassified identifiable intangible assets related to Non-Performing
    Practices into Assets associated with Non-Performing Practices,
    because the Company does not consolidate these practices. (See Note 5.) The
    Company continues to amortize these assets. Goodwill is not amortized but
    is tested for impairment under provisions of Statement of Financial Accounting
    Standards (SFAS) No. 142, Goodwill and Other Intangible
    Assets. As a result of the Companys adoption of FIN 46R, the Company
    determined that an interim impairment test was required under SFAS No. 142.
    Accordingly and with the assistance of an outside consultant, the Company
    determined that no impairment was warranted as of the test date. However,
    the Companys fair value assessment is sensitive to a decrease in the
    market price of OCA common stock. As a result, if the market price per share
    of OCA common stock were to decrease materially, it could result in an impairment
    of all or a portion of the carrying value of goodwill. See Note 4 Identifiable
    Intangible Assets and Goodwill. (d) Deferred Revenue and Service Fee Prepayments. Effective January 1,
2004, the Company records deferred revenue in its consolidated balance sheets.
Deferred revenue represents amounts received prior to the recognition of the related patient revenue. The Company no longer records
related service fee prepayments in its consolidated balance sheets. (e) Cumulative effect of change in accounting principle.As a result of
adopting FIN 46R, the Company recorded a cumulative effect charge of $74.7
million, net of income tax benefit of $41.4 million, which was affected by
items discussed above. The pre-tax charge was primarily due to the change in
the Companys revenue recognition policy, a reclassification of
certain advances to Affiliated
Practices as amounts retained by practitioners as described above and reversal of previously-recorded amortization
of identifiable intangible assets for the period following adoption of SFAS No.
142. 9




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Summary of Significant Accounting Policies For a summary of our significant accounting policies, see OCAs Annual Report
on Form 10-K for the year ended December 31, 2003. New accounting policies
resulting from the adoption of FIN 46R are outlined below. Principles of Consolidation The accompanying condensed consolidated financial statements include the
accounts of Orthodontic Centers of America, Inc. and its wholly- and
majority-owned subsidiaries and entities required to be consolidated pursuant
to FIN 46R. Patient revenue is presented in the accompanying condensed
consolidated statements of income (loss) because the Company consolidates the
assets, liabilities, equity and financial results of the Affiliated Practices
(other than Non-Performing Practices) for financial reporting purposes. All
significant intercompany accounts and transactions, including service fees,
have been eliminated in consolidation. Revenue Recognition The Company generally recognizes patient revenues related to services
provided to patients on a straight-line basis over the term of treatment (which
typically averages about 25 months). Revenues related to teeth retention
appliances, commonly known as retainers, are recognized in the final month of
treatment when braces are removed and retainers are provided to the patients,
in accordance with EITF No. 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables. Amounts Retained by
Practitioners Amounts
    retained by practitioners represents amounts retained in accordance
    with contractual terms of the Service Agreements. Amounts
retained by practitioners includes cash advances provided to practitioners to fund
    certain practice-related matters or to provide practices with unsecured financing
    which will be repaid from future distributions and which are reflected as
    an expense in the period such amounts are advanced. Amounts
retained by practitioners are reduced by repayments in the period in which repaid. On a monthly
    or biweekly basis, the Company generally distributes cash draws
to practitioners that are intended to approximate calculated amounts retained by
    the practitioners under their Service Agreements. At the end of each
    quarter, the Company calculates amounts the practitioners are entitled
    to retain in accordance with the Service Agreements. The Company then records
    a receivable or payable, as applicable, for any overpayment or underpayment.
    To the extent amounts are payable to the Company, the Company generally reduces
    the next monthly or biweekly draw to the practitioners. Patient Receivables Effective January 1, 2004, patient receivables represent amounts
owed from patients of our affiliated practices, as calculated under the Companys revenue recognition policy.  The Company provides an allowance for uncollectible
amounts based upon a percentage estimate of patient receivables that may not be collected by our affiliated practices.  The allowance percentage is determined
based on the Companys historical experience in collecting
patient receivables on behalf of the Affiliated Practices and write-off experience. Deferred Revenue Deferred revenue represents down payments, prepayments and other cash
received under patient contracts prior to the related services being provided
by Affiliated Practices. The Company defers recognition of such amounts until
they are recognized under the Companys revenue recognition policy. 10




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Goodwill and Identifiable Intangibles Pursuant
    to the consolidation provisions of FIN 46R, effective January 1, 2004,
    the Company accounts for affiliations with Affiliated Practices as business
    combinations and has reclassified identifiable intangible assets as goodwill.
    Prior to the adoption of FIN 46R, the Company amortized the identifiable intangible
    assets over the lesser of the expected life of the Service Agreement or 25 years.
    See Note 4 for a discussion of the Companys goodwill and results of
    its interim impairment tests performed in connection with the Companys
    adoption of FIN 46R. Segment Reporting Operating
    segments are components of a business enterprise that its chief operating
    decision maker (CODM) applies his decisions to allocate the resources
    to its different segments and to make assessments on their performances. The
    Companys CODM, as defined by SFAS No. 131, Disclosures about
    Segments of an Enterprise and Related Information, is OCAs Chief
    Executive Officer. The CODM assesses the performance of the Company based
    on revenues and overall profitability. By this definition, the Company operates
    only in one operating segment: the providing of purchasing, financial, marketing,
    administrative and other business services under Service Agreements to Affiliated
    Practices operated by orthodontists and pediatric dentists and/or their wholly-owned
    professional entities. 3. PROPERTY, EQUIPMENT AND IMPROVEMENTS Property, equipment and improvements consisted of the following as of the
dates indicated: March 31,
        
        December 31,2004
        
        2003(in thousands)Leasehold improvements
        
        $
        78,985
        
        
        $
        75,664Furniture, fixtures
            and equipment
        
        
        70,174
        
        
        
        68,712149,159
        
        
        
        144,376Less accumulated
            depreciation and amortization
        
        
        58,399
        
        
        
        54,918Property, equipment
            and improvements, net
        
        $
        90,760
        
        
        $
        89,458
 Depreciation expense on property, equipment and improvements was $3.8
million and $3.5 million for the three months ended March 31, 2004 and 2003,
respectively. 4.IDENTIFIABLE INTANGIBLE ASSETS AND GOODWILL The consolidation
    provisions under FIN 46R requires that the Company treat affiliations with
    Affiliated Practices (other than Non-Performing Practices) as business combinations
    for financial reporting purposes from commencement of the affiliation. As
    a result, upon adoption of FIN 46R, the Company reclassified these identifiable
    intangible assets to goodwill. SFAS No. 142 requires that goodwill and
    intangible assets with indefinite lives, including such assets recorded in
    past business combinations, not be amortized, but instead be tested for impairment
    by measuring the reporting unit at fair value. SFAS No. 142 requires
    that the impairment test be performed at least annually thereafter, with interim
    testing required if circumstances warrant. The Company performs its annual
    impairment analysis during the second quarter of its fiscal year. The Companys
    adoption of FIN 46R resulted in significant changes to its condensed consolidated
    balance sheet and qualified as a significant event warranting an interim goodwill
    impairment test. The fair value of the reporting unit was determined with
    the assistance of a third party advisor. The Company determined that goodwill
    was not impaired. As of December 31, 2003, the Companys goodwill
    related solely to the OrthAlliance merger. 11




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##### Table of Contents



5. NON-PERFORMING PRACTICES At March 31, 2004 and December 31, 2003, the Company recorded the
following assets in its consolidated balance sheets related to the
Non-Performing Practices (in thousands): March 31, 2004
    
    December 31, 2003Service fees receivables, net
    
    $
    3,535
    
    
    $
    3,535Advances to affiliated practices, net
    
    
    6,488
    
    
    
    4,287Notes receivable
    
    
    
    
    
    
    199Property, equipment and improvements, net
    
    
    2,935
    
    
    
    2,699Identifiable intangible assets, net
    
    
    19,021
    
    
    
    15,962Total
    
    $
    31,979
    
    
    $
    26,682
 OCA has commenced litigation and/or taken other actions to recover the
amounts due to OCA from these practices. The Company established an allowance
for these amounts in the amount of $2.2 million at March 31, 2004 and $2.3
million at December 31, 2003. 6. DEBT The Company has a $125.0 million credit facility comprised of a $100.0
million revolving line of credit and a $25.0 term loan. At March 31, 2004,
approximately $79.6 million was outstanding on the revolving line of credit and
$14.4 million under the term loan. The credit facility requires the Company to
maintain certain financial and nonfinancial covenants under the terms of the
agreement, including a maximum leverage ratio, minimum fixed charge coverage
ratio, minimum consolidated net worth and maximum funded debt to total patient
contract balances. The credit facility also contains positive and negative
covenants that restrict certain activities of the Company, including
limitations on the payment of cash dividends, repurchases of OCA common stock,
acquisitions, investments, incurrence of other indebtedness and other
transactions that may affect the Companys liquidity. If the Company were to
experience an event or matter that has, or is reasonably likely to have, a
material adverse effect (as defined in the credit facility) on the Company,
then the Company would be unable to borrow additional amounts under the credit
facility without a waiver by its lenders or an amendment to the credit
facility. The Company cannot assure you that it would be able to obtain such a
waiver or amendment, which could have a material adverse impact on the
Companys liquidity and capital resources. At March 31, 2004, the Company was
in compliance with the covenants and restrictions under the credit facility. 7. STOCK COMPENSATION ARRANGEMENTS As permitted by SFAS No. 123, Accounting for Stock-Based Compensation,
the Company accounts for its stock compensation arrangements with employees
under the intrinsic value method prescribed by Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees and related
interpretations. No stock-based employee compensation cost is reflected in net
income, as all options granted under these plans have an exercise price equal
to the market value of the underlying common stock on the date of grant. The
Company accounts for stock options granted to non-employees, primarily
affiliated orthodontists, at fair value determined according to SFAS No. 123.
The Company accounts for the incentive plans implemented in connection with the
OrthAlliance merger in accordance with EITF Issue No. 96-18 and Issue No.
00-18. The Company accounts for its orthodontist stock purchase plan in
accordance with EITF Issue No. 00-19. 12




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##### Table of Contents



March 31,2004
    
    2003(in thousands, except per share data)Income before cumulative
effect of change in
accounting principal
    
    $
    7,240
    
    
    $
    14,905Less: stock-based employee
compensation expense
determined under fair value
based method for all awards,
net of related tax effect
    
    
    145
    
    
    
    149Pro forma net income before
cumulative effect of change
in accounting
principle
    
    $
    7,095
    
    
    $
    14,756Income before cumulative
effect of change in
accounting principle per
share:Basic, as reported
    
    $
    0.14
    
    
    $
    0.30Basic, pro forma
    
    
    0.14
    
    
    
