APPLE ORTHODONTIX INC, 10-Q, 1999-11-15

APPLE ORTHODONTIX INC
10-Q, 1999-11-15
HEALTH SERVICES

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 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 30,1999 or

[ ] Transition report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934.

for the transition period from ___________________ to ____________________

Commission file number 1-12977

APPLE ORTHODONTIX, INC.
(exact name of Registrant as specified in its charter)

Delaware 74-2795193
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

2777 Allen Parkway, Suite 700, Houston, Texas 77019
(Address of principal executive offices) (zip code)

Registrant's telephone number, including area code: (713) 852-2500

Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]

The number of shares of Class A Common Stock and Class B Common Stock of
the Registrant, par value $.001 per share, outstanding at August 20, 1999 was
11,805,543 and 2,094,008 respectively.
<PAGE>
FORM 10-Q REPORT INDEX

10-Q PART AND ITEM NO.

PAGE
----
PART I - FINANCIAL INFORMATION

Item 1 - Condensed Consolidated Financial Statements

Condensed Consolidated Balance Sheets - September 30, 1999
(unaudited) and December 31,1998............................ 3

Condensed Consolidated Statements of Operations (unaudited) -
Three months and nine months ended September 30, 1999
and 1998.................................................... 4

Condensed Consolidated Statements of Cash Flow (unaudited) -
Nine months ended September 30, 1999 and 1998............... 5

Notes to Condensed Consolidated Financial Statements
(unaudited).................................................. 6

Item 2 -- Management's Discussion and Analysis of Financial
Condition and Results of Operations........................ 13

PART II - OTHER INFORMATION

Item 1 -- Legal Proceedings............................................ 18

Item 6 -- Exhibits and Reports on Form 8-K............................. 20

Signature.............................................................. 22

<PAGE>
PART I
ITEM 1. FINANCIAL STATEMENTS

APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)

<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
------------ ------------
ASSETS (UNAUDITED)
<S> <C> <C>
Current assets:
Cash .................................................................................. $ 2 $ 755
Restricted cash ....................................................................... -- 2,140
Receivable from orthodontic practices, net ............................................ 10,160 5,521
Prepaid expenses and other current assets ............................................. 439 919
------------ ------------
Total current assets ............................................................. 10,601 9,335
------------ ------------
Property and equipment, net ................................................................. 8,368 6,649
Intangible assets, net ...................................................................... 47,072 49,347
Receivable from orthodontic practices, net of current portion ............................... 3,006 3,890
Notes receivable ............................................................................ 914 1,451
Receivable from third parties ............................................................... 674 634
Other assets ................................................................................ 390 156
------------ ------------
Total assets ..................................................................... $ 71,025 $ 71,462
============ ============

LIABILITIES AND
STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses ................................................. $ 3,114 $ 4,065
Consideration payable to orthodontic practices ........................................ -- 2,098
Payable to orthodontic practices ...................................................... 763 454
Current maturities of long-term debt .................................................. 162 105
------------ ------------
Total current liabilities ........................................................ 4,039 6,722
------------ ------------

Long-term debt, net of current maturities ................................................... 25,110 23,654
Deferred income taxes and other long term obligations ....................................... 10,582 11,398
------------ ------------
Total liabilities ................................................................ 39,731 41,774
------------ ------------
Stockholders' equity
Class A common stock, $0.001 par value, 25,000 shares authorized, 12,072 and 11,699
shares issued and outstanding, respectively ......................................... 12 12
Class B common stock, $0.001 par value, 4,107 shares authorized, 2,045 and 2,325 shares
issued and outstanding, respectively ............................................... 2 2
Additional paid-in capital ............................................................ 65,012 64,310
Warrants .............................................................................. 1,086 1,086
Retained deficit ...................................................................... (33,349) (33,922)
Treasury stock, at cost ............................................................... (298) --
Foreign currency translation adjustment ............................................... (1,171) (1,800)
------------ ------------

Total stockholders' equity ....................................................... 31,294 29,688
------------ ------------
Total liabilities and stockholders' equity ....................................... $ 71,025 $ 71,462
============ ============
</TABLE>

The accompanying notes are an integral part of these condensed consolidated
financial statements.

- 3 -
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS AND UNAUDITED)

<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- --------------------
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Management service fee revenues ........................ $ 12,223 $ 13,114 $ 36,982 $ 36,150
Costs and expenses:
Salaries and benefits ............................ 5,049 4,653 15,168 12,931
Orthodontic supplies ............................. 1,585 1,927 4,837 5,129
Rent ............................................. 1,384 1,294 4,179 3,553
Advertising and marketing ........................ 432 689 1,215 1,545
General and administrative ....................... 2,018 1,921 6,487 5,493
Depreciation and amortization .................... 932 897 2,558 2,105
Special charge ................................... 484 -- 484 3,745
-------- -------- -------- --------
Total costs and expenses .................... 11,884 11,381 34,928 34,501
-------- -------- -------- --------
Operating income ............................ 339 1,733 2,054 1,649

Interest expense, net of capitalized interest .......... 555 293 1,448 403
Interest income ........................................ (108) (131) (364) (318)
Other (income) expense ................................. -- (20) 40 (58)
-------- -------- -------- --------
Income (loss) before income taxes ........... (108) 1,591 930 1,622
Income tax provision (benefit) ......................... (41) 605 357 616
-------- -------- -------- --------
Net income (loss) ........................... $ (67) $ 986 $ 573 $ 1,006
======== ======== ======== ========

Earnings (loss) per common and common equivalent share:
Basic ............................................ $ (0.00) $ 0.07 $ 0.04 $ 0.07
======== ======== ======== ========
Diluted .......................................... $ (0.00) $ 0.07 $ 0.04 $ 0.07
======== ======== ======== ========
Number of shares used in calculating earnings (loss) per
Basic ............................................ 14,098 13,944 14,029 13,715
======== ======== ======== ========
Diluted .......................................... 14,098 14,002 14,048 13,870
======== ======== ======== ========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.

- 4 -
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS AND UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS
ENDED SEPTEMBER 30,
-------- --------
1999 1998
-------- --------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ..................................................................... $ 573 $ 1,006
Adjustments to reconcile net income to net cash used in operating
Activities:
Depreciation and amortization ............................................. 2,558 2,105
Deferred income tax benefit ............................................... (274) 430
Provision for doubtful accounts ........................................... 948 134
Non-cash special charge ................................................... 484 --
Special compensation expense paid in stock ................................ -- 538
Changes in assets and liabilities, excluding effects of acquisitions:
Receivable from orthodontic practices ..................................... (5,925) (8,771)
Prepaid expenses and other current assets ................................. 246 (330)
Accounts payables and other accrued expenses .............................. (600) 2,283
-------- --------
Net cash provided (used) in operating activities ...... (1,990) (2,605)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures ........................................................... (3,141) (2,419)
Payments for new affiliated practices .......................................... -- (10,456)
Net proceeds from disposition of affiliated practices........................... 2,225 --
Advances to related party ...................................................... (40) (655)
Repayment of advances to third party ........................................... 380 (2,075)
Advances to affiliates ......................................................... (1,165) (1,837)
Repayment of advances by affiliates ............................................ 1,465 246
-------- --------
Net cash used in investing activities ................. (276) (17,196)
-------- --------

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from borrowings ....................................................... 2,403 20,000
Repayments of borrowings ....................................................... (890) (979)
Proceeds from issuance of common stock ........................................ -- 79
-------- --------
Net cash provided by financing activities ............. 1,513 19,100
-------- --------

NET DECREASE IN CASH ................................................................. (753) (701)

CASH AT BEGINNING OF PERIOD .......................................................... 755 2,114
-------- --------
CASH AT END OF PERIOD ................................................................ $ 2 $ 1,413
======== ========
</TABLE>

The accompanying notes are an integral part of these condensed consolidated
financial statements.

- 5 -
<PAGE>
APPLE ORTHODONTIX, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. ORGANIZATION AND BASIS OF PRESENTATION

Apple Orthodontix, Inc. ("Apple" or the "Company") provides practice management
services to orthodontic practices in the United States and Canada. As of
September 30, 1999, the Company managed 58 affiliated orthodontic practices (the
"Affiliated Practices") in 18 states and 3 Canadian provinces.

