SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
For the quarterly period ended September 30, 1998
---------------------------------
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
For the transition period from to
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Commission file number 0-22019
Specialty Care Network, Inc.
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(Exact Name of Registrant as Specified in its Charter)
Delaware 62-1623449
- -------------------------------- ------------------------------------
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
44 Union Boulevard, Suite 600, Lakewood, Colorado 80228
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(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code (303) 716-0041
--------------
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 registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
On October 31, 1998, 18,618,955 shares of the Registrant's common stock,
$.001 par value, were outstanding.
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Index
Part I. Financial Information:
Item 1. Consolidated Condensed Balance Sheets -
September 30, 1998 and December 31, 1997..............................1
Consolidated Statements of Income -
Three Months Ended September 30, 1998 and 1997
Nine Months Ended September 30, 1998 and 1997.....................2
Consolidated Condensed Statements of Cash Flows -
Nine Months Ended September 30, 1998 and 1997.........................3
Notes to Consolidated Condensed Financial Statements..................5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations..................................12
Item 3. Quantitative and Qualitative Disclosure About Market Risk ...........16
Part II. Other Information:
Item 1. Legal Proceedings....................................................17
Item 2. Changes in Securities................................................17
Item 3. Defaults upon Senior Securities .....................................17
Item 6. Exhibits and Reports on Form 8-K.....................................19
<PAGE>
Part I. Financial Information
Specialty Care Network, Inc. and Subsidiaries
Consolidated Condensed Balance Sheets
<TABLE>
<CAPTION>
September 30 December 31
1998 1997
------------ -----------
(Unaudited)
<S> <C> <C>
Assets
Cash and cash equivalents $ 369,119 $ 3,444,517
Accounts receivable, net 35,801,184 25,957,367
Loans to physician stockholders 693,940 914,737
Prepaid expenses and other 1,877,863 796,903
------------- -------------
Total current assets 38,742,106 31,113,524
Property and equipment, net 11,304,861 5,276,219
Intangible assets, net 2,180,232 1,137,808
Management service agreements, net 114,647,029 100,732,431
Equity investment -- 400,000
Advances to affiliates 1,606,938 522,022
Other assets 2,508,599 1,119,646
------------- -------------
Total assets $ 170,989,765 $ 140,301,650
============= =============
Liabilities and stockholders' equity
Current portion of capital lease obligations $ 94,149 $ 263,007
Accounts payable 359,239 701,087
Accrued payroll, incentive compensation and related
expenses 1,863,914 1,350,825
Accrued expenses 3,194,912 2,171,130
Income taxes payable 89,785 944,632
Due to affiliated physician practices 4,735,305 2,885,602
Deferred income taxes 1,280,047 872,855
------------- -------------
Total current liabilities 11,617,351 9,189,138
Convertible note payable 5,454,439 --
Line-of-credit 48,225,000 33,000,000
Capital lease obligations, less current portion 881,118 885,141
Deferred income taxes 30,969,549 32,115,476
------------- -------------
Total liabilities 97,147,457 75,189,755
Stockholders' equity:
Preferred stock, $0.001 par value, 2,000,000 -- --
shares authorized, no shares issued or outstanding -- --
Common stock, $0.001 par value, 50,000,000 shares
authorized, 18,618,955 and 17,703,293 shares
issued and outstanding in 1998 and 1997, respectively 18,619 17,703
Treasury stock (1,307,474) --
Additional paid-in capital 66,963,833 60,995,177
Retained earnings 8,167,330 4,099,015
------------- -------------
Total stockholders' equity 73,842,308 65,111,895
============= =============
Total liabilities and stockholders' equity $ 170,989,765 $ 140,301,650
============= =============
</TABLE>
See accompanying notes to consolidated condensed financial statements
1
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Consolidated Statements of Income
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30 September 30
---------------------------------------------------------------------
1998 1997 1998 1997
---------------------------------------------------------------------
<S> <C> <C> <C> <C>
Revenue:
Service fees $ 19,479,388 $ 13,512,649 $ 55,963,990 $ 29,695,702
Other 633,023 1,199,250 3,147,500 1,853,048
---------------------------------------------------------------------
20,112,411 14,711,899 59,111,490 31,548,750
Costs and expenses:
Clinic expenses 14,134,169 9,383,355 39,857,918 20,149,267
General and administrative
expenses 3,955,398 2,081,576 9,977,359 5,134,783
---------------------------------------------------------------------
18,089,567 11,464,931 49,835,277 25,284,050
Income from operations 2,022,844 3,246,968 9,276,213 6,264,700
Other:
Interest income 23,179 59,280 141,355 429,239
Interest expense (1,054,965) (333,206) (2,698,668) (390,516)
---------------------------------------------------------------------
Income before income taxes 991,058 2,973,042 6,718,900 6,303,423
Income tax expense (423,348) (1,174,352) (2,650,585) (2,537,141)
---------------------------------------------------------------------
Net income $ 567,710 $ 1,798,690 $ 4,068,315 $ 3,766,282
=====================================================================
Net income per share (basic) $ 0.03 $ 0.11 $ 0.22 $ 0.25
=====================================================================
Weighted average shares
outstanding (basic) 18,415,301 16,572,817 18,117,349 14,860,463
=====================================================================
Net income per share (diluted) $ 0.03 $ 0.11 $ 0.22 $ 0.25
=====================================================================
Weighted average shares
outstanding (diluted) 18,607,745 16,909,379 18,489,022 15,290,618
=====================================================================
</TABLE>
See accompanying notes to consolidated condensed financial statements.
