The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements, as long as those statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed in the statements. The Company desires to take advantage of these safe harbor provisions. The information in the "Risk Factors" section of Item 1 of this Form 10-K should be read in conjunction with this Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A").
Accounts receivable represent uncollected premiums related to coverage periods prior to the balance sheet date, and are stated at the estimated collectible amounts, net of an allowance for bad debts. The Company continuously monitors the timing and amount of its premium collections, and maintains a reserve for estimated bad debt losses. The amount of the reserve is based primarily on the Company's historical experience and any customer-specific collection issues that are identified. The Company believes its reserve for bad debt losses is adequate as of December 31, 2002. However, there can be no assurance that the bad debt losses ultimately incurred will not exceed the reserve for bad debts established by the Company.
Notes receivable are stated at their estimated realizable values, net of an allowance for bad debts. The Company continuously monitors its collection of payments on the notes receivable, and maintains a reserve for estimated bad debt losses. The amount of the reserve is based primarily on the Company's historical experience in collecting similar notes receivable that are no longer outstanding, and any available information about the financial condition of the note issuers, although the Company has access to very little such information. The Company believes its reserve for bad debt losses is adequate as of December 31, 2002. However, there can be no assurance that the Company will realize the carrying amount of its notes receivable.
Company is not aware of any events that have occurred since October 1, 2002 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, 2002 consist of customer relationships and other intangible assets with an aggregate net book value of $2.0 million, all of which were acquired in connection with the acquisition of Paramount in August 2002, as discussed in Note 2 to the accompanying consolidated financial statements. 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 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 net deferred tax assets have been fully reserved since September 30, 1999, due to uncertainty about whether those net assets will be realized in the future. The uncertainty is primarily due to cumulative operating losses incurred by the Company during the period from January 1, 1998, to December 31, 2002, and the existence of significant net operating loss carryforwards.
Income (loss) per share is presented in accordance with SFAS No. 128, "Earnings Per Share." Basic earnings (loss) 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 Company believes the convertible preferred stock is essentially equivalent to common stock, based on all the rights and preferences of both types of stock. Diluted net income (loss) 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, 2002, the potentially dilutive securities of the Company that were outstanding consisted of stock options, convertible notes, and warrants. The only convertible notes issued by the Company were the two (2) convertible notes issued during the three months ended September 30, 2002, as discussed in Notes 2 and 10 to the accompanying consolidated financial statements. Both of these convertible notes would have an anti-dilutive effect on net income per share in
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 operations of Paramount are included in the accompanying consolidated financial statements beginning on September 1, 2002. 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 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. 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.
Loss on impairment of assets increased from zero in 2001 to $334,000 in 2002. The loss on impairment in 2002 is due to an increase in the reserve related to notes receivable, as discussed in Note 8 to the accompanying consolidated financial statements.
Total 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.
There was an income tax benefit of $820,000 in 2002, which primarily represents a decrease in the Company's accrual for estimated income tax liabilities related to certain transactions that occurred in prior years, as discussed in Note 13 to the accompanying consolidated financial statements. There was no current income tax expense in 2002, due to temporary differences between income before income taxes for accounting purposes and taxable income for tax purposes. Those temporary differences resulted in a loss for tax purposes in 2002. There was also no deferred income tax expense in 2002, due to the valuation allowance against the Company's net deferred tax assets, as discussed in Note 13 to the accompanying consolidated financial statements.
Health care services expense decreased by $9.9 million, or 14.4%, from $68.6 million in 2000 to $58.7 million in 2001. The loss ratio decreased from 70.5% in 2000 to 69.2% in 2001. This decrease is primarily due to an increase in premium rates, and a reduction in certain types of non-standard payment arrangements to dental HMO providers. Those non-standard payment arrangements consisted primarily of discounted fee-for-service arrangements for dental services that are typically delivered through capitation arrangements, and minimum monthly capitation payments, regardless of the number of members enrolled with the provider. The Company reduced its expenses related to these non-standard arrangements by either negotiating a different arrangement with the providers, or terminating the arrangements and contracting with other providers. These factors were partially offset by a shift in the type of plan designs toward PPO/indemnity plan designs, which have a higher loss ratio than HMO plan designs. However, PPO/indemnity plan designs also have a higher amount of gross margin (premium revenue less health care services expense) per insured individual, and the Company believes they have significantly lower general and administrative expenses than HMO plan designs, as a percentage of premium revenue.
This improvement was primarily due to a $4.4 million decrease in interest expense, a $5.8 million decrease in SG&A expense, and a decrease in the loss ratio from 70.5% in 2000 to 69.2% in 2001, which is equal to a $1.1 million decrease in health care services expense.
There was no income tax expense in 2001 and no income tax benefit in 2000. The Company had no current income tax expense in 2001 due to temporary differences between income before income taxes for accounting purposes and taxable income for tax purposes, which resulted in a net loss for tax purposes. There was also no deferred income tax expense or benefit in 2001, due to the valuation allowance against the Company's net deferred tax assets, as discussed in Note 13 to the accompanying consolidated financial statements. There was no income tax benefit in 2000 because the Company had previously used all of its loss carryback opportunities, and because of the valuation allowance against its net deferred tax assets.
The Company's total debt increased from $265,000 as of December 31, 2001 to $5.4 million as of December 31, 2002, primarily due to the $2.6 million convertible note issued in the Paramount acquisition, the $2.0 million unsecured convertible note issued in August 2002, and the two capital leases noted above, which added $1.8 million of debt during the second quarter of 2002. The Company made an aggregate of $1.7 million of principal payments on debt and capital lease obligations during 2002.
Effective August 30, 2002, the Company acquired all of the outstanding capital stock of Paramount for a purchase price of 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 is payable in 36 equal monthly installments of principal and interest, beginning in October 2002. 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, at any time after August 30, 2003. 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.
Net cash provided by operating activities was $1.2 million during 2002, compared to $0.7 million of net cash used by operating activities in 2001. This change is primarily due to a $0.6 million increase in deferred premium revenue in 2002, compared to a $0.5 million decrease in deferred premium revenue in 2001, and the fact that net cash used to reduce accrued expenses decreased from $2.1 million in 2001 to $1.3 million in 2002. The changes in deferred revenue are primarily due to changes in the volume of individual plan customers who pay the Company for a year of coverage in advance. The volume of this business increased during 2002, compared to a decrease in the volume of this business during 2001. The decrease in accrued expenses in 2001 was primarily due to $1.3 million of payments made to reduce the obligations assumed in connection with the re-sale of certain dental practices in October 2000, as described in Note 3 to the accompanying consolidated financial statements. Claims payable and claims incurred but not reported ("IBNR") decreased by $1.4 million in 2002 and $1.6 million in 2001, primarily due to intentional decreases in the processing time for payment of provider claims, and in the case of 2001, partially due to a decrease in the Company's volume of PPO/indemnity business during the period. Due in part to the recent decline in interest rates on investments, the Company has adopted the practice of paying all provider claims as rapidly as possible, in order to enhance its image among dental providers.
Net cash used in financing activities decreased from $0.7 million in 2001 to $0.5 million in 2002. The net cash used in both 2001 and 2002 was primarily due to reductions in the amount of bank overdrafts, which are due to outstanding checks not yet presented for payment.
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 the Company's future earnings will be adequate to make all of the payments on the Company's obligations as they become due, or that there will not be unforeseen events that could have a material adverse impact on the Company's financial position and the adequacy of its cash balances.
The Consolidated Financial Statements and the related Notes and Schedule thereto filed as part of this 2002 Annual Report on Form 10-K are listed on the accompanying Index to Financial Statements on page .