The accompanying unaudited condensed consolidated financial statements include
the accounts of the Company and its wholly owned subsidiaries. The Company's
subsidiaries acquire operating assets and assume certain liabilities of the
affiliated orthodontic practices and provide management services to the
Affiliated Practices under the Company's long-term management services
agreements. In 1997, the Emerging Issues Task Force released issue No. 97-2
"Applications of FASB Statement No. 94, Consolidation of all Majority-Owned
Subsidiaries, and APB Opinion No. 16, Business Combinations, to Physician
Practice Management Entities and Certain Other Entities With Contractual
Management Arrangements" (Issue No. 97-2). Issue 97-2 allows consolidation by
the physician practice management company (the "PPM") with the affiliated
physician practice when the PPM has controlling financial interest through a
contractual management arrangement. The Company's management services agreements
do not meet the criteria of Issue 97-2 and the Company has not consolidated the
affiliated orthodontic practices.

The unaudited condensed consolidated financial statements included herein have
been prepared by the Company pursuant to the rules and regulations of the
Securities and Exchange Commission (the "SEC"). Pursuant to such regulations,
certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. The Company believes the presentation and
disclosures herein are adequate to make the information not misleading. The
financial statements reflect all elimination entries and normal adjustments that
are necessary for a fair presentation of the results for the interim periods
ended September 30, 1999 and 1998.

Operating results for interim periods are not necessarily indicative of the
results for full years. It is suggested that these unaudited condensed
consolidated financial statements be read in conjunction with the financial
statements of Apple and related notes thereto, and management's discussion and
analysis related thereto, all of which are included in the Company's annual
report on Form 10-K for the year ended December 31, 1998, as amended, as filed
with the SEC (the "1998 Form 10-K"). The financial information as of December
31, 1998 is derived from the Company's audited consolidated financial statements
and notes thereto for the year ended December 31, 1998.

2. SIGNIFICANT ACCOUNTING POLICIES

GENERAL

There have been no significant additions to, or changes in, accounting policies
of the Company since December 31, 1998. For a description of the Company's
accounting policies, see Note 2 of Notes to Consolidated Financial Statements in
the 1998 Form 10-K.

INTANGIBLE ASSETS, NET

Intangible assets consist primarily of service fee intangibles. Prior to April
1, 1998, these intangibles were amortized over the life of the related service
agreement (ranging from 20 to 40 years) with the respective Affiliated Practice.
In response to recent trends in the practice management industry, the Company
changed its estimate of the remaining useful life of its intangible assets to a
maximum of 25 years effective April 1, 1998 on a prospective basis. If it is
determined that the estimated remaining service period requires further
revision, such revisions would similarly be made on a prospective basis.

The Company reviews the carrying value of intangibles and other long-lived
assets to determine if facts and circumstances exist which would suggest these
assets may be impaired. The Company evaluates the carrying value of the service
fee intangible along with all other related long-lived assets in relation to the
future undiscounted cash flows

- 6 -
<PAGE>
APPLE ORTHODONTIX, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

2. SIGNIFICANT ACCOUNTING POLICIES, CONTINUED

or other available information regarding the fair value of the affiliation on a
practice by practice basis to determine when impairment has occurred. Under SFAS
121, impairment losses are recognized if the sum of the expected long-term cash
flows is less than the carrying amount of the intangible and other related
assets being evaluated. The difference between the carrying amount of the
service fee intangible and other related assets being evaluated and the
estimated fair market value of the assets represent impairment loss. The Company
determines fair value using multiples of earnings before interest, taxes,
depreciation and amortization based on estimated prices for comparable assets
and other subjective information available to the Company.

In the third quarter of 1999, the Company recorded a special charge of $484,000
on a pre-tax basis for an impairment loss related to its service fee
intangibles. The underlying cause of the impairment related to the Threatened
Practices, as discussed in Note 11, below. There was no such charge during the
third quarter of 1998.

NEW ACCOUNTING STANDARDS

In March 1998, the American Institute of Certified Public Accountants ("AICPA")
issued Statement of Position ("SOP") 98-1, Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use. SOP 98-1 requires that entities
capitalize certain internal-use software costs once certain criteria are met.
The effective date of SOP 98-1 is for fiscal years beginning after December 15,
1998. During the nine months ended September 30, 1999 the Company capitalized
$100,000 related to software developed for internal use. The Company estimates
that this software has a useful life of three years.

In April 1998, the AICPA issued SOP 98-5, Reporting on the Costs of Start-Up
Activities. SOP 98-5 requires entities to charge to expense start-up costs,
including organizational costs, as incurred. The effective date of SOP 98-5 is
for fiscal years beginning after December 15, 1998. The Company's adoption of
SOP 98-5 did not have a material effect on the Company's financial position or
results of operations.

FOREIGN CURRENCY TRANSLATION

The Canadian dollar has been determined to be the functional currency for the
Company's operations in Canada. Translation gains and losses from operations in
Canada are reported in equity and as a component of comprehensive income.

USE OF ESTIMATES

The preparation of financial statements in conformity with generally accepted
accounting principles requires the use of estimates and assumptions by
management in determining the reported amounts of liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of expenses during the reporting period. Actual results
could differ from those estimates.

RECLASSIFICATIONS

Certain reclassifications have been made to amounts in prior period financial
statements to conform with current period presentation.

3. ORTHODONTIST AFFILIATIONS

During the nine months ending September 30, 1999 the Company completed no new
orthodontist affiliations, terminated four service agreements and had
13 orthodontists join existing Affiliated Practices. During the nine months
ending September 30, 1998, the Company entered into new affiliations with 15
practices, representing 21 orthodontists. As a result, the Company was
affiliated with 58 practices representing 88 orthodontists as of September 30,
1999, and 66 practices representing 89 orthodontists as of September 30, 1998.

- 7 -
<PAGE>
APPLE ORTHODONTIX, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

4. EARNINGS (LOSS) PER SHARE

The following table sets forth the computation of basic and diluted earnings per
share for the periods indicated (in thousands, except per share data;
unaudited):

<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- -------------------
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
NET INCOME (LOSS)
Net income (loss) ................................. $ (67) $ 986 $ 573 $ 1,006
BASIC
Basic weighted average shares ..................... 14,098 13,944 14,029 13,715
======== ======== ======== =======

DILUTED
Basic weighted average shares .....................
Effect of shares issuable under the Company's stock
option plan .................................... -- 58 18 155
-------- -------- ------- -------
Diluted weighted average shares ............ 14,098 14,002 14,048 13,870
======== ======== ======== =======

NET INCOME (LOSS) PER SHARE
Basic ............................................. $ (0.00) $ 0.07 $ 0.04 $ 0.07
======== ======== ======== =======
Diluted ........................................... $ (0.00) $ 0.07 $ 0.04 $ 0.07
======== ======== ======== =======
</TABLE>

5. ALLOWANCE FOR DOUBTFUL ACCOUNTS

A summary of the Company's allowance for doubtful accounts is as follows (in
thousands):

<TABLE>
<CAPTION>
BEGINNING ENDING
BALANCE ADDITIONS WRITE-OFFS BALANCE
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Year ended December 31, 1997 .............. $ -- $ 69 $ -- $ 69

Year ended December 31, 1998 .............. $ 69 $ 5,716 $ -- $ 5,785

Nine months ended September 30, 1999 ...... $ 5,785 $ 948 $ (450) $ 6,283

</TABLE>

6. COMBINED PATIENT DATA

Combined operating data for the Affiliated Practices for the period from January
1, 1999 through September 30, 1999 is as follows (in thousands):

PATIENT CASH
REVENUES COLLECTIONS
------- -------
Practices participating under the Standard Contract .... $27,845 $23,308
Practices participating under the Alternative Contract . 9,927 9,674
Practices participating under Flat Fee Contracts ....... 11,978 11,610
------- -------
$49,750 $44,592
======= =======

- 8 -
<PAGE>
APPLE ORTHODONTIX, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

7. LONG-TERM DEBT

A summary of long-term debt is as follows (in thousands):