2
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Consolidated Condensed Statements of Cash Flows
(Unaudited)
<TABLE>
<CAPTION>
Nine Months Ended September 30
1998 1997
------------ ------------
<S> <C> <C>
Operating activities
Net income $ 4,068,315 $ 3,766,282
Adjustments to reconcile net income to net
cash provided by (used in) operating activities:
Depreciation 1,528,287 633,588
Amortization 3,092,599 684,006
Gain on sale of equity investment (1,228,701) --
Deferred income tax benefit (738,735) (923,197)
Non-cash compensation expense-stock options 82,503 159,013
Changes in operating assets and liabilities,
net of the non-cash effects of the acquisitions
of the net assets of physician groups:
Accounts receivable, net (5,056,114) (8,681,693)
Prepaid expenses and other assets (1,178,895) (713,188)
Accounts payable and accrued expenses 651,892 (805,048)
Accrued payroll, incentive compensation and
related expenses 350,584 137,816
Income taxes payable and prepaid and
recoverable income taxes, net (854,847) 916,943
Due to physicians groups 1,849,703 3,968,564
------------ ------------
Net cash provided by (used in) operating activities 2,566,591 (856,914)
Investing activities
Purchases of property and equipment (6,897,225) (1,305,025)
Proceeds from sale of equity investments 1,075,000 --
Increase in other assets 74,363 --
Increase in intangible assets (92,998) (275,103)
Equity investment and related advances (1,404,916) --
Acquisitions of physician groups (12,558,005) (38,890,502)
------------ ------------
Net cash used in investing activities (19,803,781) (40,470,630)
Financing activities
Proceeds from initial public offering, net of
current period offering costs -- 22,939,338
Proceeds from line-of-credit agreement 15,225,000 26,365,931
Principal repayments on line of credit agreement -- (5,577,681)
Principal repayments on capital lease obligations (172,881) (164,929)
Loans to physician stockholders -- (814,737)
Purchases of treasury stock (1,307,474) --
Repayments on loans to physician stockholders 185,797 --
Exercise of common stock options 231,350 220,714
------------ ------------
Net cash provided by financing activities 14,161,792 42,968,636
Net (decrease) increase in cash and cash equivalents (3,075,398) 1,641,092
Cash and cash equivalents at beginning of period 3,444,517 1,444,007
------------ ------------
Cash and cash equivalents at end of period $ 369,119 $ 3,085,099
============ ============
</TABLE>
See accompanying notes to consolidated condensed financial statements.
3
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Consolidated Condensed Statements of Cash Flows
(Unaudited) (continued)
<TABLE>
<CAPTION>
Nine Months Ended September 30
1998 1997
------------ ------------
<S> <C> <C>
Suppemental cash flow information
Interest paid $ 2,508,404 $ 315,140
============ ============
Income taxes paid $ 4,156,242 $ 2,543,394
============ ============
Supplemental schedule of noncash investing and
financing activities
Effects of the acquisitions of the net assets
of physician groups:
Assets acquired $ 21,992,643 $101,426,736
Liabilities assumed $ (280,482) (2,665,200)
Income tax liabilities assumed -- (31,398,176)
Convertible note payable issued (5,454,439) --
Cash outlay (11,799,305) (38,890,502)
------------ ------------
Common Stock issued to effect acquisitions $ 4,458,417 $ 28,472,858
============ ============
</TABLE>
See accompanying notes to consolidated condensed financial statements.
4
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Condensed Financial Statements (Unaudited)
September 30, 1998
NOTE 1 - Basis of Presentation
The accompanying unaudited consolidated condensed financial statements of
Specialty Care Network, Inc. and subsidiaries (collectively the "Company") have
been prepared in accordance with generally accepted accounting principles for
interim financial information and the instructions to Rule 10-01 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete financial
statements. In the opinion of management, these statements include all
adjustments (consisting of normal recurring accruals) considered necessary for a
fair presentation of the results of the interim periods reported herein.
Operating results for the three and nine months ended September 30, 1998 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 1998. For further information, refer to the consolidated financial
statements and footnotes thereto included in the Company's Annual Report on Form
10-K for the year ended December 31, 1997.
Description of Business
Specialty Care Network, Inc. and subsidiaries is a physician practice management
and healthcare consulting company. The Company provides practice management
services to physicians in practices that focus on musculoskeletal care. The
Company's wholly-owned subsidiary, Provider Partnerships, Inc. ("PPI"), provides
consulting services to hospitals to increase their operating performance, with a
specific focus on the cardiac area. (See Note 4 for a discussion of the
Company's acquisition of PPI). Healthcare Report Cards, Inc., ("HRCI") was
formed in September 1998 as a wholly-owned subsidiary of the Company. In
November 1998, HRCI launched an Internet web site,
HealthcareReportCards.com(TM), a hospital rating program that objectively grades
the performance of hospitals in the United States engaged in the medical
specialties of cardiology and cardiac care. All significant intercompany
balances and transactions have been eliminated in consolidation.
New Accounting Pronouncements
Disclosures about Segments of an Enterprise and Related Information:
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131 ("SFAS No. 131"), Disclosures about
Segments of an Enterprise and Related Information. SFAS No. 131 establishes
standards for the way that public business enterprises report information about
operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in interim
financial reports. It also establishes standards for related disclosures about
products and services, geographic areas, and major customers. SFAS No. 131 is
effective for financial statements for fiscal years beginning after December 15,
1997, and therefore the Company will adopt the new requirements retroactively as
of December 31, 1998.
5
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Condensed Financial Statements (Unaudited)
(continued)
Reporting Comprehensive Income:
The Company adopted Statement of Financial Accounting Standards No. 130 ("SFAS
No. 130"), Reporting Comprehensive Income, during the first quarter of 1998.
SFAS No. 130 establishes standards for reporting and display of comprehensive
income and its components (e.g., revenue, expenses, gains, loss, etc.) in a full
set of general purpose financial statements. SFAS No. 130 requires companies to
report a total for comprehensive income in condensed financial statements of
interim periods issued to shareholders with no similar requirement for
disclosure of its components. As the Company has no comprehensive income
amounts, the adoption of SFAS No. 130 currently has no impact on the Company's
financial presentation. If the Company has items of comprehensive income in
future periods, these items will be reported and displayed in accordance with
SFAS No. 130.
