The Company leases a total of approximately 68,000 square feet of office space in a single location in Aliso Viejo, California, under a lease agreement that expires in 2008. Approximately 12,000 square feet of this space is not currently used by the Company, but is subleased to unrelated third parties. The remaining 56,000 square feet of office space is used for the Company's corporate headquarters and its National Service Center, which includes member services activities, eligibility file maintenance, billing and collections, claims processing and other similar customer support activities, and for its California regional office. In addition, the Company leases office space in Irvine, California; Walnut Creek, California; Coral Springs and Tampa, Florida; and Dallas and Houston, Texas. The Company leased all of the office space used by its previously owned dental and orthodontic practices. The Company remains contingently liable for a number of these leases, which expire on various dates through 2007, as discussed in Note 12 to the accompanying consolidated financial statements. In the opinion of management, the Company's facilities are adequate for its current needs.
The selected financial data in the following table was derived from the audited consolidated financial statements of the Company. This data should be read in conjunction with such consolidated financial statements and notes thereto, and Management's Discussion and Analysis of Financial Condition and Results of Operations.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS - -------------------------------------------------------------------------------- OF OPERATIONS -------------
The statements contained in this MD&A concerning expected growth, the outcome of business strategies, future operating results and financial position, economic and market events and trends, future premium revenue, future health care expenses, the Company's ability to control health care, selling, general and administrative expenses, and all other statements that are not historical facts, are forward-looking statements. Words such as expects, projects, anticipates, intends, plans, believes, seeks or estimates, or variations of such words and similar expressions, are also intended to identify forward-looking statements. These forward-looking statements are subject to significant risks, uncertainties and contingencies, many of which are beyond the control of the Company. Actual results may differ materially from those projected in the forward-looking statements, which statements involve risks and uncertainties.
Goodwill as of December 31, 2003 consists of $3.2 million of goodwill related to the acquisition of Health Net Dental, Inc. ("HN Dental") and Health Net Vision, Inc. ("HN Vision") in October 2003, $5.3 million of goodwill related to the acquisition of Paramount Dental Plan, Inc. ("Paramount") in August 2002, and $3.9 million of goodwill related to the acquisition of First American Dental Benefits, Inc. ("First American") in 1996. See Note 2 to the accompanying consolidated financial statements for more information on the acquisitions of HN Dental, HN Vision and Paramount. In the case of each acquisition, goodwill represents the excess of the purchase price of the acquired company over the fair value of the net assets acquired, and in the case of the First American acquisition, the balance is net of accumulated amortization and an adjustment in 1999 to reduce the carrying value of the goodwill to its estimated realizable value. The Company estimated that the goodwill related to the First American acquisition had a useful life of 40 years from the date of acquisition, and amortized the goodwill over that period through December 31, 2001. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets," the Company ceased amortizing its goodwill effective January 1, 2002.
SFAS No. 142 requires that all goodwill be evaluated for possible impairment as of January 1, 2002, on an annual basis thereafter, and any time an event that may have affected the value of the goodwill occurs. SFAS No. 142 also establishes a new method of testing for possible impairment. The Company has established October 1 as the date on which it conducts its annual evaluation of goodwill for possible impairment. In accordance with SFAS No. 142, the Company tested its goodwill for possible impairment by estimating the fair value of each of its reporting units that include goodwill, and comparing the fair value of each reporting unit to the book value of the net assets of each reporting unit. The fair value of each reporting unit was determined primarily by estimating the discounted future cash flows of the reporting unit, and by estimating the amount for which the reporting unit could be sold to a third party, based on a market multiple of earnings. The Company had no impairment of its goodwill as of January 1, 2002, or as of October 1, 2003, based on the method of testing for possible impairment established by SFAS No. 142. The estimates to which the results of the Company's test are the most sensitive are the amount of shared administrative expenses that are charged to each reporting unit, and the market multiple of earnings that is used to estimate the fair value of each reporting unit. The Company believes the estimates used in its test are reasonable and appropriate, but a significant change in either of these estimates could result in the indication of an impairment of goodwill. The Company is not aware of any events that have occurred since October 1, 2003 that may have affected the value of its goodwill. However, there can be no assurance that impairment will not occur in the future.