<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
--------------- ---------------
<S> <C> <C>
Secured revolving credit facility .......................................... $25,000 $23,500
Unsecured credit facility of $480,000, maturing on October 29,
1999, interest rate of 10% ............................................... 90 --
Notes payable, maturing in varying amounts through October 2002,
with interest ranging from 7.5% to 9.3% ................................. 94 121
Capitalized lease obligations, due in monthly installments through
April 2001 with interest ranging from 9.5% to 24.7% ..................... 88 138
------- -------
25,272 23,759
Less: current maturities ............................................. (162) (105)
------- -------
Long-term debt, net of current maturities .................................. $25,110 $23,654
======= =======
</TABLE>

On April 14, 1999 the Company amended its $25 million unsecured bank credit
facility with Chase Bank of Texas, N.A. (the "Chase Credit Facility") with
respect to certain of the covenants. The Chase Credit Facility, as amended,
matures in May 2001 and provides the lenders a security interest in
substantially all the Company's assets. Availability under this facility is
limited by the level of the Company's cash flow and liquidity. At the Company's
option, interest is payable at either a prime rate or LIBOR, in each case plus a
margin, which is calculated based upon the Company's ratio of indebtedness to
cash flow. The Chase Credit Facility limits acquisitions, prohibits the payment
of cash dividends and requires the Company to comply with certain financial
covenants regarding net worth, coverage ratios and additional indebtedness. As
of September 30, 1999, the Company was not in compliance with certain coverage
ratio covenants and had $25 million outstanding under this facility. The Company
is in the process of seeking and expects to receive a waiver related to these
covenants, however, there can be no assurance that a waiver will be granted. In
the event the waiver is not granted, the lenders would be entitled to accelerate
the indebtedness owed by the Company under the Chase Credit Facility.

On September 22, 1999 the Company obtained a short term, unsecured credit
facility of $480,000 that matured on October 29, 1999. As of September 30, 1999
the Company had $390,000 available under this facility. The Company paid the
amount due under this facility and renewed the note through November 30, 1999.
As of November 15, 1999 the Company had $480,000 available under this facility.
There can be no assurance that the lender will continue to renew this facility
or that the Company's efforts to increase its liquidity or obtain additional
capital (as discussed in FINANCING ACTIVITIES, below) will be successful.

The notes payable relate to debts of the Affiliated Practices that were assumed
by the Company.

8. COMPREHENSIVE INCOME (LOSS)

Comprehensive income, as defined by Statement of Financial Accounting Standards
No. 130 - Reporting Comprehensive Income, is net income plus direct adjustments
to stockholders' equity. The cumulative foreign currency translation adjustment
related to the Company's Affiliated Practices in Canada is the only such direct
adjustment applicable to the Company. The amount of comprehensive income for the
Company is as follows (in thousands):

NINE MONTHS
ENDED SEPTEMBER 30,
------------------------------
1999 1998
--------- ---------
Net income reported ...................... $ 573 $ 1,006
Translation adjustment ................... (1,171) (1,352)
------- -------
Comprehensive income (loss) .............. $ (598) $ (346)
======= =======

- 9 -
<PAGE>
APPLE ORTHODONTIX, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

9. OPERATIONS BY INDUSTRY SEGMENT AND GEOGRAPHIC AREA

The Company has only one line of business, which provides practice management
services to orthodontic practices. The Company has operations in two geographic
areas. The following is a breakdown of revenues and long-lived assets by
geographic area (in thousands):

THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------- -----------------
1999 1998 1999 1998
------- ------- ------- -------
UNITED STATES
Management service fee revenues .. $ 8,132 $ 9,224 $25,099 $23,711
Long-lived assets ................ 38,569 43,127 38,569 43,127

CANADA
Management service fee revenues .. $ 4,091 $ 3,890 $11,883 $12,439
Long-lived assets ................ 21,855 19,000 21,855 19,000

TOTAL
Management service fee revenues .. $12,223 $13,114 $36,982 $36,150
Long-lived assets ................ 60,424 62,127 60,424 62,127

10. COMMITMENTS AND CONTINGENCIES

On February 11, 1999, the Company filed a complaint in the United States
District Court for the Southern District of Texas against David V. Young,
D.D.S., M.D.S., and David V. Young, D.D.S., M.D.S., L.C. (collectively, the
"Young Parties") alleging, among other things, breach by the Young Parties of
the Services Agreement dated December 1, 1997 among the Young Parties and the
Company (the "Young Services Agreement"), tortuous interference by the Young
Parties of the relationships of the Company with its employees resident in the
State of Utah and fraud by the Young Parties in connection with the repayment by
the Company of certain debts of Dr. Young. In August 1999, the parties entered
into a settlement agreement pursuant to which, among other things, (i) the
complaint was dismissed with prejudice and all claims of the parties were
released, (ii) the Company conveyed to the Young Parties all of the assets it
owned associated with the orthodontic practice supervised by Dr. Young in
exchange for consideration equal to the fair market value of those assets and
(iii) the Young Services Agreement was terminated.

On April 7, 1999, J. Darwin King, D.D.S., M.D.S. ("King") filed a motion for
judgment (the "Motion") in the Circuit Court of the County of Henrico, Virginia
against the Company. On July 26, 1999, the parties settled this case pursuant to
which, among other things, (i) the Motion was dismissed and all claims of the
parties were released, (ii) the Company conveyed to Dr. King all of the assets
it owned associated with the orthodontic practice supervised by him in exchange
for consideration equal to the fair market value of those assets and (iii) the
services agreement to which Dr. King and Apple were parties was terminated.

On April 27, 1999, David E. Smith, D.D.S. and the professional corporation
wholly owned by him (the "California Parties") filed a complaint against the
Company for damages in the amount of approximately $10.8 million and declaratory
relief (the "California Complaint") in the Superior Court for the County of
Riverside, California. The California Complaint alleges, among other things,
breaches by the Company of the service agreement entered into by it with the
California Parties and seeks a declaratory judgment that such services agreement
has been terminated. The Company intends to vigorously defend the claims made by
the California Parties, which the Company believes are without merit, and the
Company has filed a cross complaint against the California Parties alleging,
among other things,

- 10 -
<PAGE>
APPLE ORTHODONTIX, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

10. COMMITMENTS AND CONTINGENCIES, CONTINUED

breaches of that services agreement by the California Parties, conversion of the
Company's assets, defamation and interference with a prospective business
advantage. This lawsuit is still pending and the Company cannot predict whether
it will succeed, or if not successful, what effect this may have on the Company.

On May 18, 1999, Stewart L. Jeffries, D.M.D., William A. Spencer, D.M.D., the
respective professional services corporations wholly owned by each of them and a
professional limited liability company jointly owned by them (the "Kentucky
Parties") filed a complaint for damages and declaratory relief (the "Kentucky
Complaint") in the Circuit Court of the County of Jefferson, Kentucky against
the Company and John G. Vondrak alleging, among other things, breaches of the
services agreements entered into by the Kentucky Parties and the Company. The
Kentucky Complaint seeks unquantified damages and a declaratory judgment that
such services agreements have been terminated. The Company intends to vigorously
defend the claims made by the Kentucky Parties, which the Company believes are
without merit, and to relocate the venue of the litigation to Texas (as is
called for in the services agreements). This lawsuit is still pending and the
Company cannot predict whether it will succeed, or if not successful, what
effect this may have on the Company.

On September 14, 1999, Thomas K. Chubb, D.D.S. and the professional corporation
wholly owned by him (the "Colorado Parties") filed a complaint against the
Company for declaratory relief and damages (the "Colorado Complaint") in the
District Court of the County of Adams, Colorado. The Colorado Complaint alleges,
among other things, breaches of the service agreement entered into by the
Colorado Parties and the Company and seeks unquantified damages and a
declaratory judgment that such service agreement has been terminated. The
Company intends to vigorously defend the claims made by the Colorado Parties,
which the Company believes are without merit. This lawsuit is still pending and
the Company cannot predict whether it will succeed, or if not successful, what
effect this may have on the Company.