    0.29Diluted, as reported
    
    
    0.14
    
    
    
    0.30Diluted, pro forma
    
    
    0.14
    
    
    
    0.29
 8. INCOME TAXES The Company has deferred tax assets primarily relating to net operating
loss carryforwards and the future tax benefit of the cumulative effect from the
adoption of FIN 46R. The net operating loss carryforwards primarily relate to
the cumulative effect of (A) a change in accounting method for recognizing
revenue for income tax purposes previously approved by the Internal Revenue
Service (IRS) and (B) a change in accounting method related to applicable
class lives for certain long-lived assets. The Company expects that the
remaining net operating loss carryforwards will substantially offset the
Companys income tax liability in 2004. If the net operating loss
carryforwards are not used, they will expire between 2017 and 2023. 9. STOCKHOLDER RIGHTS PLAN On March 3, 2004, OCAs Board of Directors adopted a stockholder rights
plan. To implement the rights plan, the Board of Directors declared a dividend
distribution of one preferred stock purchase right per outstanding share of
common stock, payable to all stockholders of record as of March 3, 2004. The
rights were distributed as a non-taxable dividend and will expire on March 2,
2014. The rights will automatically trade with OCAs underlying common stock
and no separate preferred stock certificates will be distributed. The rights to
acquire preferred stock are not immediately exercisable and will become
exercisable only if a person or group acquires or commences a tender offer for
20% or more of OCAs common stock. If a person or group acquires or commences
a tender offer for 20% or more of OCAs common stock, each holder of these
rights, except the acquirer, will be entitled to exercise a right for one
one-thousandth of a share of OCAs newly-created Series A Junior Participating
Preferred Stock at an exercise price of $40.00 or a number of shares of OCAs
common stock equal to twice the exercise price of the rights divided by the
market value of OCAs common stock at the time of such acquisition. In
addition, in the event of certain business combinations, the rights permit
their holders to purchase the number of shares of the acquirers common stock
equal to twice the exercise price of the rights divided by the market value of
the acquirers common stock at the time of such acquisition. OCAs Board of
Directors may terminate the rights plan at any time or redeem the rights for
$0.00001 per right at any time before a person acquires 20% or more of OCAs
common stock. 13




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10. NET INCOME (LOSS) PER SHARE The calculation of net income (loss) per share is performed using the
treasury stock method. Computations of basic and diluted earnings (loss) per
share are presented below: Three months endedMarch 31,2004
    
    2003(in thousands)Numerator:Net income (loss) for basic and diluted
earnings (loss) per share
    
    $
    (67,421
    )
    
    $
    14,905Denominator:Denominator for basic earnings per share
    
    
    50,070
    
    
    
    50,197Effect of dilutive securities
    
    
    
    
    
    
    205Denominator for diluted earnings per share
    
    
    50,070
    
    
    
    50,402
 No options to purchase shares of OCAs common stock were included in the
computation of diluted loss per share for the three months ended March 31,
2004, because the effects would have been anti-dilutive. Options to purchase
172,185 shares of common stock at price ranging from $2.75 to $7.28 were
outstanding at March 31, 2003 but not included in the computation of diluted
earnings per share for the three months ended March 31, 2003 because the
options exercise prices were greater that the average market price of the
common stock. The options expire between 2009 and 2012. 11. CONTINGENCIES OrthAlliance Related Litigation Before OCA entered into the merger agreement with OrthAlliance in 2001, it
anticipated that some portion of OrthAlliances affiliated practices would
oppose such a merger. A description of actions brought by certain OrthAlliance
affiliated practices and the claims in these actions is contained in Item 3 of
Part I to the Companys Annual Report on Form 10-K for the year ended December
31, 2003. At March 31, 2004, 53 OrthAlliance affiliated practices were parties
to actions against OrthAlliance that were pending in courts in a number of
states. One OrthAlliance affiliated practice filed suit against OrthAlliance in
the first quarter of 2004. In addition, another 33 OrthAlliance affiliated
practices had not filed lawsuits against OrthAlliance but had ceased paying
service fees to OrthAlliance at March 31, 2004. OrthAlliance has successfully resolved disputes with a number of
non-performing OrthAlliance affiliated practices that were engaged in
litigation with it and/or had ceased paying service fees. From January 1, 2002
to March 31, 2004, OrthAlliance engaged in the following transactions with
non-performing OrthAlliance affiliated practices:  
    
    12 practices agreed to buy out of their Service Agreements
with OrthAlliance by paying OrthAlliance to terminate their
affiliation with OrthAlliance;  
    
    six practices transitioned their practice to another
affiliated practice;  
    
    nine practices amended their Service Agreements in connection
with the incentive programs offered to OrthAlliance affiliated
practitioners and continued to be affiliated with OrthAlliance; and 14




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##### Table of Contents




    
    nine practices entered into other amendments to their Service
Agreements and continued to be affiliated with OrthAlliance. Based on the Companys experience in favorably resolving some of the
lawsuits filed by OrthAlliance affiliated practices and discussions with some
of the other OrthAlliance affiliated practices who are parties to pending
litigation or their representatives, the Company currently believes that some
of these practices will settle their lawsuits by paying OrthAlliance an amount
of cash in exchange for termination or modification of their Service Agreement
with OrthAlliance, depending upon the parties ability to reach an agreement as
to the amount to be paid. The Company cannot assure you that such an agreement
or settlement will be reached in any of these lawsuits. The Company also
cannot, at this time, predict the outcome of these lawsuits or assure you that
OrthAlliance will prevail in any of them, nor can the Company estimate with
reasonable certainty at this time the amount of damages that OrthAlliance might
incur or receive in these actions. On March 1, 2004, the U.S. District Court for the Western District of
Washington ruled on the plaintiffs motion for summary judgment in a lawsuit
filed against OrthAlliance by two practitioners. The court held that the
overall relationship between OrthAlliance and the orthodontic practices
violated a Washington statute governing the corporate practice of dentistry and
that OrthAlliances Service Agreements with the practices, and the employment
agreements between the orthodontists and their professional corporations were
illegal. The court dismissed the orthodontists other claims and OrthAlliances
counterclaims, and no damages were awarded to any party. The court relied on a
series of Washington state court decisions to look beyond the express terms of
the contracts, which the court viewed to be legal on their face, to the courts
view of the underlying effect and purpose of the contracts. OrthAlliance filed
notice of appeal of the ruling in this case on March 4, 2004 and believes that
it has meritorious grounds to overturn this ruling on appeal. On April 23, 2004, the U.S. District Court for the Northern District of
Texas ruled on the plaintiffs motion for summary judgment in a lawsuit filed
by eight practitioners against OrthAlliance, which was consolidated with the
case captioned Penny v. OrthAlliance, Inc.Consistent with the courts prior
ruling in the Pennycase, the court held that, when construed together, the
purchase agreements and Service Agreements between the plaintiffs and
OrthAlliance and the employment agreements between the individual plaintiffs
and their practices violated Texas statutes prohibiting the unauthorized
practice of dentistry and were therefore invalid. No damages were awarded to
any party. OrthAlliance appealed the Pennyruling on January 21, 2004, but this
ruling has not yet been certified for appeal. OrthAlliance believes that it
has meritorious grounds to overturn the Pennyruling on appeal. On April 26, 2004, the U.S. District Court for the District of Colorado
ruled on the parties motions for summary judgment in a lawsuit filed by two
practitioners against OrthAlliance. The court granted OrthAlliances motion
for summary judgment dismissing the plaintiffs claim of fraud and negligent
misrepresentation. The court also granted the plaintiffs motion for summary
judgment, holding that the purchase agreements and Service Agreements between
the plaintiffs and OrthAlliance and the employment agreements between the
individual plaintiffs and their practices were illegal and that the covenants
not to complete within the agreements were unenforceable. The court found that
the overall relationship between OrthAlliance and the orthodontic practices
violated Colorado statutes prohibiting the unauthorized practice of dentistry
and were therefore illegal. No damages were awarded to any party. On May 11, 2004, a jury rendered a verdict in favor of two orthodontic
practices on a breach of contract claim in a lawsuit filed against OrthAlliance
in the U.S. District Court for the Northern District of Georgia. The lawsuit
was originally filed in September 2001. OrthAlliance had also filed a
counterclaim against the plaintiffs in the action. Two other plaintiffs that
were part of the action settled their claims with OrthAlliance prior to the
trial. Also prior to the trial, the court granted OrthAlliance a partial
summary judgment denying the plaintiffs any claim to damages. At trial, the
plaintiffs alleged and the jury found that, prior to the Companys acquisition
of OrthAlliance in November 2001, OrthAlliance 15




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breached the terms of the plaintiffs Service Agreements. The jury did not
award OrthAlliance damages. The verdict resulted in termination of the
plaintiffs service agreements. OrthAlliance intends to appeal this decision. Each of these rulings was limited to the plaintiffs in those particular
cases and the laws of the particular states in which the practices were
located, and do not apply to the enforceability of Service Agreements or
employment agreements with any other practices. These rulings did not have a
material effect on the Companys results of operation or financial condition. Securities Class Action On April 10, 2003, Ilena and Guiseppe Chiaretti filed an action in the
United States District Court for the Eastern District of Louisiana against OCA
and Bartholomew F. Palmisano, Sr., OCAs Chairman of the Board, President and
Chief Executive Officer, Bartholomew F. Palmisano, Jr., OCAs Chief Operating
Officer, and Thomas J. Sandeman, OCAs then Chief Financial Officer. Similar
actions were filed in the same court by other plaintiffs. On August 28, 2003,
the lawsuits were consolidated and John A. Matis, Trustee was appointed as lead
plaintiff. The consolidated action purported to be filed as a class action on
behalf of the plaintiffs and other purchasers of shares of our common stock
from November 14, 2002 to March 18, 2003, and alleged that OCA and the other
defendants violated Section 10(b) of the Securities Exchange Act of 1934, as
amended, and Rule 10b-5 thereunder, by allegedly making false and misleading
statements, and/or omitting to state material facts necessary to make the
statements made not misleading. On April 6, 2004, the court granted OCAs
motion and ordered that the lawsuit be dismissed. The court found that the
plaintiffs had failed to state a claim that OCA or its officers violated
federal securities laws. On May 6, 2004, the court entered a judgment
dismissing the case. The plaintiffs have indicated that they will not appeal
the courts ruling on the motion to dismiss. General Because litigation is inherently uncertain, the Company cannot assure you
that it or its subsidiaries will prevail in any of these or other lawsuits, nor
can the Company estimate with reasonable certainty the amount of damages it
might incur or the amount of any award it might receive. The Company and its
subsidiaries and Affiliated Practices are, and from time to time may become,
party to other litigation or administrative proceedings which arise in the
normal course of their business. Regardless of the outcome of such litigation
and proceedings, they could be costly, time-consuming and could divert the time
and attention of the Companys senior management. 16