Intangible assets as of December 31, 2003 consist of customer relationships, provider networks, and other intangible assets with an aggregate net book value of $9.9 million, which were acquired in connection with the acquisitions of HN Dental and HN Vision in October 2003, Ameritas Managed Dental Plan, Inc. in March 2003, and Paramount in August 2002. See Note 2 to the accompanying consolidated financial statements for more information on these acquisitions. The amount of the purchase price that was allocated to each of the intangible assets was equal to the Company's estimate of the fair value of each asset. Each intangible asset is being amortized over its estimated useful life on a straight-line basis.
The estimated liability for claims payable and claims incurred but not reported ("IBNR") is based primarily on the average historical lag time between the date of service and the date the related claim is paid by the Company, and
the recent trend in payment rates and the average number of incurred claims per covered individual. Since the liability for claims payable and claims incurred but not reported is an actuarial estimate, the amount of claims eventually paid for services provided prior to the balance sheet date could differ from the estimated liability. Any such differences are included in the consolidated statement of operations for the period in which the differences are identified.
The Company's accounting for income taxes is in accordance with SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of events that are recognized in the Company's financial statements in different periods than those in which the events are recognized in the Company's tax returns. The measurement of deferred tax liabilities and assets is based on current tax laws as of the balance sheet date. The Company records a valuation allowance related to deferred tax assets in the event that available evidence indicates that the future tax benefits related to deferred tax assets may not be realized. A valuation allowance is required when it is more likely than not that the deferred tax assets will not be realized. The Company's determination of whether a valuation allowance is required is subject to change based on future estimates of the recoverability of its net deferred tax assets.
Net income per share is presented in accordance with SFAS No. 128, "Earnings Per Share." Basic earnings per share is based on the weighted average common shares outstanding, including the common shares into which the convertible preferred stock is convertible, but excluding the effect of other potentially dilutive securities. The number of basic common shares outstanding includes the common share equivalents of the convertible preferred stock, because the holders of the convertible preferred stock participate in any dividends paid on the Company's common stock on an as-converted basis, and because the Company believes the convertible preferred stock is a participating security that is essentially equivalent to common stock, based on all the rights and preferences of both types of stock. Diluted net income per share is based on the weighted-average common shares outstanding, including the effect of all potentially dilutive securities. During the three years ended December 31, 2003, the potentially dilutive securities of the Company that were outstanding consisted of stock options, convertible notes, and warrants. See Note 8 to the accompanying consolidated financial statements for information on convertible notes that were outstanding during 2003 and 2002. The calculation of diluted net income per share for 2003 includes the effect of all the outstanding convertible notes. Each of these convertible notes would have an anti-dilutive effect on net income per share in 2002, and accordingly, they are excluded from the calculation of diluted net income per share for this period. The calculation of diluted net income per share for 2003, 2002 and 2001 includes the effect of all outstanding stock options with an exercise price below the average market price of the Company's common stock during each period. The only warrants issued by the Company were canceled without being exercised effective January 31, 2001, as discussed in Note 9 to the accompanying consolidated financial statements.
Health care services expense increased by $15.3 million, or 26.3%, from $57.9 million in 2002 to $73.2 million in 2003. Health care services expense as a percentage of premium revenue (the "loss ratio") was 69.8% in both 2003 and 2002. In 2003, the Company's mix of business shifted towards a higher proportion of HMO benefit plan designs, which was primarily due to the HN Dental, HN Vision and Paramount acquisitions. HMO benefit plan designs generally have lower loss ratios than PPO/indemnity benefit plan designs, and accordingly, this shift in the mix of business resulted in a slight decrease in the overall loss ratio. However, the effect of this shift was offset by a slight increase in the loss ratio on products with a PPO/indemnity plan design.
