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 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 14 to the accompanying consolidated financial statements. In the opinion of management, the Company's facilities are adequate for its current needs.
The Company has classified all of its investments as "available-for-sale." Accordingly, investments are carried at fair value, based on quoted market prices, and unrealized gains and losses, net of applicable income taxes, are reported in a separate caption of stockholders' equity. In the event there was an unrealized loss on an investment that the Company believed to be other than temporary, the loss would be reported in the statement of operations, instead of in a separate caption of stockholders' equity. As of December 31, 2002, there were no unrealized losses that the Company believed to be other than temporary.
Goodwill as of December 31, 2002 consists of $4.7 million of goodwill related to the acquisition of Paramount Dental Plan, Inc. ("Paramount") in August 2002, which is discussed in Note 2 to the accompanying consolidated financial statements, and $3.9 million of goodwill related to the acquisition of a Texas-based dental HMO company in 1996. 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 1996 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 1996 acquisition had a useful life of 40 years from the date of acquisition of the related entity, 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, 2002, 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
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.
Premium revenue is recognized in the period during which dental coverage is provided to the covered individuals. Payments received from customers in advance of the related period of coverage are reflected on the accompanying consolidated balance sheet as deferred premium revenue.
2002. 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 the years ended December 31, 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. There were no outstanding stock options or warrants with an exercise price below the average market price of the Company's common stock during the year ended December 31, 2000. Accordingly, the Company's diluted net loss per share is the same as its basic net loss per share for that period. The only warrants issued by the Company were canceled without being exercised effective January 31, 2001, as discussed in Note 11 to the accompanying consolidated financial statements.
Health care services expense decreased by $0.8 million, or 1.3%, from $58.7 million in 2001 to $57.9 million in 2002. Health care services expense as a percentage of premium revenue (the "loss ratio") increased slightly from 69.2%
in 2001 to 69.8% in 2002. The business acquired from Paramount has a significantly lower loss ratio than the Company's pre-existing business, which is primarily due to the type of benefit plan designs sold by Paramount. The effect of the Paramount acquisition on the loss ratio was offset by increases in specialty referral services, supplemental payments, and discounted fee-for-service payments to dental HMO providers. The increase in the cost of specialty referral services was due to an increase in the utilization rate for those services in 2002. Supplemental payments are additional payments made to dentists who are compensated primarily through capitation payments, in connection with the delivery of certain dental procedures by those dentists. The increases in supplemental and discounted fee-for-service payments were partially due to high-cost arrangements with certain providers, which were started early in 2002, and which were terminated prior to the end of 2002. These arrangements resulted in an unusually large amount of supplemental payments and discounted fee-for-service payments in 2002. There was also a general increase in supplemental payments in 2002, which the Company believes is due to more comprehensive submission of claims information by the dentists in its HMO network.
Selling, general and administrative ("SG&A") expense decreased by $0.9 million, or 3.4%, from $25.4 million in 2001 to $24.5 million in 2002. SG&A expenses as a percentage of premium revenue decreased from 29.9% in 2001 to 29.5% in 2002. The decrease in SG&A expenses is primarily due to decreases in depreciation expense and furniture rent, and a $350,000 refund of maintenance fees from one of the Company's vendors, which were partially offset by a $250,000 expense in 2002 related to the settlement of stockholder litigation, as described in Note 14 to the accompanying consolidated financial statements. The decrease in depreciation expense is primarily due to the fact that a significant component of the Company's computer software became fully depreciated during 2002. The decrease in furniture rent was due to the purchase of the office furniture used in the Company's primary administrative office through a new capital lease during the second quarter of 2002, as discussed in Note 10 to the accompanying consolidated financial statements. The related furniture was formerly leased under an operating lease with relatively expensive terms, compared to the new capital lease. The new capital lease caused an increase in depreciation expense, but this was more than offset by other decreases in depreciation, as noted above. The refund of maintenance fees was primarily due to the settlement of a dispute over the amount of equipment maintenance fees paid by the Company in several prior years.
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 during the past year, 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 2001 and 2002. By intentionally accelerating its payment of claims, the Company intends to enhance its image among dental providers.
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.
SG&A expense decreased by $5.8 million, or 18.6%, from $31.2 million in 2000 to $25.4 million in 2001. SG&A expense as a percentage of premium revenue decreased from 32.1% in 2000 to 29.9% in 2001. The decrease in SG&A expense as a percentage of premium revenue is due to cost reductions implemented in several categories, including equipment rent, depreciation expense, telecommunications, property rent, and others. A portion of the decrease in SG&A expense is due to decreases in broker commissions, internal commissions, and premium taxes, which are all related to the 12.8% decrease in premium revenue in 2001.