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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion summarizes the financial condition of Orthodontic
Centers of America, Inc. (we, our or OCA) at March 31, 2004, and our
results of operations for the three months ended March 31, 2004, and should be
read in conjunction with the condensed consolidated financial statements and
accompanying notes included elsewhere in this Report. OVERVIEW Founded in 1985, OCA is the leading provider of business services to
orthodontic and pediatric dental practices. At March 31, 2004, OCA was
affiliated with 363 practices located throughout the United States and parts of
Japan, Spain, Puerto Rico and Mexico. We provide affiliated practices with a
full range of business, operational and marketing services as well as
complementary Internet-based proprietary information systems and capital for
growth. We provide our services to affiliated practices under a service,
consulting or management service agreement (Service Agreement), with terms
that usually range from 20 to 25 years. The total number of affiliated practices excludes 61 orthodontic and
pediatric dental practices that were engaged in litigation with us and had
ceased paying service fees to us, but includes 40 other practices that were not
engaged in litigation with us but which had ceased paying service fees to us.
At March 31, 2004, we had generally ceased to record patient revenue for each
of such practices (Non-Performing Practices). We were also engaged in
litigation with one practice for which we were still or its subsidiary recording patient revenue
because this practice was still paying service fees to us at March 31, 2004. The
Service Agreements provide that the affiliated practices will pay OCA or
its subsidiary
monthly service fees, generally based upon a percentage of the practices
operating profit or practice revenue and reimbursement of practice-related
expenses. Excluding reimbursement of practice-related expenses, our service
fees generally equal about 40% to 50% of a practices operating profit or about
17% of a practices revenue. Affiliated practices reimburse us for
practice-related expenses that we incur on their behalf, including costs to
treat patients of the affiliated practices. These practice-related expenses are
recorded in our consolidated statements of income (loss) when incurred. Our
affiliated practices generally incur approximately 30%-35% of their total costs
to treat a patient in the first month of the patients treatment. We believe that the dollar amount of new patient contracts of our
affiliated practices is the greatest predictor of our future patient revenue.
During the three months ended March 31, 2004, our affiliated practices
generated new patient contracts totaling $176.4 million, which we expect to
provide us with a future stream of patient revenue and cash flow. ADOPTION OF FIN 46R We have made a number of changes in our accounting and financial statement
presentation effective as of January 1, 2004, in connection with our adoption
of Financial Accounting Standards Board (FASB) Interpretation No. 46R,
Consolidation of Variable Interest Entities  an Interpretation of ARB No. 51
(FIN 46R). FIN 46R was issued by the FASB in December 2003 and replaced
Interpretation No. 46 (FIN 46), which was issued by the FASB in January 2003. FIN 46R requires that we consolidate the assets, liabilities, equity and
financial results of certain entities (known as variable interest entities or
VIEs) if we are the primary beneficiary of the VIEs. Under FIN 46R, we are the
primary beneficiary of a VIE if we absorb a majority of the VIEs expected
losses,
receive a majority of the VIEs expected residual returns, or both, as a
result of ownership, contractual or other financial interests in the VIE. 17




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In connection with our required adoption of FIN 46R effective January 1,
2004, we evaluated our contractual and economic relationships with affiliated
practices, including an economic analysis of these relationships with the
assistance of third party consultants. We concluded that the affiliated
practices are VIEs for purposes of FIN 46R. We also concluded that we are the
primary beneficiary of the affiliated practices (other than Non-Performing
Practices) for purposes of FIN 46, in that we absorb a majority of the
affiliated practices expected losses and/or receive a majority of the
affiliated practices expected residual returns, as a result of contractual or
other financial interests in the affiliated practices. Accordingly, effective January 1, 2004, we are consolidating the assets,
liabilities, equity and financial results of our affiliated practices (other
than Non-Performing Practices) in our consolidated financial statements. We did
not consolidate the affiliated practices for financial reporting purposes prior
to January 1, 2004, in accordance with EITF Issue No. 97-2. These changes
resulted in a cumulative effect of change in accounting principle charge of
$74.7 million (net of an income tax benefit of $41.4 million), which was
recorded during the three months ended during March 31, 2004. We believe that the changes required under FIN 46R will enhance the
transparency and clarity of our financial reporting. With these changes, our
reported earnings should more closely reflect the net cash provided by
operating activities reported on our consolidated statements of cash flows.
These changes are described in more detail below and in the notes to our
consolidated financial statements included in this Report. Briefly, these changes include the following, effective as of January 1,
2004:  
    
    Patient revenue. We now record patient revenue under
patient contracts between affiliated practices and their patients,
rather than the fee revenue portion that represented our service
fees because we are now consolidating affiliated practices for
financial reporting purposes.  
    
    Amounts retained by practitioners. The portion of
patient revenue that is retained by practitioners is now reflected as an expense in our consolidated statements of income
(loss).  
    
    Revenue recognition. We now reflect our affiliated practices
patient activity in our consolidated financial statements. As a
result, we now recognize patient revenue based upon a straight-line
allocation of patient contract balances over the term of treatment
(which averages about 25 months), except that a portion relating to
retainers will be recognized in the final month of treatment when
braces are removed and retainers are provided to patients, in
accordance with EITF Issue No. 00-21, Accounting for Revenue
Arrangements with Multiple Deliverables. This eliminates the
recognition of revenue related to retainers over the term of
treatment, which resulted in increasing amounts of unbilled service
fees receivable under our prior revenue recognition policy.  
    
    Patient receivables. We now record patient receivables owed
to affiliated practices under their patient contracts because we now
consolidate affiliated practices for financial reporting purposes.
We no longer record service fees receivable, including service fees
receivable relating to retainers. This change will cause our patient
receivables to more closely match the actual timing of billing and
collection for retainers, which is typically in the final month of
treatment. We also no longer record the financed practice-related
expense portion of service fees receivable. The impact of these
expenses on our statements of income (loss) will more closely
reflect the timing of payment and reimbursement for these expenses. 18




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
    
    Identifiable intangibles and goodwill. We now record amounts
paid to practices to affiliate or amend Service Agreements as
goodwill, rather than identifiable intangibles. As a result, we will
test goodwill for impairment rather than record
amortization expense relating to our intangible investments in
Service Agreements.  
    
    Advances to practitioners. We now record cash
advances to practitioners during the start-up or expansion
phase of a new center as expenses when incurred (in the line item
Amounts retained by practitioners), rather than as a
receivable. These primarily related to funding of compensation and
additional funding related to the practices. Repayment of the cash
advances will now reduce amounts retained by practitioners
during the period in which the advance is repaid. This change will
result in the earnings impact of these advances more closing
tracking the actual timing of the advance and repayment. Our adoption of FIN 46R and consolidation of affiliated practices for
financial reporting purposes did not change our business practices, nor did it
change our legal and contractual relationships with affiliated practices. We
continue to provide high-quality business services to orthodontic, pediatric
dental and other practices under service and consulting agreements. We do not
have any ownership interest in our affiliated practices and we do not employ
the orthodontists, dentists or other practitioners in the affiliated practices.
The patients who are parties to patient contracts with affiliated practices
remain the patients of the affiliated practices. 19




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Consolidated Statements of Income (Loss).The following table provides
components of certain information in our condensed consolidated statements of
income (loss) for the three months ended March 31, 2004 and 2003, and for the
three months ended March 31, 2003 on a pro forma basis, as if our adoption of
FIN 46R was effective on January 1, 2003. Non-PerformingBase Practices (1)
        
        Practices (2)
        
        TotalThree months ended
            March 31, 2004:(As reported)Patient revenue
        
        $
        110,620
        
        
        $
        278
        
        
        $
        110,898Direct expenses (3)
        
        
        81,184
        
        
        
        321
        
        
        
        81,505General and administrative
            expense (3)
        
        
        12,940
        
        
        
        
        
        
        
        12,940Depreciation and
            amortization (3)
        
        
        3,791
        
        
        
        190
        
        
        
        3,981Operating income
            (loss) (3)
        
        $
        12,705
        
        
        $
        (233
        )
        
        $
        12,472Three months ended
            March 31, 2003:(As reported)Fee revenue
        
        $
        90,634
        
        
        $
        10,005
        
        
        $
        100,639Direct expenses (3)
        
        
        47,611
        
        
        
        8,031
        
        
        
        55,642General and administrative
            expense (3)
        
        
        11,204
        
        
        
        1,745
        
        
        
        12,949Depreciation and
            amortization (3)
        
        
        5,719
        
        
        
        239
        
        
        
        5,958Asset
impairments
        
        
        
        
        
        
        703
        
        
        
        703Pro forma operating
            income (loss) (3)
        
        $
        26,100
        
        
        $
        (713
        )
        
        $
        25,387Three months ended
            March 31, 2003:(Pro forma)(4)Patient revenue
        
        $
        100,777
        
        
        $
        12,140
        
        
        $
        112,917Direct expenses (3)
        
        
        74,680
        
        
        
        8,706
        
        
        
        83,386General and administrative
            expense (3)
        
        
        11,187
        
        
        
        1,569
        
        
        
        12,756Depreciation and
            amortization (3)
        
        
        3,483
        
        
        
        239
        
        
        
        3,722Asset impairments
        
        
        
        
        
        
        703
        
        
        
        703Pro forma operating
            income(3)
        
        $
        11,427
        
        
        $
        923
        
        
        $
        12,350
   (1)
    
    Represents operating results attributable to affiliated practices for
which we were recording patient revenue as of March 31, 2004 (Base
Practices).(2)
    
    Represents operating results attributable to affiliated practices
during the three months ended March 31, 2004 and 2003 for which we
recorded patient revenue or fee revenue during the respective period but
for which we had ceased to record patient revenue at March 31, 2004
(Non-Performing Practices).(3)
    
    For purposes of this table only, in determining the expenses and
operating income for the Base Practices and the Non-Performing Practices
presented in this table, we allocated all of our corporate overhead costs
during the period to the Base Practices.(4)
    
    Presented on a pro forma basis as if our change in accounting principle
pursuant to FIN 46R was effective as of January 1, 2003. 20




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Consolidated Balance Sheets.The table below provides the impact to our
condensed consolidated balance sheet at January 1, 2004, including elimination
of intercompany transactions, as a result of the adoption of FIN 46R (in
thousands).