Earnings Per Share:
In 1997, Statement of Financial Accounting Standards No. 128 ("SFAS No. 128"),
Earnings Per Share, was issued. SFAS No. 128 replaced the calculation of primary
and fully diluted earnings per share with basic and diluted earnings per share.
Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities. Diluted
earnings per share is very similar to fully diluted earnings per share under the
previous method of reporting earnings per share. All earnings per share amounts
for all periods have been presented, and where appropriate, restated to conform
to SFAS No. 128 requirements.
Change in Accounting Estimate
Beginning June 1, 1998, the Company reduced the amortizable lives of its
long-term management service agreements by assigning specific lives to each
management service agreement based on factors such as practice market share,
length of operating history and other factors. The lives range from 5 to 30
years. Previously, the Company amortized such service agreements over the term
of the underlying agreements, which is generally forty years. This action was
taken in response to viewpoints expressed by the Securities and Exchange
Commission regarding the amortization periods used by the physician practice
management industry. The change in accounting estimate resulted in additional
amortization expense of approximately $535,000 for the period June 1, 1998
through September 30, 1998.
Reclassifications
Certain amounts in the Consolidated Statements of Income for the three and nine
months ended September 30, 1998 have been reclassified in order to conform to
the current presentation.
6
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Condensed Financial Statements (Unaudited)
(continued)
NOTE 2 - Physician Practice Affiliation
Effective March 31, 1998, in connection with the acquisition, by asset purchase,
of substantially all of the assets and certain liabilities of Orlin & Cohen
Associates LLP ("OCOA"), the Company issued to OCOA 470,094 shares of common
stock and a promissory note in the principal amount of $5,579,439, and paid cash
in the amount of $11,125,000. Subsequently, pursuant to the First Amendment to
the Asset Purchase Agreement by and between SCN and OCOA, the total
consideration paid by SCN was modified to 459,562 shares of common stock, a
promissory note in the principal amount of $5,454,439 and cash in the amount of
$11,375,000. In addition, the Company paid a finder's fee of $114,000 in
connection with the acquisition. The promissory note is due in full on March 31,
2001, with annual interest payments due at the rate of 5%. The holder of the
note may convert the note, prior to maturity, into common stock of the Company
at the conversion ratio of one share of common stock for approximately $14.24 of
note principal and accrued interest. In addition to the consideration described
above, the Company may pay additional contingent consideration to OCOA based on
certain growth parameters achieved by OCOA within the first three years of the
service agreement.
NOTE 3 - Gain on Sale of Equity Investment
In 1997, the Company purchased 50% of the outstanding membership interests in
West Central Ohio Group, Ltd. ("WCOG"), an Ohio limited liability company that
was formed to construct an ambulatory surgery center in Lima, Ohio, from the
physician owners of a practice affiliated with the Company (the "Ohio Physician
Owners"). In March 1998, the Company sold its entire interest in WCOG to the
Ohio Physician Owners and a company (the "Acquiring Company") for total
consideration of approximately $1,950,000. In addition, the Company was relieved
of its obligation to pay an amount equal to 25% of WCOG's first $6,000,000 of
net income as contingent consideration in connection with the initial purchase
of its investment in WCOG. The sale resulted in a pre-tax gain of approximately
$1,200,000, which has been included in other revenue in the accompanying
consolidated financial statements. An officer and 50% stockholder of the
Acquiring Company is the brother of the President and Chief Executive Officer of
the Company (see also Note 4).
NOTE 4 - Acquisition of Provider Partnerships, Inc.
During the third quarter of 1998, the Company acquired PPI in exchange for
420,000 shares of Company common stock. PPI is a recently formed company that
provides consulting services to hospitals to increase their operating
performance, with a specific focus on the cardiac areas.
7
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Condensed Financial Statements (Unaudited)
(continued)
One of the principals of PPI, who has been elected to serve as Executive Vice
President - Provider Businesses of the Company, is the brother of the President
and Chief Executive Officer of the Company.
NOTE 5 - Exercise of Put Options
In connection with the acquisition, through merger, of substantially all of the
assets and certain liabilities of Orthopaedic Surgery, Ltd. ("OSL"), on July 1,
1997, the Company granted one physician associated with OSL the option to
require the Company to purchase 74,844 shares of Common Stock issued to such
physician as consideration for the OSL merger at a purchase price equal to
approximately $11.21 per share. In addition, in connection with the acquisition,
by asset purchase, of substantially all of the assets and certain liabilities of
Steven P. Surgnier, M.D., P.A., the Company granted Dr. Surgnier the option to
require the Company to purchase 37,841 shares of Common Stock at a purchase
price equal to approximately $12.38 per share. During the quarter ended
September 30, 1998, the abovementioned options were exercised. The Company paid
$1,307,474 to repurchase these shares and has included this amount as treasury
stock in its Consolidated Condensed Balance Sheet at September 30, 1998.
NOTE 6 - Line-Of-Credit
The Company's Credit Facility permits maximum borrowings of $75 million, subject
to certain limitations. The Credit Facility may be used (i) to fund the cash
portion of affiliation transactions and (ii) for the development of
musculoskeletal focused surgery centers and other ancillary service
capabilities. As of September 30, 1998, the Company's effective rate of interest
under the Credit Facility was approximately 7.8% per annum. The Credit Facility
is secured by substantially all of the assets of the Company and contains
several affirmative and negative covenants, including covenants limiting the
Company's ability to incur additional indebtedness, limiting the Company's
ability to and restricting the terms upon which the Company can affiliate with
physician practices in the future, prohibiting the payment of cash dividends on,
and the redemption or repurchase of, the Company's Common Stock and requiring
the maintenance of certain ratios and stockholders' equity. As of September 30,
1998, the Company was not in compliance with certain of the financial ratio
covenants and accordingly, has received waivers with respect to such covenants
from its bank lenders. Additionally, the Company is in the process of seeking
future covenant relief covering the periods from December 31, 1998 through
December 31, 1999 and, accordingly, the balance outstanding under the Credit
Facility has been excluded from current liabilities because the Company intends
that at least that amount will remain outstanding for an uninterrupted period
extending at least one year from the balance sheet date.