Selling, general and administrative ("SG&A") expense increased by $3.8 million, or 15.3%, from $24.9 million in 2002 to $28.7 million in 2003. SG&A expense as a percentage of premium revenue decreased from 29.9% in 2002 to 27.3% in 2003. The increase in SG&A expense is primarily due to increases in salaries and benefits, broker commissions, premium taxes, and amortization of intangible assets, all of which are directly related to the acquisitions of HN Dental, HN Vision and Paramount. The decrease in SG&A expense as a percentage of premium revenue is primarily due economies of scale that resulted from the acquisitions of HN Dental, HN Vision and Paramount.
Investment and other income decreased by $0.1 million, from $0.6 million in 2002 to $0.5 million in 2003. This decrease is primarily due to a decrease in interest rates on short-term fixed-income investments during the past year.
Interest expense increased by $0.3 million, from $0.2 million in 2002 to $0.5 million in 2003, primarily due to the borrowings made by the Company to finance the acquisition of HN Dental and HN Vision in October 2003 and the acquisition of Paramount in August 2002. See Notes 2 and 8 to the accompanying consolidated financial statements for information on outstanding debt.
Income before income taxes increased by $2.4 million, from $0.6 million in 2002 to $3.0 million in 2003. Income before income taxes as a percentage of premium revenue increased from 0.7% in 2002 to 2.8% in 2003. This increase was primarily due to a decrease in SG&A expense as a percentage of premium revenue, which was primarily due to the acquisitions of HN Dental, HN Vision and Paramount, as discussed above.
Premium revenue decreased by $1.8 million, or 2.1%, from $84.8 million in 2001 to $83.0 million in 2002. The average membership for which the Company provided dental coverage was approximately 616,000 members during 2002, compared to 615,000 members during 2001. Average membership increased in 2002 by approximately 80,000 members due to the Paramount acquisition, but this increase was offset by the loss of a number of the Company's customers, and a net decrease in its enrollment within retained customers. The Paramount acquisition added approximately 240,000 members to the Company during the last four months of 2002, which resulted in an average increase of 80,000 members for the full year. The operations of Paramount are included in the accompanying consolidated financial statements beginning on September 1, 2002. The Company believes the net decrease in its enrollment within retained customers is primarily due to reduced employment levels within its customers due to general economic conditions, and to reduced enrollment in the Company's dental benefit plans due to significant increases in the cost of medical coverage, which may cause employers and employees to allocate less spending for the purchase of dental coverage, which is usually viewed as being more discretionary than medical coverage. Premium revenue decreased by 2.1% in 2002 even though average membership was approximately the same in both years. This was primarily due to the Paramount acquisition, as the business acquired from Paramount consists largely of products that have significantly lower premium rates than the Company's pre-existing business. Substantially all of the Company's premium revenue was derived from dental benefit plans in 2002 and 2001. Premium revenue from vision benefit plans and other products was not material in 2002 or 2001.
Investment and other income decreased by $0.5 million, from $1.1 million in 2001 to $0.6 million in 2002. This decrease is primarily due to realized gains on the sale of investments in 2001, a decrease in interest rates on short-term fixed-income investments, a decrease in interest income from notes receivable, due to the liquidation of a portion of the Company's notes receivable during 2001, and a decrease in the amount of investments held by the Company, compared to the prior year. The decrease in the Company's investments was primarily due to significant reductions in accrued expenses and claims payable and IBNR during both 2002 and 2001. By intentionally accelerating its payment of claims, the Company intends to enhance its image among dental providers.
Interest expense decreased by $0.3 million, from $0.5 million in 2001 to $0.2 million in 2002, primarily due to the conversion of substantially all of the Company's debt into convertible preferred stock effective January 31, 2001, which eliminated nearly all of the Company's interest expense.