OCA
    
    Impact ofBalance Sheet
    
    Adopting FIN 46R
    
    ConsolidatedCash and cash equivalents
    
    $
    7,391
    
    
    $
    
    
    
    $
    7,391Patient receivables, net
    
    
    
    
    
    
    117,942
    (a)
    
    
    117,942Current portion of service fees receivable, net
    
    
    96,720
    
    
    
    (96,720
    ) (a)
    
    
    Current
portion of advances to practitioners, net
    
    
    16,544
    
    
    
    (7,526
    ) (b)
    
    
    9,018Other current assets
    
    
    62,051
    
    
    
    
    
    
    
    62,051Total current assets
    
    
    182,706
    
    
    
    13,696
    
    
    
    196,402Financed practice-related expenses portion of
service fees receivable
    
    
    51,558
    
    
    
    (51,558
    ) (a)
    
    
    Advances to practitioners, less current
portion, net
    
    
    12,921
    
    
    
    (12,921
    ) (b)
    
    
    Assets associated with non-performing practices
    
    
    26,682
    
    
    
        4,624
    
    
    
        31,306Deferred income taxes
    
    
    
    
    
    
    41,420
    
    
    
    41,420Property, equipment and improvements, net
    
    
    89,458
    
    
    
    
    
    
    
    89,458Identifiable intangible assets, net
    
    
    201,163
    
    
    
    (201,163
    ) (c)
    
    
    Goodwill
    
    
    87,641
    
    
    
    202,804
      (c)
    
    
    290,445Other assets
    
    
    13,547
    
    
    
    
    
    
    
    13,547Total assets
    
    $
    665,676
    
    
    $
        (3,098
    )
    
    $
        662,578Accounts payable
    
    $
    8,985
    
    
    $
    
    
    
    $
    8,985Accrued salaries and other current liabilities
    
    
    13,977
    
    
    
    
    
    
    
    13,977Amounts payable to practitioners
    
    
    5,373
    
    
    
    
    
    
    
    5,373Service fee prepayments
    
    
    1,157
    
    
    
    (1,157
    ) (d)
    
    
    Deferred revenue
    
    
    
    
    
    
    89,060
    (d)
    
    
    89,060Current portion of debt and notes payable
    
    
    10,455
    
    
    
    
    
    
    
    10,455Total current liabilities
    
    
    39,947
    
    
    
    87,903
    
    
    
    127,850Deferred income tax liability
    
    
    41,268
    
    
    
    (16,340
    )
    
    
    24,928Notes payable to practitioners, less current
    
    
    4,050
    
    
    
    
    
    
    
    4,050Long-term debt
    
    
    87,724
    
    
    
    
    
    
    
    87,724Shareholders equity
    
    
    492,687
    
    
    
        (74,661
    ) (e)
    
    
        418,026Total
liabilities and shareholders equity
    
    $
    665,676
    
    
    $
        (3,098
    )
    
    $
        662,578


The following discusses the more significant adjustments on certain line
items of our condensed balance sheet as a result of adopting FIN 46R.

(a)Patient
    Receivables and Service Fee Receivables. Effective January 1,
    2004, we record patient receivables in our consolidated balance sheets. Patient
    receivables represent amounts patients owe affiliated practices, as calculated
    under our revenue recognition policy. They reflect amounts yet to be received
    after being recognized as patient revenue. We no longer record service fees
    receivable in our consolidated balance sheets, including the current and financed
    practice-related expense portion of service fees receivable.

21



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(b)Advances
to Practitioners and Amounts Payable to Practitioners. Effective January 1, 2004, we do not record in our condensed
consolidated balance sheets cash advances to affiliated practices against
future distributions. At January 1, 2004, we made the following adjustments
with respect to advances to affiliated practices: (A) eliminated advances to
affiliated practices that related to cash advances to affiliated practices
against future distributions, (B) reclassified advances related to amounts due
under Service Agreements with Non-Performing Practices to assets associated
with Non-Performing Practices (which are reflected in Other assets in the
table above), and (C) eliminated advances to affiliated practices related to
amounts due under Service Agreements. We will continue to record receivables
and payables related to short-term differences between amounts distributed as
monthly or biweekly draws to practitioners and the amounts that the
practitioners are entitled to retain under their Service Agreements,
until those amounts are trued up. (c)Goodwill and Identifiable Intangibles. Pursuant to the consolidation
provisions of FIN 46R, effective January 1, 2004, we account for affiliations
with practices as business combinations and therefore are required to reclassify identifiable
intangible assets related to Service Agreements as goodwill. Prior to the
adoption of FIN 46R, we recorded these amounts as identifiable intangible
assets and amortized these assets. Also, as of January 1, 2004, we
reclassified identifiable intangible assets related to Non-Performing Practices into
Assets associated with Non-Performing Practices, because we do not consolidate
these practices. We continue to amortize these assets. Goodwill is not
amortized but is tested for impairment under provisions of SFAS No. 142. As a
result of our adoption of FIN 46R, we determined that an interim impairment
test was required under SFAS No. 142. Accordingly and with the assistance of an
outside consultant, we determined that no impairment was warranted as of the
test date. However, our fair value assessment is sensitive to a decrease in
the market price of OCA common stock. As a result, if the market price per
share of OCA common stock were to decrease materially, it could result in an
impairment of all or a portion of the carrying value of goodwill. (d)Deferred Revenue and Service Fee Prepayments. Effective January 1,
2004, we record deferred revenue in our consolidated balance sheets. Deferred
revenue represents amounts we receive prior to recognition of the related patient revenue. We no longer record service fee
prepayments on our consolidated balance sheets. (e) Cumulative effect of change in accounting principle.As a result of
adopting FIN 46R, we recorded a cumulative effect charge of $74.7 million, net
of income tax benefit of $41.4 million, which was affected by items discussed
above. The pre-tax charge was primarily due to the change in our revenue
recognition policy, a reclassification of certain advances to
Affiliated Practices as amounts retained by practitioners as described above and reversal of previously-recorded
amortization of identifiable intangible assets for the period following adoption of SFAS No. 142. 22




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PRACTICE COLLECTIONS Our financial
    success is dependent on the financial success of our affiliated practices.
    We generally collect patient fees from patients and third-party
payors on behalf of affiliated practices. The
    following chart illustrates the increases in patient fees collected by affiliated
    practices by quarter beginning in the first quarter of 2001. The graph also
    illustrates the growth in collections of patient fees by Base Practices that
    have remained in our system since our acquisition of OrthAlliance in November 2001.
    The graph also illustrates the effect of the Non-Performing Practices on total
    patient fees collected by affiliated practices since our acquisition of OrthAlliance,
    as collections included for Non-Performing Practices (most of which were OrthAlliance
    affiliated practices) steadily declined following the first quarter of 2002
    until they neared zero in the first quarter of 2004. Patient Fees Collected by Practices
    (1)  (GRAPH)   (1)
    
    These amounts reflect patient fees collected from patients or third
party payors by or on behalf of affiliated practices during the
respective periods. These amounts do not represent our fee revenue or
patient revenue, which are determined in accordance with our revenue
recognition policy. These amounts do not include any collections by
Non-Performing Practices after we cease recording fee revenue or patient
revenue for the practices.(2)
    
    Represents patient fees collected by or on behalf of affiliated
practices for which we were recording patient revenue as of March 31,
2004 (Base Practices).(3)
    
    Represents patient fees collected by or on behalf of affiliated
practices for which we recorded fee revenue or patient revenue during the
respective periods but for which we had ceased to record revenue at March
31, 2004 (Non-Performing Practices). Accordingly, we ceased to include
collections by Non-Performing Practices in the graph above after we
ceased recording fee revenue or patient revenue for the practices.(4)
    
    Represents total patient fees collected by Base Practices and
Non-Performing Practices during the periods. 23




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##### Table of Contents



CRITICAL ACCOUNTING POLICIES AND ESTIMATES OCAs management is required to make estimates and assumptions in the
preparation of the financial statements in accordance with accounting
principles generally accepted in the United States. The following are
critical accounting policies that resulted from our adoption of FIN 46R
effective January 1, 2004. See Item 7. Managements Discussion and Analysis of
Financial Condition and Results of Operations and Note 2 to our consolidated
financial statements in our Annual Report on Form 10-K for the year ended
December 31, 2003 for information about other critical accounting policies.
These policies are important in portraying our financial condition and results
of operations, and require managements difficult, subjective or complex
judgments due to the sensitivity of the methods, assumptions and estimates used
in preparing our consolidated financial statements. Actual results may differ
from these estimates under different assumptions and estimates. Consolidation FIN 46R requires the consolidation of entities known as variable interest
entities or VIEs when an enterprise absorbs a majority of the VIEs expected
losses, receives a majority of the VIEs expected residual returns, or both, as
a result of ownership, contractual or other financial interests in the VIE.
Management must make assessments whether our affiliated practices are VIEs and
whether we hold a controlling financial interest in the VIEs, as determined
under FIN 46R. Accordingly, we will consolidate the assets, liabilities, equity
and financial results of those affiliated practices in our consolidated
financial statements if we determine that we do hold a controlling financial
interest. We are required to reevaluate whether or not we consolidate our
VIEs when a reconsideration event occurs. We do not consolidate the assets,
liabilities, equity and financial results of the Non-Performing Practices. The laws of each of the jurisdictions in which we operate prohibit us from
owning orthodontic or pediatric dental practices. We enter into exclusive
long-term Service Agreements with practitioners and professional entities that
operate orthodontic and pediatric dental practices. We do not have any
ownership interest in affiliated practices and we do not employ the
orthodontists, dentists or other
practitioners in the affiliated practices. The patients who are parties to
patient contracts with affiliated practices remain the patients of the
affiliated practices. Amounts Retained by
Practitioners Amounts
    retained by practitioners represents amounts retained in accordance
    with contractual terms of the Service Agreements. Amounts
retained by practitioners includes cash advances provided to
practitioners to fund certain
    practice-related matters or to provide practices with unsecured financing
    which will be repaid from future distributions and which are reflected as
    an expense in the period such amounts are advanced. Amounts
retained by practitioners are reduced by repayments in the period in which repaid. On a monthly
    or biweekly basis, we generally distributes cash draws to
practitioners
    that are intended to approximate calculated amounts retained by
the practitioners under their Service Agreements. At the end of each quarter, we calculate
    amounts the practitioners are entitled to retain in accordance with
    the Service Agreements. We then record a receivable or payable, as applicable,
    for any overpayment or under payment. To the extent amounts are owed to us,
    we generally reduce the next monthly or biweekly draw to the
practitioners. Advances to Affiliated Practices We
apply the provisions of Accounting Research Bulletin No. 51, Consolidated Financial Statements, when assessing advances to
affiliated practices and amounts retained by affiliated practices. Accordingly, we do not record cash advances against future
distributions to affiliated practices in our consolidated financial statements as advances to affilated practices. Such amounts are
recorded as an expense, in amounts retained by affiliated practices, in the period in which the distributions are made. However, as
these amounts are repaid from future earnings of the Affilated Practices, we record the amounts as a reduction of amounts retained by
affiliated practices. We record as advances to practitioners or
amounts payable to practitioners the short-term differences
between amounts distributed as monthly or bi-weekly draws to
practitioners and the amounts that the practitioners are
entitled to retain under their Service Agreements. Revenue Recognition and Realization of Patient Receivables We generally recognize patient revenues related to services provided to
patients on a straight-line basis over the term of treatment (which typically
averages about 25 months). Revenues related to teeth retention appliances,
commonly known as retainers, are recognized in the final month of treatment
when 24