8
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Condensed Financial Statements (Unaudited)
(continued)
NOTE 7 - Subsequent Events
Proposed Restructuring
During November 1998, the Company announced that it is exploring a plan to
restructure the Company's arrangements with its affiliated practices. As
currently contemplated, the restructuring would:
o provide for the repurchase by affiliated physicians of practice assets in
exchange for cash and SCN common stock;
o limit management services provided to the affiliated practices by SCN to
specific practice needs;
o reduce the term of SCN's management agreements with its affiliated
practices; and
o lower service fees paid by affiliated practices to SCN.
The proposed repurchase of practice assets by physicians is designed to enable
SCN to retire a substantial amount of its debt and significantly reduce the
number of shares outstanding. Moreover, the restructuring is designed to enable
SCN to more effectively focus the services it provides to affiliated practices
and to expand its efforts in connection with its ancillary, hospital consulting
and Internet businesses, while reducing the financial burden to its affiliated
practices under the management agreements.
The restructuring would be contingent upon:
o the negotiation of definitive agreements between SCN and its affiliated
practices and physicians;
o Board of Directors and stockholder approval and;
o consent of SCN's bankers
The Company anticipates that it would record a material restructuring charge
against earnings if the restructuring is completed. It is possible that the
framework of the proposed restructuring may change, or that the restructuring
may not be effected at all. The Company's Board of Directors has appointed a
special committee consisting of the Company's non-physician directors to
consider the proposed restructuring as well as alternatives to the proposed
restructuring.
Legal Proceedings
On November 13, 1998 a complaint was filed in the Superior Court for the State
of California in and for the County of Solano by The Specialists Orthopaedic
Medical Corporation (the "Practice"), one of the Company's affiliated practices;
The Specialists Surgery Center ("TSSC"), a partnership that operates at a
surgery center, the assets of which were sold by TSSC to the Company in
connection with the Practice's affiliation with the Company; and four physicians
who practice at, and own an interest in, one or both of the plaintiff entities
(the "Doctors"), against the administrator of the predecessor to the Practice;
legal, accounting and consulting advisors to the plaintiffs in connection with
the affiliation
9
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Condensed Financial Statements (Unaudited)
(continued)
transactions (collectively with the administrator, the "Advisors"); entities
affiliated with certain of the Advisors; the Company; an employee of the
Company; and 25 unnamed Does.
The complaint contains numerous allegations against one of more of the Advisors,
including, among others, a fraudulent scheme by the Advisors to benefit
themselves financially at the expense of the plaintiffs; misrepresentations and
fraudulent disclosures by the Advisors to the Doctors concerning the terms of
the agreements by which the Company acquired the predecessor to the Practice and
the surgery center (the "Acquisition Agreements") as well as the service
agreements that the plaintiffs entered into with the Company (collectively, with
the Acquisition Agreements, the "Contracts"); "effectively selling the
Doctors into indentured servitude"; the conversion by the administrator of
$1.94 million of the cash proceeds payable under the Acquisition Agreements as
well as the diversion of other assets of the Practice and TSSC by the
administrator for his own use; breach of fiduciary duty; negligence;
professional negligence; and legal malpractice. With respect to the Company, the
complaint alleges, among other things, that the Company and its employee
conspired with the Advisors to induce the plaintiffs to enter into the
Contracts; that the Company and the employee misrepresented terms of the
Contracts to the Doctors; that, in connection with the issuance of Company
securities to the Doctors in the affiliation transactions, the Company and
the other defendants violated California securities laws by making material
misstatements or omitting to state material facts; that the service agreements
are void because they are against public policy and in violation of California
law; that the required service fees are unconscionable; and that the service
agreements do not represent the true intention of the parties with regard to the
service fees to be charged.
The plaintiffs seek a judicial declaration that the service fees are
unenforceable; a reformation of the service agreements to reflect service fees
within the alleged intent of the parties; an accounting of the cash proceeds
from the affiliation transactions; special damages of $2.48 million (including
$300,000 paid to the Company); compensatory, consequential and punitive damages;
damages for emotional distress, attorneys fees and costs.
The Company believes that the allegations, as they pertain to the Company and
its employee, are without merit and intends to vigorously contest the action.
On November 16, 1998, the Company filed a complaint in the Circuit Court of the
Second Judicial Circuit in and for Leon County, Florida against TOC Specialists,
P.L., one of the Company's affiliated practices ("TOC"), 15 physicians who have
an ownership interest in and conduct business at the practice (the "Physicians")
and The State of Florida, Department of Health, Board of Medicine (the "Board of
Medicine"). The complaint alleges that, since September 30, 1998 and in
violation of their service agreement with the Company, TOC and the Physicians
have diverted accounts receivable receipts that are the property of the Company
into an account controlled by TOC and the Physicians (based on an averaging of
accounts receivable receipts over the nine months ended September 30, 1998, such
receipts are approximately $1,114,468 per month). In addition, the complaint
alleges that TOC and the Physicians have failed to pay to the Company service
fees due to the Company, which unpaid fees amounted to at least $233,753 at the
time of the filing of the complaint. The complaint also alleges that TOC and the
Physicians have effectively "locked-out" the Company by failing to provide
10
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Notes to Consolidated Condensed Financial Statements (Unaudited)
(continued)
necessary records to enable the Company to perform effectively its management
functions and are apparently performing such services themselves, or through a
third party, in violation of the service agreement. Moreover, the complaint
alleges that TOC and the Physicians have improperly attempted to terminate the
service agreement, have attempted to interfere with the Company's contractual
relations with other affiliated practices and have violated the confidentiality,
noncompetition and restrictive covenant provisions of the service agreement. In
addition, the complaint alleges that, in breach of its representation that the
agreement does not violate any statute, rule or regulation applicable to TOC or
any Physician, TOC and the Physicians filed a petition with the Board of
Medicine alleging concern over whether the service fee payable under the service
agreement violates the "fee-splitting" prohibition under Florida law.