On September 15, 1999, Carl P. Roy, D.D.S., M.S. and the professional limited
liability company wholly owned by him (the "Virginia Parties") filed a motion
for judgment (the "Motion") against the Company seeking damages in the amount of
approximately $1.8 million in the Circuit Court of the City of Norfolk,
Virginia. The Motion alleges, among other things, breaches of the service
agreement entered into by the Virginia Parties and the Company. The Company
intends to vigorously defend the claims made by the Virginia Parties, which the
Company believes are without merit. This lawsuit is still pending and the
Company cannot predict whether it will succeed, or if not successful, what
effect this may have on the Company.

The Company is not currently a party to any material claims, suits or complaints
relating to services and products provided by the Company or the existing
Affiliated Practices, except for those previously reported, although there can
be no assurance that such claims will not be asserted against the Company in the
future. The Company is subject to certain pending claims as a result of
successor liability in connection with its affiliations with existing Affiliated
Practices; however, the Company believes that the ultimate resolution of those
claims will not have a material adverse effect on the financial position or
operating results of the Company.

11. RECENT EVENTS

Since December 31, 1998, 12 Affiliated Practices have alleged breaches of their
service agreements by the Company and sought to have the service agreements
terminated (the "Threatened Practices"). As of November 15, 1999 the Company has
terminated four of these service agreements, entered into one assignment
agreement and continues to pursue a favorable resolution of disagreements with
the remaining seven Threatened Practices. The Company is

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<PAGE>
APPLE ORTHODONTIX, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

11. RECENT EVENTS, CONTINUED

involved in legal proceedings with five of the remaining Threatened Practices.
The Company vigorously denies any breach of the service agreements and is
currently seeking enforcement of these agreements. The management service fee
revenues related to the Threatened Practices were $3.3 million and $4.0 million
for the nine months ending September 30, 1999 and the twelve months ending
December 31, 1998, respectively. The management service fee revenues related to
the terminated practices were $459,000 and $1.9 million for the nine months
ending September 30, 1999 and the twelve months ending December 31, 1998,
respectively. All unrecoverable receivables associated with terminated practices
have been written off. In addition, the Company is in the process of negotiating
the termination of one additional service agreement with an Affiliated Practice
that had management service fee revenues of approximately $273,000 and $342,000
for the nine months ending September 30, 1999 and the twelve months ending
December 31, 1998, respectively.

The assignment agreement discussed above provides for the Company to issue
181,818 shares of Common Stock to one of the Threatened Practices in return for
the right to direct the current owners of the dental practice to assign the
ownership interest in the practice to another licensed orthodontist. The Company
will have this right on the first anniversary of the date of the agreement
(April 23, 2000) or upon the occurrence of one of the following events (which
ever occurs first): (1) a change in control of the Company; (2) the trading of
Apple's common stock at a price per share equal to or greater than $5.00; or (3)
the trading of Apple's common stock for 10 consecutive trading days at a price
per share equal to or greater than $3.00 where the cumulative trading volume
during that period equals or exceeds 665,280 shares. The management service fee
revenues associated with this practice were $1.9 million and $2.4 million for
the nine months ending September 30, 1999 and the twelve months ending December
31, 1998, respectively.

On April 27,1999, the Company signed a non-binding letter of intent with an
investor group (the "Investor Group") in connection with the consideration of a
potential investment (the "Proposed Transaction") in the Company. The period of
exclusivity related to this letter of intent has expired, however, the Company
continues to negotiate the Proposed Transaction with the Investor Group. The
Proposed Transaction remains subject to further negotiation of applicable terms
and conditions including price, the negotiation of definitive documents, the
satisfactory completion of due diligence, the receipt of any necessary
regulatory approvals and third-party consents, and other customary closing
conditions.

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<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

THE FOLLOWING DISCUSSION AND ANALYSIS CONTAINS CERTAIN STATEMENTS OF A
FORWARD-LOOKING NATURE RELATING TO FUTURE EVENTS OR THE FUTURE FINANCIAL
PERFORMANCE OF THE COMPANY. SUCH STATEMENTS ARE ONLY PREDICTIONS AND THE ACTUAL
EVENTS OR RESULTS MAY DIFFER MATERIALLY FROM THE RESULTS DISCUSSED IN THE
FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH
DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, RISKS ASSOCIATED WITH AFFILIATIONS,
FLUCTUATIONS IN OPERATING RESULTS BECAUSE OF AFFILIATIONS AND VARIATIONS IN
STOCK PRICE, CHANGES IN GOVERNMENT REGULATIONS, COMPETITION, RISKS OF OPERATIONS
AND GROWTH OF EXISTING AND NEW AFFILIATED ORTHODONTIC PRACTICES, AND RISKS
DETAILED IN THE COMPANY'S SEC FILINGS. THE HISTORICAL RESULTS SET FORTH IN THIS
DISCUSSION AND ANALYSIS ARE NOT INDICATIVE OF TRENDS WITH RESPECT TO ANY ACTUAL
OR PROJECTED FUTURE FINANCIAL PERFORMANCE OF THE COMPANY. THIS DISCUSSION AND
ANALYSIS SHOULD BE READ IN CONJUNCTION WITH THE UNAUDITED CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS OF THE COMPANY AND THE RELATED NOTES THERETO INCLUDED
ELSEWHERE IN THIS FORM 10-Q AND THE ANNUAL CONSOLIDATED FINANCIAL STATEMENTS
INCLUDED IN THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER
31, 1998, AS AMENDED.

OVERVIEW

Apple provides practice management services (which exclude the management and
delivery of orthodontic services) to orthodontic practices in the United States
and Canada. As of September 30, 1999, the Company had service agreements with 58
practices representing 88 orthodontists in 117 offices as compared to 66
practices representing 89 orthodontists in 123 offices as of September 30, 1998.

Since the fourth quarter of 1998, the Company has attempted to raise additional
capital to fund its expansion strategy. This effort has been unsuccessful to
date. Consequently, the Company has suspended its strategy of expansion through
acquisitions in order to devote its limited resources to the integration of
existing Affiliated Practices. Another element of the Company's expansion
strategy has been the development of new offices within selected markets served
by the existing Affiliated Practices. The Company believes that the new offices
will increase the geographic area served by the existing Affiliated Practices,
thereby increasing the potential market and leveraging the advertising budget.
The Company is currently limited in the development of new offices due to
funding constraints. The Company plans to reinitiate certain elements of its
expansion strategy dependent upon the recovery of the market value of the
Company's Common Stock and the Company's ability to obtain outside financing (as
discussed in FINANCING ACTIVITIES below.) The Company is continuing its strategy
to implement a comprehensive practice operating approach designed to drive
internal growth of the Affiliated Practices.

Through its service agreements, the Company provides a full complement of
practice management services to Affiliated Practices in return for management
service fees. The management service fees earned by the Company are in
accordance with three general types of Service agreements -- the standard form
of service agreement (the "Standard Contract"), the alternative form of service
agreement (the "Alternative Contract") and a service agreement based upon a flat
fee (the "Flat Fee Contract"). The Standard Contract calls for a calculation of
the monthly service fee based on the total patient revenues earned by the
Affiliated Practices, which is defined by the agreement to represent 24% of the
total contract value in the initial month of a patient's treatment with the
remainder of the contract balance earned evenly over the balance of the contract
term. From total patient revenues, the practices retain a percentage of the
Affiliated Practices' cash collections.

The Alternative Contract is used in certain jurisdictions where use of the
Standard Contract is not permitted. It is a cost-plus fee arrangement, whereby
the service fee includes the reimbursement of defined expenses incurred by Apple
in the course of providing services to the Affiliated Practice plus a percentage
of revenues.

The Flat Fee Contract is based on a flat fee subject to adjustment on an annual
basis. It is used when local jurisdictions do not allow use of the Standard
Contract or Alternative Contract.

The Company believes the fees generated by each of these formulas reflect the
fair market value of the services provided and are comparable to the fees earned
by other practice management service companies in the respective jurisdictions
where these arrangements exist.