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##### Table of Contents



braces are removed and retainers are provided to the patients, in
accordance with EITF Issue No. 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables. Patient
    receivables represent amounts owed by patients or third-party payors to our
    affiliated practices, as calculated under our revenue recognition policy.
    In addition, in some instances, management is required to estimate patient
    receivables from certain of our affiliated practices based upon information
    provided by those affiliated practices. Management provides an allowance for
    uncollectible amounts based upon a percentage estimate of patient receivables
    that may not be collected by our affiliated practices. The allowance percentage
    is determined based upon our experience in collecting patient receivables on
    behalf of affiliated practices. Managements estimates may change based
    on future conditions and circumstances. Recoverability of Assets Related to Non-Performing Practices At March 31, 2004, we had approximately $32.0 million of assets recorded
in our condensed consolidated balance sheets associated with Non-Performing
Practices, which consisted of $19.0 million of identifiable intangible assets,
$2.9 million of property, equipment, and improvements, net of accumulated
amortization and depreciation, and $10.0 million of service fees receivable and
advances to affiliated practices, net of allowances for uncollectible amounts.
The assessment of the recoverability of these assets is complex and requires
significant judgment by management due to certain factors, primarily the
uncertainty of litigation, evaluation of the outcome of pending litigation, the
lack of financial information provided to us from these practices, the
uncertainty of these practices fulfilling their contractual obligations to us
and estimated amounts expected to be received from these practices under terms
of their Service Agreements. Management estimates the amounts to be received
from these practices using historical data, experience in resolving these
situations and the practitioners willingness to resolve the matter.
Management has favorably resolved some of the lawsuits filed by OrthAlliance
where these practices have paid us cash in excess of the net book value of the
assets attributable to these practices. We have established allowances on
certain amounts due from these practices and believe the net amounts recorded
are realizable as of March 31, 2004. In addition, we believe that we may
receive
cash in excess of the net book value of the assets attributable to these
practices; however, adverse results from litigation could significantly affect
the recoverability of these assets and may require us to write off these assets
in the future. SERVICE AGREEMENTS WITH AFFILIATED PRACTICES We provide business services to an affiliated practice under an agreement
with an affiliated orthodontist or pediatric dentist and/or his or her
wholly-owned professional entity. The form of agreement used for a particular
affiliated practice is based upon the dental regulatory provisions of the state
in which the affiliated practice is located. In most states, we use a form of
service agreement, with some minor variations from state to state. In a small
number of states with particularly stringent laws relating to the practice of
dentistry, we use a consulting agreement, which also varies somewhat from state
to state. OrthAlliance and its affiliated practices are parties to service,
management service and consulting agreements that differ in some respects from
the service and consulting agreements that OCA has historically used. The
terms of the Service Agreements typically range from 20 to 40 years, with most
ranging from 20 to 25 years. The Service Agreements generally provide for monthly service fees based
upon a percentage of the practices operating profit or practice revenue and
reimbursement of practice-related expenses. Excluding reimbursement of
practice-related expenses, these service fees generally equal about 40% to 50%
of a practices operating profit or about 17% of a practices revenue. 25




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ORTHALLIANCE AFFILIATED PRACTICES In November 2001, OrthAlliance became our wholly-owned subsidiary. Before
we entered into the merger agreement with OrthAlliance, we anticipated that a
number of OrthAlliance practices would oppose the merger because of
disappointment with OrthAlliances stock price, unwillingness to affiliate with
a competing business services provider and perceived differences in the
companies cultures and operating strategies. We factored these risks into the
economics of the merger consideration. A number of OrthAlliance affiliated
practices have filed lawsuits against OrthAlliance, alleging, among other
things, that OrthAlliance breached their Service Agreements and that the
agreements are illegal and unenforceable. During 2002, we established a settlement task force comprised of key
members of our executive management team to focus on potential settlements of
litigation or disputes with OrthAlliance affiliated practices. At March 31,
2004, we were engaged in litigation with 53 OrthAlliance affiliated practices
that have ceased paying service fees to us and for which we had generally
ceased to record patient revenue. In addition, we were affiliated with another
33 OrthAlliance practices that have also ceased paying service fees to us and
for which we had generally ceased recording patient revenue but that have not
filed litigation at March 31, 2004. From January 1, 2002 to March 31, 2004, we
engaged in the following transactions with OrthAlliance affiliated practices:  
    
    12 OrthAlliance affiliated practices agreed to buy out of
their service or consulting agreements with OrthAlliance by paying
us to terminate their affiliation with OrthAlliance;
    
    six OrthAlliance affiliated practices transitioned their
practice to another affiliated practice;
    
    nine OrthAlliance affiliated practices amended their service
or consulting agreements in connection with the incentive programs
offered to OrthAlliance affiliated practitioners and continued to be
affiliated with OrthAlliance; and
    
    nine OrthAlliance affiliated practices entered into other
amendments to their service or consulting agreements and continued
to be affiliated with OrthAlliance. None of the above transactions had a material effect on our financial
statements. Based on our experience in favorably resolving some of the lawsuits filed
by OrthAlliance affiliated practices and discussions with some of the other
OrthAlliance affiliated practices who are parties to pending litigation or
their representatives, we currently believe that some of these practices will
settle their lawsuits by paying us an amount of cash in exchange for
termination or modification of their service, consulting and management service
agreements with OrthAlliance, depending upon the parties ability to reach an
agreement as to the amount to be paid. We cannot assure you that such an
agreement or settlement will be reached in any of these lawsuits. We also
cannot, at this time, predict the outcome of these lawsuits or assure you that
we will prevail in any of them, nor can we estimate at this time the amount of
damages that we might incur or receive in these actions. SEASONALITY Historically, our affiliated practices typically experience higher patient
case starts resulting in higher revenue during the summer months, when most
children are not in school. During the fourth quarter, which includes the
Thanksgiving and Winter Holiday season, our affiliated practices have
experienced reduced volume. 26




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##### Table of Contents



RESULTS OF OPERATIONS As a result of adopting the provisions of FIN 46R, the presentation of our
condensed consolidated statements of income (loss) for the three months ended
March 31, 2004 and 2003 has changed. Our adoption of FIN 46R had a significant
impact on our results of operations and financial condition and significantly
impacts the comparability of our consolidated financial statements for prior
periods. As a result, we have included in our discussion below a comparison of
actual results for the first quarter of 2004 to pro forma results for the first
quarter of 2003 assuming the adoption of FIN 46R was effective January 1, 2003. The following discussion provides an analysis of our results of operations
for the three months ended March 31, 2004 and 2003. The following table
provides information about (a) the percentage of patient revenue or fee revenue
represented by certain items in our condensed consolidated statements of income
(loss) for the periods indicated, (b) for those same items, the percentage of
patient revenue for the three months ended March 31, 2003 calculated as if our
adoption of FIN 46R was effective as of January 1, 2003, and (b) the percentage
increase or decrease in those items from period to period: Threemonths
        
        Pro Forma
        
        Percentageended
        
        Three months
        
        Increase/(Decrease)March 31,
        
        endedMarch 31,
        
        2004 to 2003
        
        2004 to 20032004
        
        2003
        
        2003 (1)
        
        Actual
        
        Pro formaPatient revenue and
            fee revenue, respectively
        
        
        100.0
        %
        
        
        100.0
        %
        
        
        100.0
        %
        
        
        N/A
        
        
        
        14.6
        %Direct expenses:Amounts retained
            by practitioners
        
        
        29.5
        
        
        
        
        
        
        
        24.6
        
        
        
        N/A
        
        
        
        17.8Salaries and benefits
        
        
        24.6
        
        
        
        29.1
        
        
        
        25.9
        
        
        
        (7.0
        )%
        
        
        (7.0
        )Clinical supplies
            and lab fees
        
        
        8.2
        
        
        
        10.5
        
        
        
        9.4
        
        
        
        (13.7
        )
        
        
        (13.7
        )Rent
        
        
        6.5
        
        
        
        9.5
        
        
        
        8.4
        
        
        
        (24.4
        )
        
        
        (24.4
        )Marketing and advertising
        
        
        4.7
        
        
        
        6.2
        
        
        
        5.5
        
        
        
        (15.9
        )
        
        
        (15.9
        )Total direct expenses
        
        
        73.5
        
        
        
        55.3
        
        
        
        73.8
        
        
        
        46.5
        
        
        
        (2.3
        )General and administrative
        
        
        11.7
        
        
        
        12.9
        
        
        
        11.3
        
        
        
        (0.1
        )
        
        
        1.4Depreciation
        
        
        3.4
        
        
        
        3.5
        
        
        
        3.1
        
        
        
        (3.6
        )
        
        
        7.3Amortization
        
        
        0.2
        
        
        
        2.4
        
        
        
        0.2
        
        
        
        (93.0
        )
        
        
        0.0Asset impairments
        
        
        
        
        
        
        0.7
        
        
        
        0.6
        
        
        
        N/A
        
        
        
        N/AOperating income
        
        
        11.2
        
        
        
        25.2
        
        
        
        10.9
        
        
        
        (50.9
        )
        
        
        1.0Income before income
            taxes and cumulative effect
        
        
        10.3
        
        
        
        23.8
        
        
        
        9.5
        
        
        
        (52.4
        )
        
        
        5.8Income before cumulative
            effect of change in accounting principle
        
        
        6.5
        
        
        
        14.8
        
        
        
        5.9
        
        
        
        51.4
        
        
        
        8.5Cumulative effect,
            net of income tax benefit
        
        
        (67.3
        )
        
        
        0.0
        
        
        
        0.0
        
        
        
        N/A
        
        
        
        N/ANet income (loss)
        
        
        (60.8
        )
        
        
        14.8
        
        
        
        5.9
        
        
        
        (552.3
        )
        
        
        N/A
   (1)
    
    Presented on a pro forma basis as if our adoption of FIN 46R was
effective as of January 1, 2003. Net Income (Loss). Net loss for the three months ended March 31, 2004 was
$67.4 million compared to net income of $14.9 million for the same period in
2003. As previously discussed, we adopted FIN 46R on January 1, 2004 which
required us to consolidate our affiliated practices. As a result, we recorded
a cumulative effect of a change in accounting principle of $74.7 million, net
of income tax benefit of $41.4 million. The following discusses the significant factors affecting net income
(loss): Patient Revenue and Fee Revenue.The consolidation provisions of FIN 46R
requires us to record patient revenue of our affiliated practices in our
consolidated financial statements. Patient revenue is recognized on a
straight-line basis over the term of the patient contract, except for a portion
related to retainers, which is recognized in the final month of treatment when
braces are removed and retainers are provided to the patient. Fee revenue
represented amounts related to services provided to affiliated practices and
recorded under our prior revenue recognition policy. Patient revenue for the
three months ended March 31, 2004 was $110.9 million. 27