The Company is seeking a declaratory judgment and injunctive and unspecified
monetary relief, including, among other things, a judgment that the service
agreement is in full force and effect; an order that TOC and the Physicians
specifically perform their obligations under the service agreement (or, in the
alternative, pay an unspecified amount of compensation damages), provide an
accounting of all accounts receivable receipts that have been wrongfully
diverted and converted by TOC and the Physicians and pay all past due service
fees; and an order enjoining TOC and the Physicians from interfering with SCN's
contractual relationship with others or taking other actions that the Company
alleges violate the service agreement. In addition, the Company seeks an order
prohibiting the Board of Medicine from considering the petition filed by TOC and
the Physicians and prohibiting TOC and the Physicians from taking further action
before the Board of Medicine.
11
<PAGE>
Item 2:
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Statements in this section, including statements concerning the proposed
restructuring, the receipt of future covenant relief under its Credit Facility,
the sufficiency of funds available under the Company's Credit Facility and cash
flows from operations, possible additional bank borrowings and issuance of
equity or debt securities, anticipated capital expenditures, Company
efforts to address Year 2000 issues and cost of Year 2000 initiatives are
"forward looking statements". Actual events or results may differ materially
from those discussed in forward looking statements as a result of various
factors, including changes in proposed restructuring, abandonment of the
proposed restructuring, failure of the Board of Directors or the stockholders to
approve the proposed restructuring, failure of the Company's bankers to consent
to the restructuring, unwillingness of the Company's bankers to provide
covenant relief on acceptable terms, unavailability of bank or other debt or
equity financings on acceptable terms, unanticipated expenditures, inadequacy of
efforts to remediate Year 2000 issues, unanticipated costs related to Year
2000 initiatives and other factors discussed below and in the Company's Annual
Report on Form 10-K for the year ended December 31, 1997, particularly under,
"Risk Factors" in Item 1.
General
Specialty Care Network, Inc. and subsidiaries (the "Company" or "SCN") is a
health care management services company that provides physician practice
management services, to practices focusing on musculoskeletal care, consulting
services to hospitals with a specific focus on the cardiac areas and an Internet
Web Site that grades the performance of hospitals engaged in certain medical
specialties. Traditionally, SCN's physician practice management affiliations
have been achieved through long-term service agreements with physician practices
following the acquisition by SCN of assets and liabilities of those practices or
their predecessors. The Company also offers an MSA arrangement which involves a
short-term management service agreement and does not involve the acquisition of
practice assets by SCN. The Company provides practice management services to 183
physicians in 24 practices (the "Affiliated Practices") located in 12 states
(including 21 physicians in two states who have contracted under MSA
arrangements.) In addition, the Company also manages two outpatient surgery
centers, five physical therapy operations and one occupational medicine
operation.
Accounting Treatment
Costs of obtaining long-term management service agreements are amortized using
the straight-line method over estimated lives of 5 - 30 years (see Note 1 to the
Consolidated Condensed Financial Statements for discussion of the change in
accounting estimate related to the amortization period for the Company's
long-term management service agreements). Under the service agreements between
the Company and each of the Affiliated Practices, the Company has the exclusive
right to provide management, administrative and development services during the
term of the agreement.
12
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
Recent Events
During November 1998, the Company announced that it is exploring a plan to
restructure the Company's arrangements with its affiliated practices. As
currently contemplated, the restructuring would:
o provide for the repurchase by affiliated physicians of practice assets in
exchange for cash and SCN common stock;
o limit management services provided to the affiliated practices by SCN to
specific practice needs;
o reduce the term of SCN's management agreements with its affiliated
practices; and
o lower service fees paid by affiliated practices to SCN.
The proposed repurchase of practice assets by physicians is designed to enable
SCN to retire a substantial amount of its debt and significantly reduce the
number of shares outstanding. Moreover, the restructuring is designed to enable
SCN to more effectively focus the services it provides to affiliated practices
and to expand its efforts in connection with its ancillary, hospital consulting
and Internet businesses, while reducing the financial burden to its affiliated
practices under the management agreements.
The restructuring would be contingent upon:
o the negotiation of definitive agreements between SCN and its affiliated
practices and physicians;
o Board of Directors and stockholder approval and;
o consent of SCN's bankers
The Company anticipates that it would record a material restructuring charge
against earnings if the restructuring is completed. It is possible that the
framework of the proposed restructuring may change, or that the restructuring
may not be effected at all. The Company's Board of Directors has appointed a
special committee of the Company's non-physician directors to consider the
proposed restructuring as well as alternatives to the proposed restructuring.
Results of Operations
Revenue. The Company's service fees revenue, including reimbursement of clinic
expenses, increased by $26.3 million to $56.0 million for the nine months ended
September 30, 1998 compared to $29.7 million for the same period in 1997. For
the three months ended September 30, 1998, service fees revenue, including
reimbursement of clinic expenses was $19.5 million compared with $13.5 million
for the same period of 1997. These increases were primarily the result of an
increase in affiliation transactions during the latter part of 1997 and the
first quarter of 1998. Other revenue for the nine months ended September 30,
1998 was $3.1 million compared to $1.9 million for the same period in 1997. This
increase occurred primarily because of a pre-tax gain of $1.2 million from the
sale of an equity investment in March 1998 (see Note 3 to the Consolidated
Condensed Financial Statements).