The expenses incurred by the Company in fulfilling its obligations under the
service agreements are generally of the same nature as the operating costs and
expenses that would have otherwise been incurred by the Affiliated Practices,
including salaries, wages and benefits of practice personnel (excluding
orthodontists and, in some cases, orthodontic assistants and other professional
personnel), orthodontic supplies and office supplies used in administering their
clinic practices, the office (general and administrative) expenses of the
practices and depreciation and amortization of assets acquired from the founding
Affiliated Practices. In addition to the operating costs and expenses discussed
above, the Company incurs personnel and administrative expenses in connection
with establishing and maintaining a corporate office, which provides management,
administrative, marketing and business development services.

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<PAGE>
The Company conducted no significant operations before its Initial Public
Offering (the "IPO") in May 1997 when the Company acquired the tangible and
intangible assets and liabilities of, and entered into service agreements with,
31 Founding Affiliated Practices. The acquisition of the assets and assumption
of certain liabilities for all of the Founding Affiliated Practices was
accounted for by the Company at the transferors' historical cost basis, with the
shares of Common Stock issued in those affiliations being valued at the
historical cost of the non-monetary assets acquired net of liabilities assumed
in accordance with Staff Accounting Bulletin ("SAB") No. 48. SAB 48 is not
applicable to affiliations affected by the Company after the IPO. The subsequent
affiliations resulted in substantial intangible assets being recorded.
Amortization of these intangible assets was being recognized over a period of 20
to 40 years to match the term of the related Service Agreement. Effective April
1, 1998, the Company changed its estimate of the remaining useful life of its
intangible assets to a maximum of 25 years in light of trends in the practice
management industry.

RESULTS OF OPERATIONS FOR THE INTERIM PERIODS ENDED SEPTEMBER 30, 1999 AND 1998
(UNAUDITED)

MANAGEMENT SERVICE FEE REVENUES

The Company generated management service fee revenues of $12.2 million and $37.0
million for the three and nine-month periods ended September 30, 1999, as
compared with $13.1 million and $36.2 million for the three and nine-month
periods ended September 30, 1998. The decrease of approximately $900,000 for the
three months ended September 30, 1999 was the result of a decrease in the number
of Affiliated Practices, as compared to the three months ended September
30,1998. The increase of approximately $800,000 for the nine months ended
September 30, 1999 was the result of an increase in cash collections, as
compared to the nine months ended September 30, 1998.

COSTS AND EXPENSES

The Company incurred costs and expenses of $11.9 million and $34.9 million
(97.5% and 94.3%, respectively, of management service fee revenues) for the
three and nine-month periods ended September 30, 1999, as compared with $11.3
million and $34.5 million (86.3% and 95.3%, respectively, of management service
fee revenues) for the three and nine-month periods ended September 30, 1998.
Costs and expenses also include special charges of $484,000 and $3.7 million for
1999 and 1998, respectively. The 1999 special charge was recorded in the third
quarter and is related to the impairment of one of the Threatened Practices
discussed in Note 11, above. The 1998 special charge was recorded in the second
quarter and related to severance costs associated with a series of management
changes, costs of terminated transaction negotiations and certain other items.
Exclusive of the special charges, costs and expenses were $11.4 million and
$34.4 million (93.4% and 93.0%, respectively, of management service fee
revenues) for the three and nine-month periods ended September 30, 1999, and
$30.8 million (85.1% of management service fee revenues) for the nine-month
period ended September 30, 1998.

The increase in costs and expenses for the nine months ended September 30, 1999,
as compared to the nine months ended September 30, 1998, excluding the $3.7
million charge, was primarily due to increases in salaries and benefits, general
and administrative, depreciation and amortization, and rent. The $2.2 million
increase in salaries and benefits expense was related primarily to: (i)
suspension of the business development program, and (ii) a higher number of
employees related to fifteen new orthodontist affiliations. In prior periods,
business development costs directly related to an affiliation were recorded on
the balance sheet and amortized as acquisition costs. The $1.5 million increase
in general and administrative expense was the result of (i) an increase in
professional fees related to regulatory issues in Canada (as discussed in Note
12 of the 1998 Form 10-K) and the costs of additional audit, legal and
consulting fees related to the Company's pursuit of certain strategic
alternatives, and (ii) an increase in training expense, administrative services
and office supplies related to a greater number of Affiliated Practices. The
$453,000 increase in depreciation and amortization expense was the result of (i)
the change of the Company's estimate of the remaining useful life of its
intangible assets from 40 years to 25 years, and (ii) the additional
orthodontist affiliations in the first and second quarters of 1998. The $626,000
increase in rent expense was primarily the result of a greater number of
Affiliated Practices.

OPERATING INCOME (LOSS)

The Company generated operating income of $339,000 and $2.1 million (2.8% and
5.7% of management service fee revenues) for the three and nine-month periods
ended September 30, 1999, as compared with $1.7 million and $1.6 for the three
and nine-month periods ended September 30, 1998. Exclusive of the special
charges discussed in COSTS AND EXPENSES above, operating income was $823,000 and
$2.6 million (6.7% and 7%, respectively, of management service revenue) for the
three and nine-month periods ended September 30, 1999, and $5.3 million (14.6%
of management service fee revenues) for the nine month period ended September
30, 1998.

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<PAGE>
INTEREST EXPENSE, NET

Interest expense is summarized as follows (in thousands):

THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
------- ------- ------- -------
1999 1998 1999 1998
------- ------- ------- -------
Gross interest .................. $ 578 $ 361 $ 1,493 $ 575
Less: capitalized interest ...... (23) (68) (45) (172)
------- ------- ------- -------
Interest expense ................ $ 555 $ 293 $ 1,448 $ 403
======= ======= ======= =======

Gross interest increased $217,000 and $918,000 for the three and nine-month
periods ended September 30, 1999 as compared to the three and nine-month periods
ended September 30, 1998. The increase in gross interest was due to higher
average debt levels.

INTEREST INCOME

Interest income was $108,000 and $364,000 for the three and nine-month periods
ended September 30, 1999 as compared to $131,000 and $318,000 for the three and
nine-month periods ended September 30, 1998, a decrease of (17.6%) and an
increase of 14.5%, respectively, for such periods. The decrease for the three
months ended September 30, 1999, as compared to the three months ended September
30, 1998, was primarily due to prepayment of notes receivable by certain
practices. The increase for the nine month period ended September 30, 1999, as
compared to the nine months ended September 30, 1998, reflects net additions to
notes receivable from certain of the Affiliated Practices to fund new office
construction and working capital needs.

INCOME TAX PROVISION (BENEFIT)

The Company's year to date operations in 1999 resulted in an income tax
provision (benefit) of ($41,000) and $357,000 for the three month and nine month
periods ended September 30, 1999, as compared to $605,000 and $616,000 for the
three months and nine months periods ended September 30, 1998. The Company's
effective tax rate for the nine-month period ended September 30, 1999 was 38.3%
compared to 38.0% for the corresponding period in fiscal 1998.

NET INCOME (LOSS)

As a result of the foregoing factors, net income decreased $1.1 million and
$433,000 for the three and nine-month periods ended September 30, 1999, as
compared to the three and nine-month periods ended September 30, 1998. Net
income as a percentage of management service fee revenues was (0.5%) and 1.5%
for the three and nine month period ended September 30, 1999. Exclusive of the
special charges discussed in COSTS AND EXPENSES above, the Company generated net
income of $233,000 and $877,000 (1.9% and 2.4%, respectively, of management
service fee revenues) for the three and nine-month periods ended September 30,
1999, and $3.3 million (9.1% of management service fee revenues) for the
nine-month period ended September 30, 1998.

YEAR 2000 IMPACT ON INFORMATION TECHNOLOGY INFRASTRUCTURE

The Company is in the process of upgrading the practice management systems at
its Affiliated Practices (the "Affiliated Practice Systems"). The purpose of
this upgrade includes enhancement of the diagnostic, imaging, scheduling and
financial features of the Affiliated Practice Systems. The Company has also
conducted an evaluation of its information technology infrastructure, including
information technology systems in the Company's corporate office (the "Corporate
Systems") and the Affiliated Practice Systems, to analyze the impact of the
technical problems anticipated for the year 2000 (the "Year 2000 Issue").
Following its evaluation, the Company determined that substantially all its
Corporate Systems would be unaffected by such problems. The Year 2000 Issue,
however, would affect certain of the Affiliated Practice Systems.