Income before income taxes decreased by $0.7 million, from $1.3 million in 2001 to $0.6 million in 2002. Income before income taxes as a percentage of premium revenue decreased from 1.5% in 2001 to 0.7% in 2002. This decrease was primarily due to an increase in the loss ratio, which was partially offset by a decrease in SG&A expense as a percentage of premium revenue, both as discussed above.
The Company's net working capital increased from $2.0 million as of December 31, 2002 to $13.5 million as of December 31, 2003, primarily due to the Company's earnings during 2003, the acquisition of HN Dental and HN Vision in October 2003, and the issuance of $19.0 million of convertible notes in October 2003. Net income less net deferred income tax benefits, plus depreciation and amortization expense, added approximately $5.0 million of working capital during 2003. HN Dental and HN Vision had an aggregate of $3.0 million of working capital as of the acquisition date, which added $3.0 million to the Company's working capital. In addition, the Company borrowed $19.0 million in connection with the acquisition of HN Dental and HN Vision, and the total cost of the acquisition was $15.2 million, resulting in a $3.8 million addition to working capital. See Note 2 to the accompanying consolidated financial statements for more information on the acquisition of HN Dental and HN Vision, and the $19.0 million of convertible notes.
The Company's total debt increased from $5.4 million as of December 31, 2002 to $22.9 million as of December 31, 2003, primarily due to $19.0 million of convertible notes issued in October 2003, in connection with the acquisition
In October 2003, the Company acquired all of the outstanding capital stock of HN Dental, which is a California dental HMO, and certain PPO/indemnity dental business underwritten by Health Net Life Insurance Company ("HN Life"), which was formerly an affiliate of HN Dental, for $10.7 million in cash, and an agreement to provide private label dental HMO and PPO/indemnity products to be sold in the marketplace by subsidiaries of Health Net, Inc., the former parent company of HN Dental, for a period of at least five years following the transaction, subject to certain conditions. In October 2003, the Company also acquired all of the outstanding capital stock of HN Vision, which is a California vision HMO and an affiliate of HN Dental, and certain PPO/indemnity vision business underwritten by HN Life, for $4.5 million in cash. The combined revenue of the acquired businesses was approximately $61 million during the ten months ended October 31, 2003. The operations of HN Dental, HN Vision, and the related dental and vision PPO/indemnity business are included in the Company's consolidated financial statements beginning on November 1, 2003.
In March 2003, the Company acquired all of the outstanding capital stock of Ameritas Managed Dental Plan, Inc. ("Ameritas") for $1.0 million in cash, plus contingent monthly payments during the five years following the acquisition date. Based on the amount of premium revenue during the period from April 1, 2003 to December 31, 2003, from customers of Ameritas that existed as of March 31, 2003, the maximum aggregate amount of the contingent monthly payments would be approximately $1.5 million, if the Company retained all of the existing customers of Ameritas for five years after the acquisition date at the premium rates in effect during 2003. The operations of Ameritas are included in the Company's consolidated financial statements beginning on April 1, 2003.
In August 2002, the Company acquired all of the outstanding capital stock of Paramount for approximately $6.7 million, consisting of $3.0 million in cash, a secured convertible note for $2,625,000, and 769,231 shares of the Company's common stock. The secured convertible note bears interest at 7.0% annually, and was originally payable in 36 equal monthly installments of principal and interest, beginning in October 2002. The terms of the note were amended in the fourth quarter of 2003, and the outstanding balance is now payable in monthly installments of interest only until a date to be specified by the holder of the convertible note at least 90 days in advance of such date, which must be no earlier than January 1, 2005, and no later than January 1, 2007. Effective on the date specified by the holder, the convertible note will be payable in 21 equal monthly installments of principal and interest. The outstanding balance under the secured convertible note is convertible into common stock of the Company at a conversion price of $1.625 per share. The convertible note is secured by the stock of the Company's dental HMO subsidiary in Florida. The operations of Paramount are included in the accompanying consolidated financial statements beginning on September 1, 2002.