Costs and expenses. For the nine months ended September 30, 1998, total clinic
expenses were $39.9 million compared to $20.1 million for the same period of
1997. Clinic expenses were $14.1 million for the three months ended September
30, 1998 compared to $9.4 million for the same period of 1997.
13
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
These increases were primarily due to increased affiliation transactions during
the latter part of 1997 and the first quarter of 1998. General and
administrative expenses increased by $4.9 million to $10.0 million for the nine
months ended September 30, 1998 compared to $5.1 million for the same period in
1997. For the three months ended September 30, 1998, general and administrative
expenses were $4.0 million compared with $2.1 million for the same period of
1997. These increases were primarily due to increased amortization expense
related to the increase in the Company's entries into additional long-term
management service agreements with and additions in personnel required for the
provision of services to, the practices that affiliated with the Company during
the latter part of 1997 and the first quarter of 1998.
Interest expense. During the nine months ended September 30, 1998, the Company
incurred interest expense of $2.7 million compared to $0.4 million for the same
period of 1997. Interest expense for the three months ended September 30, 1998
was $1.1 million compared to $0.3 million for the same period of 1997. The
increase is primarily the result of additional borrowings under the Company's
bank credit facility (the "Credit Facility"), which were made to fund the
Company's affiliation transactions and to fund the Company's purchases of
ancillary equipment for installation at affiliated practices sites. At September
30, 1998, $48.2 million was outstanding under the Credit Facility.
Liquidity and Capital Resources
At September 30, 1998, the Company had $27.1 million in working capital, an
increase of $5.2 million from $21.9 million as of December 31, 1997. For the
first nine months of 1998, cash flow provided by operations was $2.8 million
compared to cash flow used in operations of $.9 million for the same period of
1997.
During the nine months ended September 30, 1998, the Company's expenditures for
property and equipment were $6.9 million, related primarily to the purchase of
magnetic resonance imaging units and other ancillary equipment items at the
affiliated practices. The Company borrowed $15.2 million under the Credit
Facility, primarily to fund the cash requirements of its practice affiliation
with Orlin & Cohen Associates LLP, and to finance the ancillary equipment
purchases.
The Company's Credit Facility permits maximum borrowing of $75 million, subject
to certain limitations, as further described below. The Credit Facility may be
used principally (i) to fund the cash portion of affiliation transactions and
(ii) for the development of musculoskeletal focused surgery centers and other
ancillary service capabilities. As of September 30, 1998, the Company's
effective rate of interest under the Credit Facility was approximately 7.8% per
annum. The Credit Facility is secured by substantially all of the assets of the
Company and contains several affirmative and negative covenants, including
covenants limiting the Company's ability to incur additional indebtedness,
limiting the Company's ability to and restricting the terms upon which the
Company can affiliate with physician practices in the future, prohibiting the
payment of cash dividends on, and the redemption or repurchase of, the Company's
Common Stock and requiring the maintenance of certain ratios and stockholders'
equity. As of September 30, 1998, the Company was not in compliance with certain
of the financial ratio covenants and accordingly, has received waivers with
respect to such covenants from its bank lenders. The covenant ratios the Company
had not complied with were the "Funded Debt to Cash Flow" and the "Debt Service
Coverage" ratios. Funded Debt to Cash Flow measures the Company's total funded
debt to earnings before income tax, depreciation and amortization ("EBITDA").
The Debt Service Coverage ratio is a measure of the Company's EBITDA to its
total debt service (consisting of interest expense, capital and operating lease
payments and a portion of the outstanding balance under the Credit Facility).
Additionally, the Company is in the process of seeking and expects to receive
future covenant relief covering the periods from December 31, 1998 through
December 31, 1999. The waivers granted by the bank lenders contain the
restriction that the Company may not enter into additional affiliation
transactions without the consent of a majority of the bank lenders party to the
Credit Facility.
14
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
Management believes that cash flow from operations and funds available under the
Credit Facility will be sufficient to fund the Company's operations at its
current level for at least the next twelve months. However, one of the Company's
affiliated practices has, since September 30, 1998, diverted accounts receivable
receipts that are the property of the Company into an account controlled by the
practice (based on an averaging of accounts receivable receipts, over the nine
months ended September 30, 1998, such receipts are approximately $1,114,468 per
month). On November 16, 1998, the Company filed a complaint against the
Practice. (See further discussion under Part II. Other Information -- Item 1:
Legal Proceedings). Additionally, especially in light of the action described
above, the Company anticipates that it will require additional funds to finance
capital expenditures relating to expansion of its business. The Company expects
that capital expenditures during the remainder of 1998 and 1999 will relate
primarily to (i) the development of ancillary facilities, (ii) expansion and
replacement of medical and office equipment for the Affiliated Practices and
(iii) the purchase of equipment for expansion of corporate offices. If the
proposed restructuring is effected, certain of these expenditures will not be
made. The Company anticipates that, in order to fund expansion of its business,
it may from time to time make additional short- and long-term bank borrowings
and may issue equity or debt securities, the availability and terms of which
will depend on market and other conditions. There can be no assurance that
sufficient funds will be available on terms acceptable to the Company, if at
all. If funds are unavailable when needed, the Company may be compelled to
modify its expansion plans.
Year 2000
The Year 2000 (Y2K) issue is a result of a global programming standard that
records dates as six digits (i.e., mm/dd/yy), using only the last two digits for
the year. Any software application or hardware product that uses two-digit
fields could understand the year 2000 as the year 1900 if the problem is not
corrected. Systems that do not properly recognize the correct year could
generate erroneous data or cause a system to fail, resulting in business
interruption. This situation is not limited to computers; it has the potential
to affect many systems, components and devices that have embedded computer chips
that may be date sensitive.