The Company believes that its upgrade of the Affiliated Practice Systems will
adequately address the Year 2000 Issue and that this upgrade process will be
completed (with respect to the Year 2000 Issue) during the fourth quarter of
1999. During the execution of this process, the Company will continue to incur
internal staff costs as well as consulting and

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<PAGE>
other expenses related to the upgrade. The expenses of this upgrade are not
expected to have a material adverse effect on the Company's financial position
or results of operations.

LIQUIDITY AND CAPITAL RESOURCES

FINANCING ACTIVITIES

The Company has funded its operations to date primarily through cash flow from
operations, the Chase Credit Facility and proceeds from the sale of its common
stock. On April 14, 1999, the Company amended the $25 million Chase Credit
Facility with respect to certain of the covenants. The Chase Credit Facility, as
amended, matures in May 2001 and provides the lenders a security interest in
substantially all the Company's assets. Availability under this facility is
limited by the level of the Company's cash flow and liquidity. At the Company's
option, interest is payable at either a prime rate or LIBOR in each case plus a
margin which is calculated based upon the Company's ratio of indebtedness to
cash flow. The Company is required to maintain certain financial covenants
regarding net worth, coverage ratios and additional indebtedness. As of
September 30, 1999, the Company was not in compliance with certain coverage
ratio covenants and had $25 million outstanding under this facility. The Company
is in the process of seeking and expects to receive a waiver related to these
covenants, however, there can be no assurance that a waiver will be granted. In
the event the waiver is not granted the lenders would be entitled to accelerate
the indebtedness owed by the Company under the Chase Credit Facility.

On April 27,1999, the Company signed a non-binding letter of intent with the
Investor Group in connection with the consideration of a potential investment in
the Company. The period of exclusivity related to this letter of intent has
expired, however, the Company continues to negotiate the Proposed Transaction
with the Investor Group. The Proposed Transaction remains subject to further
negotiation of applicable terms and conditions including price, the negotiation
of definitive documents, the satisfactory completion of due diligence, the
receipt of any necessary regulatory approvals and third-party consents, and
other customary closing conditions.

In order to increase its liquidity, the Company has developed the following
strategies: (i) suspension of its new practice affiliation program, (ii)
substantial curtailment of its new office development program, (iii)
implementation of tighter credit policies with its Affiliated Practices, (iv)
consideration of terminating the service agreements of selected under-performing
Affiliated Practices, (v) reducing costs in the Company's corporate office, (vi)
raising additional capital and (vii) the consideration of strategic alternatives
which could include, but are not limited to, a sale of the Company or a business
combination with another physician practice management company or financial
sponsor.

There can be no assurance that the Company's strategies will be achieved. In
addition, the Company's capital expenditure and other liquidity needs are
dependent upon access to additional capital. Any limitation on the Company's
ability to obtain additional financing could have a material adverse effect on
the Company's business, financial condition and results of operations. As a
result of the above factors, there is substantial doubt as to the Company's
ability to continue as a going concern. The accompanying financial statements do
not reflect any adjustments related to the recoverability and classification of
recorded assets or other adjustments which might be required should the Company
be unable to continue as a going concern.

Total long-term debt increased from $23.7 million at December 31, 1998, to $25.1
million at September 30, 1999. The increase is attributable to borrowings for
the purchase of property and equipment and general working capital needs. The
Company's weighted average cost of indebtedness was 7.54% for the nine months
ended September 30, 1999.

WORKING CAPITAL MANAGEMENT

The Company's strategy in managing working capital is to maintain sufficient
availability under the Chase Facility to finance short-term capital needs in
excess of internally generated funds and minimize excess cash on its balance
sheet. As of September 30, 1999, however, the Chase Credit Facility was fully
extended. The Company has obtained a short term, unsecured credit facility of
$480,000 that matures on November 30, 1999. As of November 15, 1999 the Company
has the full amount available under this facility, although from time to time,
the facility has been fully extended. There can be no assurance that the lender
will continue to renew this facility or that the Company's efforts to increase
its liquidity or obtain additional capital (as discussed in FINANCING ACTIVITIES
above) will be successful.

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<PAGE>
The restricted cash balance of $2.1 million at December 31, 1998, consisted
primarily of borrowings under the Chase Facility, which were placed into escrow
pending the resolution of certain post-closing contingencies related to a new
affiliate orthodontist transaction closed during the third quarter of 1997. In
January 1999 these post-closing contingencies resulted in payment of the $2.1
million to the sellers.

The Company's total receivable from orthodontic practices (current and
non-current) increased $4.3 million from December 31, 1998 to September 30,
1999. This increase resulted from a number of factors, including (i) service fee
receivables related to unbilled patient receivables, (ii) the portion of service
fee receivables from the Company's Affiliated Practices in Canada which are
payable in future periods, (iii) notes receivable related to the Affiliated
Practices' share of the cost of new office development projects, (iv) notes
receivable from the Affiliated Practices for general working capital purposes,
and (v) uncollected service fees. Based on the nature of the various types of
receivables, the various types of collateral held by the Company and the
Company's strategic operating programs to grow the patient revenue of the
Affiliated Practices, the Company believes that its net receivables from
orthodontic practices are collectible.

CAPITAL EXPENDITURES

The Company made capital expenditures for the Affiliated Practices during the
nine months ended September 30, 1999, of approximately $3.1 million to fund,
among other things, the development of satellite offices. The Service Agreements
provide for advances by the Company to the Affiliated Practices for working
capital requirements (including any deficits in cash flows of Affiliated
Practices resulting from, among other things, development of satellite offices)
and other purposes. Such loans bear interest at prime plus one percent and are
repayable over varying periods of time not to exceed five years. Total notes
receivable from Affiliated Practices were $4.6 million at September 30, 1999.

The Company's expansion strategy requires substantial capital resources. Capital
is needed for future affiliations and the effective integration, operation and
expansion of the existing and future Affiliated Practices. In addition, the
Affiliated Practices may, from time to time, require capital for renovation and
expansion and for the addition of equipment and technology. The extent to which
the Company is able or willing to use shares of Common Stock to enter into
future affiliations, or provide future financing, will depend on the market
value of the Common Stock and, in the case of affiliations, the willingness of
owners of potential Affiliated Practices to accept Common Stock as full or
partial payment of consideration for affiliations. If the Company's strategies
to increase liquidity (see FINANCING ACTIVITIES above) are not successful,
outside capital would be required to fund all or a portion of these activities.
There can be no assurance that the Company will be able to obtain additional
funds when needed on satisfactory terms or at all. The availability of capital
from outside financing sources will depend upon prevailing market conditions,
interest rates and the then existing financial condition of the Company. Any
limitation on the Company's ability to obtain additional financing could have a
material adverse effect on the Company's business, financial condition and
results of operations.

AFFORDABLE PAYMENT PLANS

A part of the Company's business strategy is to encourage Affiliated Practices
to offer more affordable payment plans to patients. The Company does not expect
the affordable payment plans, or any potential increase in bad debt expense
resulting from these plans, to have any significant negative impact on the
working capital or liquidity of the Affiliated Practices. Existing Affiliated
Practices using such payment plans have experienced an initial decrease in
working capital; however, the Company believes that the decrease in working
capital generally will be offset by an increase in the number of patients
receiving orthodontic treatment because of the combined effect of advertising,
offering more affordable payment plans and the use of the Company's
practice-building program. The Company believes the Affiliated Practices have
the financial wherewithal to sustain any negative impact that may result from
these payment plans. Therefore, Apple does not anticipate that the offering of
affordable payment plans by the Affiliated Practices will impair the Company's
ability to collect management service revenues from the Affiliated Practices.
However, the Company's ability to encourage the Affiliated Practices to adopt,
or maintain, an affordable payment plan may be limited due to funding
constraints. To date, the Company has funded its operations primarily through
cash flow from operations, the Chase Credit Facility and proceeds from the sale
of its common stock. If the Company's strategies to increase liquidity (see
FINANCING ACTIVITIES above) are not successful, outside capital would be
required to fund all or a portion of the Company's activities. There can be no
assurance that the Company will be able to obtain additional funds when needed
on satisfactory terms or at all.