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On a pro forma basis, calculated as if our adoption of FIN 46R was
effective as of January 1, 2003, patient revenue slightly decreased to $110.9
million for the three months ended March 31, 2004 from $112.9 million for the
three months ended March 31, 2003. The following factors affected our patient
revenue for the two periods compared on a pro forma basis: (A) increase of $9.8
million, or 9.8%, in patient revenue from Base Practices and (B) decrease of
$11.9 million, or 98.0%, in patient revenue from Non-Performing Practices for
which we generally no longer recorded patient revenue at March 31, 2004. The
increase of $9.8 million on a pro forma basis in patient revenue from Base
Practices was primarily due to an increase in patient revenue growth of 12.6%
for practices for which we recorded patient revenue throughout the three months
ended March 31, 2004 and 2003, calculated as if our change in accounting
principle occurred on January 1, 2003. At March 31, 2004, we were affiliated with 323 practices for which we were
recording patient revenue, compared with 342 practices for which we were
recording fee revenue at March 31, 2003. This represents a net reduction of 19
affiliated practices. Most of these practices were affiliated with
OrthAlliance. We expect some continued fluctuations in patient revenue as
OrthAlliance affiliated practices may buy out of their Service Agreements or
stop paying service fees and providing certain financial information we use to
compute patient revenue. However, certain practices that are not currently
included in our results may begin utilizing our services and paying service
fees in the future or may be transitioned to another practice. The decline in
patient revenue from practices for which we discontinued recording revenue also
contributed to a decline in direct expenses, as discussed below. Direct Expenses.Direct expenses include all operating costs of our
affiliated practices, amounts retained by practitioners and expenses of
our corporate office.  
    
    Amounts retained by practitioners represents amounts
that have been retained by practitioners under the
contractual terms of their Service Agreements. The consolidation
provisions of FIN 46R requires us to record these amounts in our
financial statements. Amounts retained by practitioners
primarily includes compensation of owner practitioners and associate
practitioner salaries.
    
    Salaries and benefits includes payroll and benefits costs for
employees at our corporate headquarters and affiliated centers
(which do not include the orthodontists, dentists and other licensed
professionals).
    
    Clinical supplies and lab fees, which primarily represents the
costs of bands, brackets, wires, retainers and other removable or
fixed appliances and laboratory costs incurred in treating patients
by our affiliated practices,
    
    Rent expense, which primarily consists of costs of leasing
office space, including common area maintenance charges, for our
affiliated centers and corporate headquarters, and
    
    Marketing and advertising expense, which represents costs
associated with television, radio and print media advertising for
affiliated practices. During the three months ended March 31, 2004, direct expenses increased
$25.9 million, or 46.6%, to $81.5 million from $55.6 million for the same
period in 2003. This overall increase during the three months ended March 31,
2004 was primarily due to amounts retained by affiliated practices. On a pro
forma basis, calculated as if our adoption of FIN 46R and change in revenue
recognition policy were effective as of January 1, 2003, direct expenses
decreased $1.9 million, or 2.3%, to $81.5 million for the three months ended
March 31, 2004 from $83.4 million for the three months ended March 31, 2003. Amounts
retained by practitioners totaled $32.7 million, or 29.5%
of patient revenue, for the three months ended March 31, 2004. On a pro forma
basis, calculated as if our adoption of FIN 46R 28




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was effective as of January 1,
2003, amounts retained by practitioners was $27.7 million, or 24.6% of
patient revenue, for the three months ended March 31, 2003. The $4.9 million
increase on a pro forma basis in amounts retained by practitioners
during the three months ended March 31, 2004 was primarily due to the increase
in patient revenue growth. The increase in amounts retained by
practitioners as a percentage of patient revenue on a pro forma basis was primarily
due to an increase in the profitability of certain affiliated
practices, increased participation in our service fee rebate incentive program for higher revenue
producing practices and the phase-out of corporate-level expense
allocation among certain affiliated practices. Except for amounts retained by
practitioners, all other direct costs decreased $6.8 million to $48.8
million for the three months ended March 31, 2004 from $55.6 million for the
three months ended March 31, 2003. This decrease was primarily due to a net reduction in the number of affiliated practices
for which we recorded direct expenses during the first quarter of 2004, as a result of practices that
bought out of their Service Agreements or which we generally ceased to record
fee revenue or patient revenue after March 31, 2003. Our adoption of FIN 46R did not affect our direct expenses
other than amounts retained by affiliated practices. General and Administrative. General and administrative expense represents
other costs incurred in the operation of our business, including costs for
telephone, utilities, accounting and legal services, office supplies, general
liability and property insurance coverage and provisions for uncollectible
amounts. During the three months ended March 31, 2004 and 2003, general and
administrative expense was $12.9 million. Amortization.Amortization represents the amortization expense on our
identifiable intangible assets. For the three months ended March 31, 2004,
amortization expense was $0.2 million compared to $2.7 million for the same
period in 2003. The decrease in amortization expense during the three months
ended March 31, 2004 compared to the same period in 2003 was primarily due to
the adoption of FIN 46R. The consolidation provisions under FIN 46R required
us, for financial reporting purposes only, to recognize affiliations with our
affiliated practices (other than Non-Performing Practices) as a business
combination, which resulted in us recording as goodwill the amount of
affiliation payments to obtain or amend Service Agreements that exceed the fair
value of tangible assets acquired. We do not amortize goodwill but test it for
impairment under SFAS No. 142. We continue to amortize identifiable
intangible assets associated with Non-Performing Practices. Asset impairments. During the three months ended March 31, 2003, we
recorded impairments of approximately $0.4 million related to property,
equipment and improvements for offices closed during 2003 and approximately $0.3
million related to intangible assets. Income Taxes.Our effective income tax rate was 36.5% for the three
months ended March 31, 2004 and 37.8% for the three months ended March 31,
2003, respectively. We record a liability for matters of uncertainty or
dispute with tax authorities as a component of deferred taxes. We assess this
liability on a quarterly basis and reduced our effective rate during the three
months ended March 31, 2004. Cumulative Effect.During the three months ended March 31, 2004, we
recorded a cumulative effect of a change in accounting principle of $74.7
million, net of income tax benefit of $41.4 million, with respect to our
adoption of FIN 46R effective January 1, 2004. See the table under Adoption
of FIN 46R  Consolidated Balance Sheets above for
additional information about the components of this cumulative effect. LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents was $11.3 million at March 31, 2004 and $7.4
million at December 31, 2003. Our working capital (total current assets less
total current liabilities) was $70.1 million at March 31, 2004, compared to
$142.8 million at December 31, 2003. Our current ratio (total current assets
divided by total current liabilities) was 1.5 at March 31, 2004, compared to
4.6 at December 31, 2003. The decrease in working capital at March 31, 2004
compared to December 31, 2003 was primarily due to 29




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a decrease of $96.7 million
in service fees receivable and an increase of $92.3 million in deferred
revenue, offset by an increase of $123.0 million in patient receivables. The
changes in these accounts was primarily due to our adoption of FIN 46R
effective January 1, 2004 and the impact these changes had on certain of our
balance sheet items, including the items mentioned above. During the three
months ended March 31, 2004, we did not borrow under our line of credit but
generated excess cash from operations to fund our capital expenditures and to
reduce our debt. At March 31, 2004, we had $20.4 million available to borrow
under our credit facility. We expect to continue generating excess cash to meet
our capital requirements and liquidity needs during the remainder of 2004. Uses of Capital We believe that our cash needs will primarily relate to capital
expenditures for existing affiliated practices and for the development of
additional centers, repayment of indebtedness, incentive payments and general
corporate purposes. Our cash needs could vary significantly depending upon our
growth, results of operations and new affiliations with additional practices,
as well as the outcome of pending litigation and other contingencies. Capital Expenditures.Our capital expenditures primarily consist of costs
related to developing de novocenters and remodeling and maintenance
expenditures at existing centers for our affiliated practices. The average
costs of developing a new orthodontic center in the United States is about
$350,000, including the cost of equipment, leasehold improvements, working
capital and start-up losses associated with the initial operations of the
orthodontic center. These costs are shared by us and the particular affiliated
practice. We generally bear an affiliated practices share of these costs until
we are reimbursed by the practice. Under most of our Service Agreements, the
affiliated practices repay these costs over a five-year period. In some cases,
we have assisted our practices in obtaining financing for their share of these
costs by providing a guaranty of loans from our primary lender. We generally no
longer guarantee new debt for our affiliated practices. During our rapid growth in the 1990s, we expended a disproportionately
high amount of our capital investment on de novocenters relative to
expenditures on existing centers. During recent years, however, our capital
expenditures have been increasingly directed toward remodeling, improving and
expanding our existing affiliated centers to facilitate internal growth. During
recent years, we also invested significantly in computer systems infrastructure
and other technology for our affiliated centers, such as advanced digital
cameras or DSL data delivery capability. In addition, we continue to invest in
our international operations. We currently expect to incur capital
expenditures of at least $15.5 million during the remainder of 2004, primarily
in connection with the development of de novocenters. We expect to fund these
capital expenditures using cash generated from operations. Advances to Affiliated Practices.We advance cash to affiliated practices
primarily against future distributions of the practice or provide advances
relating to amounts due to us under service agreements. We generally advance
cash to affiliated practices to (a) fund compensation for the practices
affiliated practitioners during the startup or expansion phase of a newly
developed center, (b) provide additional funds to affiliated practices for
certain practice-related matters or other unsecured financing or (c) finance
the acquisition of another practice. Newly-developed affiliated practices and
existing affiliated practices that expand their capacity by adding additional
centers or practitioners typically experience cash flow needs until they begin
generating sufficient operating profits at the newly-developed or
newly-expanded centers. We may advance funds to affiliated practices to assist
them in maintaining their compensation during the startup or expansion phase of
their practices. We also provide advances related to amounts due to us under
Service Agreements by (1) remitting more funds during the quarter to the
affiliated practice than the practice was actually entitled to retain under its
service agreement, (2) paying expenses to third parties on behalf of certain
affiliated practices that collect their own patient fees and do not reimburse
us for those expenses or (3) not receiving all service fees due from certain
affiliated practices that collect their own patient fees. 30