The Company is coordinating its efforts to address the Y2K issue with its
affiliated practices, payors and vendors. However, there can be no assurances
that the systems of other companies on which the Company's systems rely will be
timely converted, or that a failure to convert by another company, or a
conversion that is incompatible with the Company's systems, would not have a
material adverse effect on the Company.
In 1997, the Company established a Y2K Coordinator to oversee all corporate-wide
Y2K initiatives. These initiatives encompass all of the company's computer
software and embedded systems, which also involves contingency planning. Teams
of internal and external specialists were established to inventory and test
critical computer programs and automated operational systems. Additionally, a
detailed project plan has been created that outlines all activities related to
the Y2K issue. Generally speaking, the project involves three areas of the
Company: Corporate Headquarters, Affiliated Practices and Interface Agents.
Corporate Headquarters: Because the Company was formed in 1996, most of its
corporate computer hardware is relatively new. Additionally, most of the
software applications are "off the shelf", resulting in few internal software
modifications. All vendors of these "off the shelf" products have been contacted
and remediation activities are underway with respect to those applications that
are not currently Y2K compliant. Internal applications are currently being
reviewed and updated. The Comnpany currently anticipates that all software
utilized for internal corporate headquarters activities will be Y2K compliant by
the end of the first quarter of 1999.
15
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
Affiliated Practices: The Company is currently assessing the status of the
computer systems at its affiliated practices. Based on the results of this
assessment, the Company will evaluate appropriate courses of preventive
corrective action including the replacement of certain systems in connection
with standardizing the various systems utilized by its affiliated practices with
Y2K compliant systems. Management does not anticipate that these activities will
have a material adverse impact on the financial position, results of operations
or cash flows of the Company or its affiliates. The Company anticipates that
this assessment will be completed by the end of 1998.
Interface Agents: The Company has important relationships with third party
payors and managed care organizations. The Company has been reviewing with its
major payors and managed care organizations the status of their Y2K readiness.
Most of the Company's major payors are large insurance carriers along with
certain government agencies. The Company anticipates that all of these entities
will be contacted as part of the Y2K project plan by the end of 1998.
After a thorough analysis of these activities is performed, the Company will be
formulating contingency plans intended to deal with the impact on the Company of
Y2K problems that may arise. The Company is also alerting the appropriate
vendors to their need to address these problems, but the Company has few
alternatives available, other than reversion to manual methods, for avoiding or
mitigating the effects of lack of Y2K readiness. In any event, even though the
Company is developing contingency plans, there can be no assurance that such
plans will address all the problems that may arise, or that such plans, even if
implemented, will be successful. For the Y2K non-compliance issues identified to
date, the cost of upgrade or remediation is not expected to be material to the
Company's operating results. The Company expects to conclude its cost estimates
by the end of the calendar year 1998.
Item 3. Quantitative and Qualitative Disclosure About Market Risk
None.
16
<PAGE>
PART II. Other Information
Item 1: Legal Proceedings
On November 13, 1998 a complaint was filed in the Superior Court for the State
of California in and for the County of Solano by The Specialists Orthopaedic
medical Corporation (the "Practice"), one of the Company's affiliated practices;
The Specialists Surgery Center ("TSSC"), a partnership that operates at a
surgery center the assets of which were sold by TSSC to the Company in
connection with the Practice's affiliation with the Company; and four physicians
who practice at, and own an interest in, one or both of the plaintiff entities
(the "Doctors"), against the administrator of the predecessor to the Practice;
legal, accounting and consulting advisors to the plaintiffs in connection with
the affiliation transactions (collectively with the administrator, the
"Advisors"); entities affiliated with certain of the Advisors; the Company; an
employee of the Company; and 25 unnamed Does.
The complaint contains numerous allegations against one of more of the Advisors,
including, among others, a fraudulent scheme by the Advisors to benefit
themselves financially at the expense of the plaintiffs; misrepresentations and
fraudulent disclosures by the Advisors to the Physicians concerning the terms of
the agreements by which the Company acquired the predecessor to the Practice and
the surgery center (the "Acquisition Agreements") as well as the service
agreements that the plaintiffs entered into with the Company (collectively, with
the Acquisition Agreements, the "Contracts"); "effectively selling the Doctors
into indentured servitude"; the conversion by the administrator of $1.94 million
of the cash proceeds payable under the Acquisition Agreements as well as the
diversion of other assets of the Practice and TSSC by the administrator for his
own use; breach of fiduciary duty; negligence; professional negligence; and
legal malpractice. With respect to the Company, the complaint alleges, among
other things, that the Company and its employee conspired with the Advisors to
induce the Plaintiffs to enter into the Contracts; that the Company and the
employee misrepresented terms of the Contracts to the Doctors; that, in
connection with the issuance of Company securities to the Doctors in the
affiliation transactions, the Company and the other defendants violated
California securities laws by making material misstatements or omitting to state
material facts; that the service agreements are void because they are against
public policy and in violation of California law; that the required service fees
are unconscionable; and that the service agreements do not represent the true
intention of the parties with regard to the service fees to be charged.
The plaintiffs seek a judicial declaration that the service fees are
unenforceable; a reformation of the service agreements to reflect service fees
within the alleged intent of the parties; an accounting to the cash proceeds
from the affiliation transactions; special damages of $2.48 million (including
$300,000 paid to the Company); compensatory, consequential and punitive damages;
damages for emotional distress, attorneys fees and costs.
The Company believes that the allegations, as they pertain to the Company and
its employee, are without merit and intends to vigorously contest the action.