Investment and other income decreased by $0.3 million, or 25.9%, from $1.4 million in 2000 to $1.1 million in 2001. This decrease is primarily due to a decrease in interest income from notes receivable, due to the liquidation of a majority of the Company's notes receivable during 2001 and 2000, and a decrease in interest rates on fixed income investments. These factors were partially offset by realized gains on the sale of investments in the first quarter of 2001.
Total interest expense decreased by $4.4 million, or 89.7%, from $4.9 million in 2000 to $0.5 million in 2001. This decrease is primarily due to the recapitalization transaction that was completed effective January 31, 2001, which converted substantially all of the Company's debt to convertible preferred stock. See Note 11 to the accompanying consolidated financial statements for more information on this transaction.
The income (loss) before income taxes, discontinued operations and extraordinary item improved from a loss of $6.5 million, or 6.6% of premium revenue, in 2000, to income of $1.3 million, or 1.5% of premium revenue, in 2001.
The loss from discontinued operations decreased from $2.5 million in 2000 to zero in 2001. The loss in 2000 represents a reduction in the carrying value of the net assets related to certain dental and orthodontic practices, which the Company originally sold to an unrelated party in 1997 and 1998. These assets were re-sold to another unrelated party in October 2000, as discussed in Note 3 to the accompanying consolidated financial statements.
There was an $11.3 million extraordinary gain on the conversion of the Company's debt to convertible preferred stock in 2001. See Note 11 to the accompanying consolidated financial statements for more information on this extraordinary gain.
The Company's net working capital decreased from $4.2 million as of December 31, 2001 to $2.0 million as of December 31, 2002, primarily due to the acquisition of Paramount Dental Plan, Inc. ("Paramount") in August 2002, as discussed in Note 2 to the accompanying consolidated financial statements. The Paramount acquisition decreased working capital by a total of $3.5 million, including $2.7 million of net cash used in the acquisition and the current portion of the secured convertible note issued in the transaction, which is $0.8 million. The impact of the Paramount acquisition was partially offset by an increase in working capital due to net income of $1.5 million during 2002. The Company borrowed $2.0 million of working capital in August 2002, but this increase in working capital was largely offset by the current portion of the two capital lease obligations entered into in June 2002, as discussed in Note 10 to the accompanying consolidated financial statements, which was $1.0 million, and the current portion of the unsecured convertible note issued in August 2002, which was $0.6 million.
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 the two new capital leases discussed above, and to provide for the payments due under the settlement of the stockholder litigation discussed in Note 13 to the accompanying consolidated financial statements. The borrowing was made under an unsecured convertible note that bears interest at 7.0% annually and is payable in 36 equal monthly installments of principal and interest, beginning in September 2002. The outstanding balance under the convertible note is convertible into common stock of the Company at a conversion price of $1.625 per share, at any time after one year from the date of the borrowing.
Net cash provided by investing activities was $0.8 million in 2002, compared to $1.5 million in 2001. In 2002, the Company had a net liquidation of $3.9 million of investments, the proceeds of which were used primarily to finance the acquisition of Paramount and capital expenditures. In 2001, the Company had a net liquidation of $1.3 million of investments and received $1.3 million from the liquidation of certain of its notes receivable, the proceeds of which were used primarily to finance capital expenditures and a reduction in bank overdrafts, as discussed below.
A summary of the Company's future commitments is as follows (in thousands):
If the entities to which the dental office leases have been assigned fail to make a significant amount of the lease payments, this could have a material adverse affect on the Company. See Note 12 to the accompanying consolidated financial statements for more information on other long-term liabilities, and see Note 14 for more information on operating lease commitments and contingent lease obligations.
Several of the Company's subsidiaries are subject to state regulations that require them to maintain restricted deposits in the form of cash or investments. The Company had total restricted deposits of $3.3 million and $2.8 million as of December 31, 2002 and 2001, respectively.
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. The aggregate minimum statutory capital and surplus that is
required with respect to all of the Company's subsidiaries that are subject to minimum capital and surplus requirements was approximately $8.8 million as of December 31, 2002. The aggregate statutory capital and surplus in these subsidiaries as of December 31, 2002 was approximately $9.9 million. As a result of these regulatory requirements, approximately $10.3 million of the Company's consolidated stockholders' equity as of December 31, 2002 was not available for the payment of dividends 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 a planned increase in cash used for capital expenditures in 2003 and any financing that may be required in connection with potential acquisitions. The Company anticipates that its cash outlays for capital expenditures, which were $0.4 million during 2002, will increase in 2003 due to a planned conversion to a new computer software application, as discussed in Note 10 to the accompanying consolidated financial statements.
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 33% 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.