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These advances are payable on demand and generally interest free and
unsecured. We intend to fund these advances and any continued financing using
cash from operations and borrowings under our credit facility, if
needed. See  Adoption of FIN 46R regarding accounting treatment of these advances. Incentive Program Payments, Notes Payable and Debt Obligations.Certain
OrthAlliance affiliated practices are eligible, in connection with amending or
extending Service Agreements, to receive annual payments under our incentive
programs in 2004 and 2005. If all conditions are met under these programs
during 2004, we would pay participants an aggregate of $6.1 million for amounts
earned in 2004. At March 31 2004, we had current maturities of $8.3 million
under our credit facility and $2.4 million due to our affiliated practices. We
expect cash flow from operations to fund these payments during 2004. Stock Repurchase Program.In August 2003, our Board of Directors approved
a common stock repurchase program that authorizes us to repurchase up to 2.0
million shares of our common stock from time to time in the open market at
prevailing market prices or in privately negotiated transactions. We anticipate
making repurchases of our common stock in the future under this program.
Repurchased shares are held in treasury, and may be available for use in
connection with our stock option plans, stock programs and acquisitions or for
other corporate purposes. Sources of Capital We currently believe that we will be able to meet our anticipated funding
requirements for at least the next 12 months. However, our ability to meet
these funding needs could be adversely affected if we were to suffer adverse
results from our operations, or lose a material portion of our affiliated
practices, if our affiliated practices were to suffer adverse results of
operations or a material loss of patients, if we suffer adverse outcomes from
pending litigation and other contingencies or if we violate the covenants and
restrictions of our credit facility. Cash from Operations.We expect to fund our cash needs primarily from
cash flows from our operations. During the three months ended March 31, 2004,
we used our deferred tax assets relating to net operating loss carryforwards to
offset our tax provision for the first quarter of 2004. These net operating
loss carryforwards primarily related to the cumulative effect of (a) a change
in accounting method for recognizing revenue for income tax purposes approved
by the IRS in January 2003 and (b) a change in accounting method related to
applicable class lives for certain long-lived assets filed during 2003 pursuant
to IRS rules that provide for an automatic change in accounting method. We
expect that the remaining net operating loss carryforwards will substantially
offset our income tax liability for the remainder of 2004. We expect to use the
cash arising from this benefit to fund other operational needs for the
remainder of 2004. We also have deferred tax assets of $41.4 million recorded
as a result of the cumulative effect from the adoption of FIN 46R. We
anticipate monetizing this deferred tax asset in the future. Credit Facility.We maintain a $125.0 million credit facility with a
lending group that consists of Bank of America, N.A., Bank One, N.A., U.S. Bank
National Association, Hibernia National Bank and Whitney National Bank. The
credit facility is comprised of a $100.0 million revolving line of credit and a
$25.0 million term loan. The revolving line of credit provides funding for our
general working capital and expansion. Borrowings under the credit facility
generally bear interest at varying rates above the lenders prime rate ranging
from 0.50% to 1.50% or above the Eurodollar rate ranging from 1.50% to 2.50%.
This margin is based on our leverage ratio as computed under the credit
facility. Amounts borrowed under the credit facility are secured by a security
interest in the capital stock of our operating subsidiaries. The revolving
line of credit expires January 2, 2006. At March 31, 2004, $79.6 million was
outstanding under the revolving line of credit and $14.4 million was
outstanding under the term loan. The term loan is fully amortizing over three
years with level, quarterly principal payments of $2.1 million, plus interest. 31




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Our credit facility requires that we maintain certain financial and
non-financial covenants under the terms of the credit agreement, including a
maximum leverage ratio, minimum fixed charge coverage ratio, minimum
consolidated net worth and maximum ratio of funded debt to total patient
contract balances. The credit agreement also imposes restrictions on our
acquisitions, investments, dividends, stock repurchases and other aspects of
our business. If we do not comply with these covenants and restrictions, the
lenders could demand immediate payment of all amounts borrowed under the credit
facility, and terminate our ability to borrow funds under the credit facility.
If we were to experience an event or matter that has, or is reasonably likely
to have, a material adverse effect (as defined in the credit facility) on us,
we would be unable to borrow additional amounts under the credit facility
without a waiver by our lenders or an amendment to the credit facility. We
cannot assure you that we could obtain such a waiver or amendment, which could
have a material adverse impact on our liquidity and capital resources. At
March 31, 2004, we were in compliance with the covenants and restrictions under
the credit facility. Other Sources.We are also exploring the possibility of monetizing
certain of our assets through securitization and other forms of financing to
raise capital. Funds generated from these activities would be used to repay
indebtedness, to repurchase shares of our common stock and for working capital
and general corporate purposes. Cash Flows The following table summarizes cash flow information for the three months ended
March 31, 2004 and 2003: Three months endedMarch 31,2004
    
    2003Net cash provided by operating activities
    
    $
    14,674
    
    
    $
    12,884Net cash used in investing activities
    
    
    (7,968
    )
    
    
    (6,107
    )Net cash used in financing activities
    
    
    (2,380
    )
    
    
    (1,963
    )Change in cash and cash equivalents
    
    
    3,954
    
    
    
    4,604
 Operating Activities.See our discussion of net income in the section
above captioned  Results of Operations. Our working capital decreased 50.9%
to $70.1 million at March 31, 2004 from $142.8 million at December 31, 2003,
primarily as a result of our adoption of FIN 46R. Investing Activities.Net cash used in investing activities during the
three months ended March 31, 2004 was comparable to the net cash used during
the same period in 2003. We used $5.1 million and $4.3 million in cash to
purchase property, equipment and improvements during the three months ended
March 31, 2004 and 2003, respectively. These expenditures primarily related to
the development of new or de novocenters in the United States and abroad and
the remodeling or refurbishing of existing centers. We expect to make
additional purchases of property, equipment and improvements in future periods
as we open and refurbish additional centers. We currently expect to spend
approximately $15.5 million during the remainder of 2004. Financing Activities.Net cash used in financing activities was $2.4
million and $2.0 million for the three months ended March 31, 2004 and 2003,
respectively. During the three months ended March 31, 2003, we obtained a new
credit facility under which we borrowed $109.9 million to retire our prior
credit facility and bridge credit facility and to pay related transaction
costs. 32




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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK During the three months ended March 31, 2004, there were no material
changes to the quantitative and qualitative disclosures about market risks
presented in our Annual Report on Form 10-K for the year ended December 31,
2003. 
 ITEM 4. CONTROLS AND PROCEDURES **Evaluation of Disclosure Controls
    and Procedures** We, with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, carried out an evaluation of the
effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934) as of the end of the period covered by this Report.
Based upon that evaluation and as of the end of the period covered by the
Report, our Chief Executive Officer and Chief Financial Officer concluded that
our disclosure controls and procedures are effective in timely alerting them to
information required to be disclosed in our reports that we file or submit to
the SEC under the Securities Exchange Act of 1934, subject to certain
enhancements to our internal controls as described below. **Changes in Internal Control
    Over Financial Reporting** In April 2004, we received a letter dated March 15, 2004 from Ernst &
Young LLP, our former independent auditors, stating that they believed that
there were material weaknesses in internal controls over our financial
statement close process. Our senior management and the members of our Audit
Committee are reviewing carefully this letter and Ernst & Youngs related
recommendations, and are developing a plan to address each item in the letter. Certain
    items in the letter from Ernst & Young may no longer be applicable due
    to our adoption of FIN 46R and change in revenue recognition policy effective
    January 1, 2004. Among other things, these changes eliminated the need to
    calculate fee revenue and service fees receivable, since these accounts are
    no longer recorded in our consolidated financial statements. The determination
    of fee revenue under our prior revenue recognition policy required significant
    judgments by management to determine the portion of a straight-line allocation
    of patient contract amounts that was estimated to be retained by affiliated
    practices in future periods, as well as the portion of unreimbursed practice-related
    expenses that was secured by patient fees receivable and therefore recognizable
    as fee revenue. These complex and data-intensive calculations are not applicable
    under our new revenue recognition policy. Since
    December 31, 2003, we have taken certain steps to enhance our internal
    control over financial reporting. These enhancements include increased automation
    in determining our patient revenue and patient receivables.
    We have also taken steps to improve communication between our operations and
financial accounting areas, including appointment of a chief financial
    officer with experience in our operations area. We have also
formed a committee
    that includes representatives of our operations, legal and
financial accounting areas to periodically discuss and assess our pending litigation
    with affiliated practices and assets associated with those practices.
    We are working to further document and enhance our controls and
procedures.
    We intend to hire additional staff in our financial accounting
area and to engage outside consultants to advise our management on additional
    enhancements to our internal controls. 33




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PART II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS OrthAlliance Related Litigation Before we entered into the merger agreement with OrthAlliance, we
anticipated that some portion of OrthAlliances affiliated practices would
oppose such a merger. A description of actions brought by certain OrthAlliance
affiliated practices and the claims in these actions is contained in Item 3 of
Part I to our Annual Report on Form 10-K for the year ended December 31, 2003.
At March 31, 2004, 53 OrthAlliance affiliated practices were parties to actions
against OrthAlliance that were pending in courts in a number of states. One
OrthAlliance affiliated practice filed suit against OrthAlliance in the first
quarter of 2004. In addition, another 33 OrthAlliance affiliated practices had
not filed lawsuits against OrthAlliance but had ceased paying us service fees
at March 31, 2004. OrthAlliance has successfully resolved disputes with a number of
non-performing OrthAlliance affiliated practices that were engaged in
litigation with it and/or had ceased paying service fees. From January 1, 2002
to March 31, 2004, OrthAlliance engaged in the following transactions with
non-performing OrthAlliance affiliated practices:  
    
    12 practices agreed to buy out of their service or consulting
agreements with OrthAlliance by paying OrthAlliance to terminate
their affiliation with OrthAlliance;
    
    six practices transitioned their practice to another
affiliated practice;
    
    nine practices amended their service or consulting agreements
in connection with the incentive programs offered to OrthAlliance
affiliated practitioners and continued to be affiliated with
OrthAlliance; and
    
    nine practices entered into other amendments to their service
or consulting agreements and continued to be affiliated with
OrthAlliance. Based on our experience in favorably resolving some of the lawsuits filed
by OrthAlliance affiliated practices and discussions with some of the other
OrthAlliance affiliated practices who are parties to pending litigation or
their representatives, we currently believe that some of these practices will
settle their lawsuits by paying OrthAlliance an amount of cash in exchange for
termination or modification of their service agreement with OrthAlliance,
depending upon the parties ability to reach an agreement as to the amount to
be paid. We cannot assure you that such an agreement or settlement will be
reached in any of these lawsuits. We also cannot, at this time, predict the
outcome of these lawsuits or assure you that OrthAlliance will prevail in any
of them, nor can we estimate with reasonable certainty at this time the amount
of damages that OrthAlliance might incur or receive in these actions. On March 1, 2004, the U.S. District Court for the Western District of
Washington ruled on the plaintiffs motion for summary judgment in a lawsuit
filed against OrthAlliance by Dr. David L. Crouch and Dr. Donald L. Grim. The
court held that the overall relationship between OrthAlliance and the
orthodontic practices violated a Washington statute governing the corporate
practice of dentistry and that OrthAlliances service agreements with the
practices, and the employment agreements between the orthodontists and their
professional corporations were illegal. The court dismissed the orthodontists
other claims and OrthAlliances counterclaims, and no damages were awarded. The
court relied on a series of Washington state court decisions to look beyond the
express terms of the contracts, which the court viewed to be legal on their
face, to the courts view of the underlying effect and purpose of the
contracts. OrthAlliance filed notice of appeal of the ruling in this case on
March 4, 2004 and believes that it has meritorious grounds to overturn this
ruling on appeal. 34