On November 16, 1998, the Company filed a complaint in the Circuit Court of the
Second Judicial Circuit in and for Leon County, Florida against TOC Specialists,
P.L., one of the Company's affiliated practices ("TOC"), 15 physicians who have
an ownership interest in and conduct business at the practice (the "Physicians")
and The State of Florida, Department of Health, Board of Medicine (the "Board of
Medicine"). The complaint alleges that, since September 30, 1998 and in
violation of their service agreement with the Company, TOC and the Physicians
have diverted accounts receivable
17
<PAGE>
Item 1: Legal Proceedings (continued)
receipts that are the property of the Company into an account controlled by TOC
and the Physicians (based on an averaging of accounts receivable receipts over
the nine months ended September 30, 1998, such receipts are approximately
$1,114,468 per month). In addition, the complaint alleges that TOC and the
Physicians have failed to pay to the Company service fees due to the Company,
which unpaid fees amounted to at least $233,753 at the time of the filing of the
complaint. The complaint also alleges that TOC and the Physicians have
effectively "locked-out" the Company by failing to provide necessary records to
enable the Company to perform effectively its management functions and are
apparently performing such services themselves, or through a third party, in
violation of the service agreement. Moreover, the complaint alleges that TOC and
the Physicians have improperly attempted to terminate the service agreement,
have attempted to interfere with the Company's contractual relations with other
affiliated practices and have violated the confidentiality, noncompetition and
restrictive covenant provisions of the service agreement. In addition, the
complaint alleges that, in breach of its representation that the agreement does
not violate any statute, rule or regulation applicable to TOC or any Physician,
TOC and the Physicians filed a petition with the Board of Medicine alleging
concern over whether the service fee payable under the service agreement
violates the "fee-splitting" prohibition under Florida law.
The Company is seeking a declaratory judgment and injunctive and unspecified
monetary relief, including, among other things, a judgment that the service
agreement is in full force and effect; an order that TOC and the Physicians
specifically perform their obligations under the service agreement (or, in the
alternative, pay an unspecified amount of compensation damages), provide an
accounting of all accounts receivable receipts that have been wrongfully
diverted and converted by TOC and the Physicians and pay all past due service
fees; and an order enjoining TOC and the Physicians from interfering with SCN's
contractual relationship with others or taking other actions that the Company
alleges violate the service agreement. In addition, the Company seeks an order
prohibiting the Board of Medicine from considering the petition filed by TOC and
the Physicians and prohibiting TOC and the Physicians from taking further action
before the Board of Medicine.
Item 2. Changes in Securities
Reference is made to the description of the Company's acquisition of Provider
Partnerships, Inc. in Note 4 of the Notes to Consolidated Condensed Financial
Statements included in this report. The Company effected the foregoing
transactions in reliance on the exemption from registration provided under
Section 4(2) of the Securities Act of 1933. In this regard, the Company believes
the transactions complied with the requirements of Rule 506 under the Act.
Item 3. Defaults Upon Senior Securities
During November 1998, the Company received a waiver from its bank lenders in
connection with its failure to meet certain of its financial covenant ratios
under its Credit Facility. (See further discussion under Part I, Item 2:
Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources.)
18
<PAGE>
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits -- The following is a list of exhibits filed as part of this
quarterly report on Form 10-Q.
Exhibit
Number Description
11 Statement re: computation of per share earnings
27 Summary financial data schedule
(b) Reports on Form 8-K. No reports were filed on Form 8-K during the period
covered by this report.
19
<PAGE>
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.
SPECIALTY CARE NETWORK, INC.
Date: November 16, 1998 By: /s/ D. Paul Davis
-------------------------------- --------------------------
D. Paul Davis
Senior Vice President, Finance
(Chief Financial Officer)
20
<PAGE>
Specialty Care Network, Inc. and Subsidiaries
Exhibit Index
Exhibit 11 Computation of Per Share Earnings.........................21
Exhibit 27 Summary Financial Data Schedule...........................22
Specialty Care Network, Inc. and Subsidiaries
Exhibit 11 - Computation of Per Share Earnings
<TABLE>
<CAPTION>
For the For the For the For the
Three Three Nine Nine
Months Months Months Months
Ended Ended Ended Ended
September 30, September 30, September September 30,
1998 1997 30, 1998 1997
------------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Weighted average
shares outstanding 18,415,301 16,572,817 18,117,349 14,860,463
Effect of dilutive securities:
Employee stock options 192,444 336,562 371,673 430,155
----------- ----------- ----------- -----------
Weighted average number of
common shares and common
share equivalents used in
computation 18,607,745 16,909,379 18,489,022 15,290,618
=========== =========== =========== ===========
Net income $ 567,710 $ 1,798,690 $ 4,068,315 $ 3,766,282
=========== =========== =========== ===========
Net income per common share (basic) $ 0.03 $ 0.11 $ 0.22 $ 0.25
=========== =========== =========== ===========
Net income per common share (diluted) $ 0.03 $ 0.11 $ 0.22 $ 0.25
=========== =========== =========== ===========
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<CURRENCY> U.S.
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<EXCHANGE-RATE> 1
<CASH> 369
<SECURITIES> 0
<RECEIVABLES> 75,340
<ALLOWANCES> 39,540
<INVENTORY> 0
<CURRENT-ASSETS> 38,742
<PP&E> 16,115
<DEPRECIATION> 4,810
<TOTAL-ASSETS> 170,990
<CURRENT-LIABILITIES> 11,617
<BONDS> 0
0
0
<COMMON> 19
<OTHER-SE> 73,823
<TOTAL-LIABILITY-AND-EQUITY> 170,990
<SALES> 55,964
<TOTAL-REVENUES> 59,111
<CGS> 0
<TOTAL-COSTS> 49,835
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 2,557
<INCOME-PRETAX> 6,719
<INCOME-TAX> 2,651
<INCOME-CONTINUING> 4,068
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,068
<EPS-PRIMARY> 0.22
<EPS-DILUTED> 0.22
</TABLE>