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<PAGE>
PART II

ITEM 1. LEGAL PROCEEDINGS

- 18 -
<PAGE>
things, breaches of the service agreement entered into by the Virginia Parties
and the Company. The Company intends to vigorously defend the claims made by the
Virginia Parties, which the Company believes are without merit. This lawsuit is
still pending and the Company cannot predict whether it will succeed, or if not
successful, what effect this may have on the Company.

ITEM 2. CHANGE IN SECURITIES AND USE OF PROCEEDS.

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

None, except for such mentioned above in Note 6 of the financial statements.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None.

ITEM 5. OTHER INFORMATION.
None.

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<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits.

EXHIBIT DESCRIPTION
--------- -----------------
*3.1 Restated Certificate of Incorporation (Incorporated herein
by reference to Exhibit 3.1 of the Company's Registration
Statement on Form S-1 (Registration No. 333-22785)).
*3.2 Bylaws (Incorporated herein by reference to Exhibit 3.2 of
the Company's Registration Statement on Form S-1
(Registration No. 333-22785)).
*4.1 Form of certificate evidencing ownership of Common Stock of
Apple Orthodontix, Inc. (Incorporated herein by reference to
Exhibit 4.1 of the Company's Registration Statement on Form
S-1 (Registration No. 333-22785)).
*4.2 Form of Registration Rights Agreement (Incorporated herein
by reference to Exhibit 4.1 of the Company's Registration
Statement on Form S-1 (Registration No. 333-22785)).
*4.3 Registration Rights Agreement among Apple Orthodontix, Inc.,
John G. Vondrak, D.D.S. and TriCap Funding I, L.L.C.
(Incorporated herein by reference to Exhibit 4.3 of the
Company's Registration Statement on Form S-1 (Registration
No. 333-22785)).
*4.4 Registration Rights Agreement between TriCap Partners,
L.L.C. and Apple Orthodontix, Inc. (Incorporated herein by
reference to Exhibit 4.4 of the Company's Registration
Statement on Form S-1 (Registration No. 333-22785)).
*10.1 Revolving Credit Facility with Chase Bank of Texas, N.A.
(formerly named "Texas Commerce Bank, N.A.")(Incorporated
herein by reference to Exhibit 10.1 of the Company's
Registration Statement on Form S-1 (Registration
No. 333-38817)).
*10.2 Apple Orthodontix, Inc. 1997 Stock Compensation Plan
(Incorporated herein by reference to Exhibit 10.2 of the
Company's Registration Statement on Form S-1 (Registration
No. 333-38817)).
*10.3 Form of Option Agreement for the Apple Orthodontix, Inc.
1997 Stock Compensation Plan (Incorporated herein by
reference to Exhibit 10.3 of the Company's Registration
Statement on Form S-1 (Registration No. 333-38817)
*10.4 Employment Agreement between Apple Orthodontix, Inc. and
John G. Vondrak, D.D.S. (Incorporated herein by reference
to Exhibit 10.2 of the Company's Registration Statement on
Form S-1 (Registration No. 333-22785)).
*10.5 Employment Agreement between Apple Orthodontix, Inc. and
Robert J. Syverson (Incorporated herein by reference to
Exhibit 10.3 of the Company's Registration Statement on
Form S-1 (Registration No. 333-22785)).
*10.6 Employment Agreement between Apple Orthodontix, Inc. and
Michael W. Harlan (Incorporated herein by reference to
Exhibit 10.4 of the Company's Registration Statement on
Form S-1 (Registration No. 333-22785)).
*10.7 Employment Agreement between Apple Orthodontix, Inc. and
W. Daniel Cook (Incorporated herein by reference to
Exhibit 10.5 of the Company's Registration Statement on
Form S-1 (Registration No. 333-22785)).
*10.8 Employment Agreement of H. Steven Walton (Incorporated
herein by reference to Exhibit 10.7 of the Company's
Registration Statement on Form S-1 (Registration No.
333-22785)).
*10.9 Amendment to Employment Agreement of H. Steven Walton
(Incorporated herein by reference to Exhibit 10.9 of the
Company's Registration Statement on Form S-1 (Registration
No. 333-38817)).
*10.10 Second Amendment to Employment Agreement of H. Steven Walton
(Incorporated herein by reference to Exhibit 99.2 of the
Company's Current Report on Form 8-K dated February 24,
1998).
*10.11 Form of Service Agreement for Founding Affiliated Practices
(Incorporated herein by reference to Exhibit 10.8 of the
Company's Registration Statement on Form S-1 (Registration
No. 333-22785)).
*10.12 Form of Alternative Service Agreement for Founding
Affiliated Practices (Incorporated herein by reference to
Exhibit 10.6 of the Company's Registration Statement on Form
S-1 (Registration No. 333-22785)).

- 20 -
<PAGE>
*10.13 Form of Flat Fee Service Agreement for Founding Affiliated
Practices (Incorporated herein by reference to Exhibit 10.11
of the Company's Registration Statement on Form S-1
(Registration No. 333-22785)).
*10.14 First Amendment to Employment Agreement of Robert J.
Syverson (Incorporated herein by reference to Exhibit 99.1
of the Company's Current Report on Form 8-K dated February
24,1998).
*10.15 Employment Agreement between Apple Orthodontix, Inc. and
A. Stone Douglass, dated August 6, 1998 (incorporated herein
by reference to Exhibit 10.1 of the Company's Quarterly
Report on Form 10-Q for the quarter ended September 30,
1998).
*10.16 Employment Agreement between Apple Orthodontix, Inc. and
James E. Bobbitt, dated August 11, 1998 (incorporated herein
by reference to Exhibit 10.2 of the Company's Quarterly
Report on Form 10-Q for the quarter ended September 30,
1998).
*10.17 Agreement Regarding Termination of Employment between Apple
Orthodontix, Inc. and Michael W. Harlan, dated August 11,
1998 (incorporated herein by reference to Exhibit 10.3 of
the Company's Quarterly Report on Form 10-Q for the quarter
ended September 30, 1998).
*10.18 Agreement Regarding Termination of Employment and Severance
Benefits between Apple Orthodontix, Inc. and H. Steven
Walton, dated May 6, 1998 (incorporated herein by reference
to Exhibit 10.4 of the Company's Quarterly Report on Form
10-Q for the quarter ended September 30, 1998).
*10.19 Consulting Agreement between Apple Orthodontix, Inc. and
Michael W. Harlan, dated August 11, 1998 (incorporated
herein by reference to Exhibit 10.5 of the Company's
Quarterly Report on Form 10-Q for the quarter ended
September 30, 1998).
*10.20 Promissory Note between Apple Orthodontix, Inc. and John G.
Vondrak, dated September 8, 1998 (incorporated herein by
reference to Exhibit 10.6 of the Company's Quarterly Report
on Form 10-Q for the quarter ended September 30, 1998).
*10.21 Stock Pledge Agreement between Apple Orthodontix, Inc. and
John G. Vondrak, dated September 9, 1998 (incorporated
herein by reference to Exhibit 10.7 of the Company's
Quarterly Report on Form 10-Q for the quarter ended
September 30, 1998).
*10.22 Amendment to Employment Agreement of John G. Vondrak, dated
September 10, 1998 (incorporated herein by reference to
Exhibit 10.9 of the Company's Quarterly Report on Form 10-Q
for the quarter ended September 30, 1998).
*10.23 Amendment to Employment Agreement of A. Stone Douglass,
dated November 23, 1998 (incorporated by reference to
Exhibit 10.23 of the Company's Annual Report on Form 10-K
for the year ended December 31, 1998).
*10.24 Amendment to Employment Agreement of James E. Bobbitt, dated
November 23, 1998 (incorporated by reference to Exhibit
10.24 of the Company's Annual Report on Form 10-K for the
year ended December 31, 1998).
*10.25 First Amendment to Credit Agreement with Chase Bank of
Texas, N.A., dated May 21, 1998 (incorporated by reference
to Exhibit 10.25 of the Company's Annual Report on Form 10-K
for the year ended December 31, 1998).
*10.26 Agreement Regarding Termination of Employment and Severance
Benefits between Apple Orthodontix, Inc. and Robert J.
Syverson, dated May 20, 1998. (incorporated by reference to
Exhibit 10.26 of the Company's Annual Report on Form 10-K/A
(Amendment No. 1) for the year ended December 31 ,1998).
*10.27 Second Amendment and Waiver to Credit Agreement with Chase
Bank of Texas, N.A., dated April 14, 1999. (incorporated by
reference to Exhibit 10.27 of the Company's Annual Report on
Form 10-K/A (Amendment No. 1)for the year ended December 31,
1998).
10.28 Renewal Promissory Note with Chase Bank of Texas, National
Association, dated October 29, 1999.
*21.1 Subsidiaries of the Registrant (incorporated by reference to
Exhibit 21.1 of the Company's Annual Report on Form 10-K/A
Amendment No. 2) for the year ended December 31, 1997).