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On April 23, 2004, the U.S. District Court for the Northern District of
Texas ruled on the plaintiffs motion for summary judgment in a lawsuit filed
by Dr. Ronald Barnett, Dr. Robert Buck, Dr. Monte Collins, Dr. Michael Habern,
Dr. Lester Kuperman, Dr. Joe Richards, Dr. Claude Stevens, and Dr. Hal
Stevenson against OrthAlliance, which was consolidated with the case captioned
Penny v. OrthAlliance, Inc.Consistent with the courts prior ruling in the
Pennycase, the court held that, when construed together, the purchase
agreements and service agreements between the plaintiffs and OrthAlliance and
the employment agreements between the individual plaintiffs and their practices
violated Texas statutes prohibiting the unauthorized practice of dentistry and
were therefore invalid. No damages were awarded. This ruling is limited to
these plaintiffs and Texas law, and does not apply to the enforceability of
service agreements or employment agreements with any other practices.
OrthAlliance appealed the Pennyruling on January 21, 2004, but this ruling has
not yet been certified for appeal. OrthAlliance believes that it has
meritorious grounds to overturn the Pennyruling on appeal. On April 26, 2004, the U.S. District Court for the District of Colorado
ruled on the parties motions for summary judgment in a lawsuit filed by Dr.
Kirk J. Nielson and Dr. S. Kent Lauson against OrthAlliance. The court granted
OrthAlliances motion for summary judgment dismissing the plaintiffs claim of
fraud and negligent misrepresentation. The court also granted the plaintiffs
motion for summary judgment, holding that the purchase agreements and service
agreements between the plaintiffs and OrthAlliance and the employment
agreements between the individual plaintiffs and their practices were illegal
and that the covenants not to complete within the agreements were
unenforceable. The court found that the overall relationship between
OrthAlliance and the orthodontic practices violated Colorado statutes
prohibiting the unauthorized practice of dentistry and were therefore illegal.
No damages were awarded. OrthAlliance intends to challenge this ruling and
believes that it has meritorious grounds to overturn this ruling on appeal. On May 11, 2004, a jury rendered a verdict in favor of Hester & Fender,
D.M.D., P.C. and Mitchell Dentistry, P.C. on a breach of contract claim in a
lawsuit filed against OrthAlliance in the U.S. District Court for the Northern
District of Georgia. The lawsuit was originally filed in September 2001.
OrthAlliance had also filed a counterclaim against the plaintiffs in the
action. Two other plaintiffs that were part of the action settled their claims
with OrthAlliance prior to the trial. Also prior to the trial, the court
granted OrthAlliance a partial summary judgment denying the plaintiffs any
claim to damages. At trial, the plaintiffs alleged and the jury found that,
prior to our acquisition of OrthAlliance in November 2001, OrthAlliance
breached the terms of the plaintiffs Service Agreements. The jury did not
award OrthAlliance damages. The verdict resulted in termination of the
plaintiffs service agreements. OrthAlliance intends to appeal this decision. Each of these rulings was limited to the plaintiffs in those particular
cases and the laws of the particular states in which the practices were
located, and do not apply to the enforceability of Service Agreements or
employment agreements with any other practices. These rulings did not have a
material effect on the Companys results of operation or financial condition. On October 22, 2003, we filed a lawsuit in the Harris County, Texas
District Court against a number of defendants for interfering with our
contractual relationships with affiliated practices. The defendants include two
law firms, Locke, Liddell & Sapp, L.L.P. of Houston, Texas, and Goldstein,
Tanen & Trench, P.A. of Miami, Florida, and a number of orthodontists and
pediatric dentists who are represented by those firms in other litigation with
us or OrthAlliance. The complaint alleges that the defendants conspired to
persuade affiliated practices to breach their service agreements with us and
OrthAlliance in order to generate significant legal fees for the law firm
defendants and force us to agree to more favorable settlement terms with the
defendants. The complaint also alleges that the defendants used a series of
letters, emails, meetings, personal solicitations and Internet message board
postings to further their conspiracy. In addition, we allege that certain of
the practitioner defendants breached their service agreements. We seek to
enjoin the defendants from further interference with our contractual
relationships with affiliated practices. On April 23, 2004 the court granted
summary judgment for certain of the 35




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defendants, including Locke, Liddell & Sapp, L.L.P. and two Texas
orthodontists, denying any relief on our claims against these defendants. The
court did so based upon these defendants motions that argued that their
conduct did not provide us a cause of action. Although our claims against the
other defendants in the action were not dismissed, we elected voluntarily to
dismiss those defendants, without prejudice, so that we could appeal the
courts summary judgment ruling. Securities Class Action On April 10, 2003, Ilena and Guiseppe Chiaretti filed an action in the
United States District Court for the Eastern District of Louisiana against us
and Bartholomew F. Palmisano, Sr., our Chairman of the Board, President and
Chief Executive Officer, Bartholomew F. Palmisano, Jr., our Chief Operating
Officer, and Thomas J. Sandeman, our then Chief Financial Officer. Similar
actions were filed in the same court by other plaintiffs. On August 28, 2003,
the lawsuits were consolidated and John A. Matis, Trustee was appointed as lead
plaintiff. The consolidated action purported to be filed as a class action on
behalf of the plaintiffs and other purchasers of shares of our common stock
from November 14, 2002 to March 18, 2003, and alleged that we and the other
defendants violated Section 10(b) of the Securities Exchange Act of 1934, as
amended, and Rule 10b-5 thereunder, by allegedly making false and misleading
statements, and/or omitting to state material facts necessary to make the
statements made not misleading. On April 6, 2004, the court granted our motion
and ordered that the lawsuit be dismissed. The court found that the plaintiffs
had failed to state a claim that we or our officers violated federal securities
laws. On May 6, 2004, the court entered a judgment dismissing the case. The
plaintiffs have indicated that they will not appeal the courts ruling on the
motion to dismiss. General Because litigation is inherently uncertain, we cannot assure you that we
or our subsidiaries will prevail in any of these or other lawsuits, nor can we
estimate with reasonable certainty the amount of damages we might incur or the
amount of any award we might receive. We and our subsidiaries and affiliated
practices are, and from time to time may become, party to other litigation or
administrative proceedings which arise in the normal course of business.
Regardless of the outcome of such litigation and proceedings, they could be
costly, time-consuming and could divert the time and attention of our senior
management 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS Exhibit number
    
    Description3.1
    
    Bylaws of the Registrant (incorporated by reference to exhibits filed
with the Registrants Registration Statement on Form S-1, Registration
Statement No. 33-85326)3.2
    
    Restated Certificate of Incorporation of the Registrant (incorporated by
reference to exhibits filed with the Registrants Registration Statement
on Form S-1, Registration Statement No. 33-85326)4.1
    
    Specimen Stock Certificate (incorporated by reference to exhibits filed
with the Registrants Registration Statement on Form S-1, Registration
Statement No. 33-85326)
 36




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Exhibit number
    
    Description31.1
    
    Certification of the Chief Executive Officer of Orthodontic Centers of
America, Inc. pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities
Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of
the Sarbanes-Oxley Act of 200231.2
    
    Certification of the Senior Vice President of Finance and Chief Financial
Officer of Orthodontic Centers of America, Inc. pursuant to Rule 13a-14(a)
or 15d-14(a) under the Securities Exchange Act of 1934, as amended, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 200232.1
    
    Certification of the Chief Executive Officer of Orthodontic Centers of
America, Inc. pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of the Senior Vice President of Finance and Chief Financial
Officer of Orthodontic Centers of America, Inc. pursuant to 18 U.S.C. §
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   *
    
    Incorporated by reference to exhibits filed with the Registrants Annual
Report on Form 10-K for the year ended December 31, 2003 (File No.
001-13457). (b) REPORTS ON FORM 8-K During the three months ended March 31, 2004, we furnished a current
report on Form 8-K on March 4, 2004 reporting information under Item 5. Other
events and Item 7. Financial Statements and Exhibits and a current report on
Form 8-K on March 16, 2004 reporting information under Item 7. Financial
Statements and Exhibits and Item 12. Results of Operations and Financial
Condition. 37




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned thereunto duly authorized. Orthodontic Centers of America, Inc.
(Registrant)/s/ Bartholomew F. Palmisano, Sr.Bartholomew F. Palmisano, Sr.Chairman of the Board, President
and Chief Executive Officer /s/ David E. VerretDavid E. VerretSenior Vice President of Finance and
Chief Financial Officer Date: May 20, 2004 38




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EXHIBIT INDEX Exhibit number
    
    Description3.1
    
    Bylaws of the Registrant (incorporated by reference to exhibits filed
with the Registrants Registration Statement on Form S-1, Registration
Statement No. 33-85326)3.2
    
    Restated Certificate of Incorporation of the Registrant (incorporated by
reference to exhibits filed with the Registrants Registration Statement
on Form S-1, Registration Statement No. 33-85326)4.1
    
    Specimen Stock Certificate (incorporated by reference to exhibits filed
with the Registrants Registration Statement on Form S-1, Registration
Statement No. 33-85326)31.1
    
    Certification of the Chief Executive Officer of Orthodontic Centers of
America, Inc. pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities
Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of
the Sarbanes-Oxley Act of 200231.2
    
    Certification of the Senior Vice President of Finance and Chief Financial
Officer of Orthodontic Centers of America, Inc. pursuant to Rule 13a-14(a)
or 15d-14(a) under the Securities Exchange Act of 1934, as amended, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 200232.1
    
    Certification of the Chief Executive Officer of Orthodontic Centers of
America, Inc. pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of the Senior Vice President of Finance and Chief Financial
Officer of Orthodontic Centers of America, Inc. pursuant to 18 U.S.C. §
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   *
    
    Incorporated by reference to exhibits filed with the Registrants Annual
Report on Form 10-K for the year ended December 31, 2003 (File No.
001-13457). 39