In August 2002, the Company borrowed $2.0 million from one of its principal stockholders, which was used to increase the Company's working capital, to provide for the payments due under certain capital leases entered into in June 2002, and to provide for the payments due under the settlement of the stockholder litigation discussed in Note
12 to the accompanying consolidated financial statements. The borrowing was made under an unsecured convertible note that bears interest at 7.0% annually, and was originally payable in equal monthly installments of principal and interest through August 2005. The terms of the note were amended during the second quarter of 2003, and the outstanding balance is now payable in monthly installments of interest only through May 2006, then in monthly installments of principal and interest from June 2006 through August 2008. The outstanding balance under the convertible note is convertible into common stock of the Company at a conversion price of $1.625 per share.
Net cash provided by operating activities increased from $1.2 million during 2002 to $6.4 million in 2003, which was primarily due to increases in accrued expenses and claims payable and claims incurred but not reported ("IBNR") in 2003, compared to significant decreases in these liabilities in 2002, and an increase in net income, excluding the non-cash deferred income tax benefit in 2003. The increase in accrued expenses in 2003 was primarily due to an increase in accrued incentive compensation, which was related to the improvement in the Company's operating results in 2003. The decrease in accrued expenses in 2002 was primarily due to payments made to reduce accrued lease obligations related to equipment that was no longer used by the Company, and to reduce certain obligations related to discontinued operations that were disposed of prior to 2001. The increase in claims payable and claims IBNR in 2003 was primarily due to an increase in the number of members covered under PPO/indemnity benefit plan designs, which account for a majority of the total claims payable and claims IBNR liability. The decrease in claims payable and claims IBNR in 2002 was primarily due to intentional decreases in the processing time for payment of provider claims. Due in part to the recent decline in interest rates on investments, the Company adopted the practice of paying all provider claims as rapidly as possible, in order to enhance its image among dental providers.
Net cash provided by financing activities was $16.7 million in 2003, compared to $0.5 million of net cash used in 2002. The change was due to $19.0 million of borrowings in 2003, compared to $2.0 million of borrowings in 2002.
In addition, several of the Company's subsidiaries are subject to state regulations that require them to maintain minimum amounts of statutory capital and surplus, and that otherwise restrict the Company's access to the assets of its regulated subsidiaries. As a result of these regulatory restrictions, substantially all of the Company's consolidated stockholders' equity as of December 31, 2003, was not available for distribution to the Company's stockholders.
The Company's primary source of funds is cash flows from operations and investment income. The Company believes that cash flows from operations and investment income will be adequate to meet the Company's cash requirements for at least the next twelve months, except for financing that may be required to complete potential acquisitions. The Company does not expect any significant changes in its cash requirements in the foreseeable future, except for any financing that may be required in connection with potential acquisitions.
The Company believes it has adequate financial resources to continue its current operations for the foreseeable future, and that it will be able to meet its financial obligations from its existing financial resources and future cash flows from its operations. However, there can be no assurance that there will not be unforeseen events that could prevent the Company from doing so.
See Note 1 to the accompanying consolidated financial statements for information on recent accounting pronouncements.
The Company's operations are potentially impacted by inflation, which can affect premium rates, health care services expense, and selling, general and administrative expense. The Company expects that its earnings will be positively impacted by inflation in premium rates, because premium rates for dental benefit plans in general have been increasing due to inflation in recent years. The Company expects that its earnings will be negatively impacted by inflation in health care costs, because fees charged by dentists and other dental providers have been increasing due to inflation in recent years. The impact of inflation on the Company's health care services expense is mitigated in the short-term by the fact that approximately 32% of total health care services expense consists of capitation (fixed) payments to providers. In addition, most of the Company's selling, general and administrative expenses are impacted by general inflation in the economy.