* Incorporated herein by reference as indicated.

(b) Reports on Form 8-K

None

- 21 -
<PAGE>
SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant, Apple Orthodontix, Inc., has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

APPLE ORTHODONTIX, INC.

Dated: November 15, 1999 /S/ JAMES E. BOBBITT
By: James E. Bobbitt
Vice President - Chief Financial Officer

- 22 -

EXHIBIT 10.28

RENEWAL PROMISSORY NOTE

$480,000.00 Houston, Harris County, Texas October 29, 1999

FOR VALUE RECEIVED, on or before November 30, 1999, APPLE ORTHODONTIX,
INC., a Delaware corporation ("MAKER"), promises to pay to the order of CHASE
BANK OF TEXAS, NATIONAL ASSOCIATION ("LENDER"), whose address is 712 Main
Street, Houston, Harris County, Texas 77002, at said address or such other
address as may be designated in writing by the holder hereof from time to time,
the principal sum of FOUR HUNDRED EIGHTY THOUSAND AND NO/100 DOLLARS
($480,000.00), or, if less, the aggregate unpaid principal amount outstanding
hereunder, together with interest on said principal, at a rate equal to ten
percent (10%) per annum; provided, however, that in no event shall such rate
exceed the maximum legal rate of interest permitted by the applicable laws of
the State of Texas or the United States of America, whichever shall permit the
higher lawful rate, and as to which Maker could not successfully assert a claim
or defense of usury.

The Maker promises to pay interest on the unpaid principal amount of each
Loan from the date of such Loan until such principal amount is paid in full, at
the maturity hereof, however, said maturity is brought about at such interest
rates as are specified herein. This Note may be prepaid, in whole or in part, at
any time without penalty.

This Note is a revolving credit note. Prior to any default hereunder,
amounts may, at the sole and absolute discretion of Lender, be advanced, repaid
and readvanced without affecting the validity of this Note. It is hereby
specifically recognized by Maker that funds advanced hereunder are advanced for
the purpose of funding certain overdrafts paid by Lender at the request of
Maker. The provisions of Chapter 346 of the Texas Finance Code, as amended,
shall not be applicable to this Note.

Interest charges will be calculated on amounts advanced hereunder on the
actual number of days said amounts are outstanding on the basis of a 365 day
year. It is the intention of Maker and Lender to conform strictly to the usury
laws in force in the State of Texas and the United States of America. It is
therefore agreed that (i) any unearned interest shall be canceled automatically,
or if theretofore paid, shall be credited on the unpaid principal amount of this
Note, or if the principal amount of this Note has been paid, refunded to Maker,
(ii) the aggregate of all interest and other charges constituting interest under
applicable law and contracted for, chargeable or receivable under this Note or
otherwise in connection with this loan transaction shall never exceed the
maximum amount of interest, or produce a rate in excess of the maximum rate of
interest that Lender may charge Maker under applicable law and in regard to
which Maker may not successfully

<PAGE>
assert the claim or defense of usury, and (iii) if any excess interest is
provided for, it shall be deemed a mistake and the same shall either be refunded
to Maker or credited on the unpaid principal amount hereof, and this Note shall
be automatically deemed reformed so as to permit only the collection of the
maximum non-usurious rate and amount of interest allowed by applicable law. All
sums paid or agreed to be paid to the holder or holders hereof for the use,
forbearance or detention of the indebtedness evidenced hereby shall, to the full
extent permitted by applicable law, be amortized, prorated, allocated and spread
through the full term of this Note.

No security taken for the payment of this Note shall affect the liability
of any person liable for payment of this Note. Lender may require payment by
Maker and any surety, endorser, or guarantor hereof without first resorting to
any security for this Note, and no judgment taken against any such party shall
terminate any lien, security interest or other interest of Lender in said
security. Maker consents to the release or discharge of any party liable hereon
(including Maker) and to the release or impairment of any collateral for this
Note by Lender.

In the event default is make in the payment of this Note in whatever manner
its maturity may be brought about, and it is placed in the hands of an attorney
for collection, or is collected through probate, bankruptcy or other
proceedings, Maker promises to pay all reasonable amounts actually incurred by
lender for court costs and attorney's fees in connection therewith. In the event
of any repossession of any collateral, Maker agrees to pay the reasonable costs
actually expended by Lender for repossessing, storing preparing for sale, and/or
selling any such collateral. Additionally, Maker also promises to pay to Lender
all lawful fees paid by Lender to any public office for filing, recording and/or
releasing any instrument securing the loan evidenced by this Note.

Maker and every surety, endorser and guarantor of this Note waive grace,
notice, demand, presentment for payment, notice of non-payment, protest, notice
of protest, notice of intention to accelerate, notice of acceleration of the
indebtedness due hereunder and all other notice, filing of suit and diligence in
collecting this Note, and the enforcing of any of the security rights of Lender,
and consent and agree that the time of payment hereof may be extended without
notice at any time and from time to time, and for periods of time, whether or
not for a term or terms in excess of the original term hereof, without notice or
consideration to, or consent from, any of them. Time is of the essence hereof.

This Note shall be considered a Loan Document under that certain Credit
Agreement among Maker, Lender as Agent and the parties named therein as Banks,
dated July 28, 1997, as amended from time to time, and is secured by all
Security Documents and all Collateral securing the Obligations, as said
capitalized terms are therein defined. The indebtedness evidenced by this Note
shall be considered a part of the Obligations under said Credit Agreement.

-2-
<PAGE>
This Note is in partial renewal and extension, but not in extinguishment,
of the indebtedness originally evidenced by that one certain promissory note
dated September 22, 1999, executed by Maker to the order of Lender in the
original principal amount of $480,000.00, bearing interest and due and payable
as therein provided, which prior not had a maturity date of October 29, 1999,
and is entitled to all of the priorities, rights and benefits contained in said
prior note.

THIS NOTE SHALL BE GOVERNED BY AND CONSTRUED UNDER THE LAWS OF THE STATE OF
TEXAS.

THIS NOTE CONSTITUTES A "LOAN AGREEMENT' AS DEFINED IN SECTION 26.02(a) OF
THE TEXAS BUSINESS AND COMMERCE CODE, AND REPRESENTS THE FINAL, AGREEMENT
BETWEEN THE PARTIES RELATING TO THE SUBJECT MATTER HEREOF AND THEREOF AND MAY
NOT BE CONTRADICTED BY EVIDENCE OF PRIOR, CONTEMPORANEOUS OR SUBSEQUENT ORAL
AGREEMENTS OF THE PARTIES. THERE ARE NO UNWRITTEN ORAL AGREEMENTS BETWEEN THE
PARTIES.

EXECUTED TO BE EFFECTIVE THE DAY AND YEAR FIRST WRITTEN ABOVE.

APPLE ORTHODONTIX, INC.

By: /s/ JAMES E. BOBBITT
Name: JAMES E. BOBBITT
Titles: CFO

-3-

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<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-END> SEP-30-1999
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<RECEIVABLES> 20
<ALLOWANCES> 6,283
<INVENTORY> 0
<CURRENT-ASSETS> 10,601
<PP&E> 8,368
<DEPRECIATION> 2,558
<TOTAL-ASSETS> 71,025
<CURRENT-LIABILITIES> 4,039
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0
0
<COMMON> 14,117
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<TOTAL-LIABILITY-AND-EQUITY> 71,025
<SALES> 0
<TOTAL-REVENUES> 36,982
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