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 0-12050
SAFEGUARD HEALTH ENTERPRISES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 52-1528581
(State or other (I.R.S. Employer
jurisdiction of incorporation) Identification No.)
95 ENTERPRISE
ALISO VIEJO, CALIFORNIA 92656
(Address of principal executive offices)
(Zip Code)
(949) 425-4300
(Registrant's telephone number, including area code)
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 registrant's common stock, par value $.01 per share,
outstanding at September 30, 1999, was 4,747,498 shares (not including 3,274,788
shares of common stock held in treasury).
<PAGE>
SAFEGUARD HEALTH ENTERPRISES, INC.
AND SUBSIDIARIES
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 1999
INFORMATION INCLUDED IN REPORT
Page
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PART I. FINANCIAL INFORMATION 1
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Item 1. Consolidated Financial Statements 1
-------- -----------------------------------
Consolidated Statements of Financial Position 2
-------------------------------------------------
Consolidated Statements of Income 3
-------------------------------------
Consolidated Statements of Cash Flows 4
------------------------------------------
Notes to Consolidated Financial Statements 9
----------------------------------------------
Item 2. Management's Discussion and Analysis of Financial
------- -----------------------------------------------------
Condition andResults of Operations 14
------------------------------------
Item 3. Quantitative and Qualitative Disclosures about Market Risk 14
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Part II. Other Information 14
- ---------- ------------------
Item 1. Legal Proceedings 14
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Item 3. Defaults upon Senior Securities 14
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Item 5. Other Information 13
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Item 6. Exhibits and Reports on Form 8-K 15
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SIGNATURES 16
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<TABLE>
<CAPTION>
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
ASSETS
SEPTEMBER 30, DECEMBER 31,
1999 1998
--------------- --------------
<S> <C> <C>
Current assets:
Cash $ 1,753 $ 2,978
Investments available-for-sale, at estimated fair value 2,814 392
Accounts receivable, net of allowances 3,720 3,345
Assets held for sale -- 3,562
Income taxes receivable 480 485
Prepaid expenses and other current assets 560 1,017
Deferred income taxes -- 67
--------------- --------------
Total current assets 9,327 11,846
Property and equipment, net of accumulated depreciation 5,155 6,105
Restricted cash and investments available for sale 3,458 6,298
Investments available-for-sale, at estimated fair value 669 772
Notes receivable, net of allowances 3,499 3,523
Assets of discontinued operations transferred under contractual arrangements 2,500 8,950
Intangible assets, net of accumulated amortization 4,495 31,807
Deferred income taxes -- 8,415
Other assets 283 240
--------------- --------------
Total assets $ 29,386 $ 77,956
=============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable $ 7,363 $ 4,918
Accrued expenses 3,615 5,129
Short-term debt 255 9,894
Claims payable and claims incurred but not reported 5,283 3,558
Deferred revenue 1,390 1,022
--------------- --------------
Total current liabilities 17,906 24,521
Long-term debt 39,545 32,500
Accrued compensation agreement 1,384 1,169
Stockholders' equity:
Preferred stock -- --
Common stock 21,829 21,509
Retained earnings (accumulated deficit) (33,176) 16,734
Accumulated other comprehensive income (loss) 21 (354)
Treasury stock, at cost (18,123) (18,123)
--------------- --------------
Total stockholders' equity (deficit) (29,449) 19,766
--------------- --------------
Total liabilities and stockholders' equity (deficit) $ 29,386 $ 77,956
=============== ==============
See accompanying Notes to Consolidated Financial Statements.
</TABLE>
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<TABLE>
<CAPTION>
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998
(IN THOUSANDS, EXCEPT PER SHARE DATA)
1999 1998
------------- --------
<S> <C> <C>
(see Note 7)
(As restated)
Premium revenue $ 24,065 $23,504
Health care services expense 17,074 16,539
Selling, general and administrative expense 10,144 7,920
Loss on impairment of assets 24,576 --
------------- --------
Operating loss (27,729) (955)
Investment and other income (losses) (147) (948)
Interest expense (2,801) (1,020)
------------- --------
Loss before income taxes and discontinued operations (30,677) (2,923)
Income tax expense (benefit) 12,224 (988)
------------- --------
Loss before discontinued operations (42,901) (1,935)
Discontinued operations:
Loss from operations to be disposed of (1,099) (122)
------------- --------
Net loss $ (44,000) $(2,057)
============= ========
Basic and diluted loss per share:
Loss from continuing operations $ (9.04) $ (0.41)
Loss from discontinued operations (0.23) (0.02)
------------- --------
Net loss $ (9.27) $ (0.43)
============= ========
Weighted average basic shares outstanding 4,747 4,747
See accompanying Notes to Consolidated Financial Statements.
</TABLE>
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<TABLE>
<CAPTION>
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998
(IN THOUSANDS, EXCEPT PER SHARE DATA)
1999 1998
--------- --------
<S> <C> <C>
(As restated)
(see Note 7)
Premium revenue $ 71,917 $72,340
Health care services expense 50,310 49,258
Selling, general and administrative expense 28,587 22,392
Loss on impairment of assets 24,576 --
--------- --------
Operating income (loss) (31,556) 690
Investment and other income (losses) 1,793 (217)
Interest expense (4,850) (2,915)
--------- --------
Loss before income taxes and discontinued operations (34,613) (2,442)
Income tax expense (benefit) 10,934 (730)
--------- --------
Loss before discontinued operations (45,547) (1,712)
Discontinued operations:
Loss from operations to be disposed of (4,363) (2,430)
--------- --------
Net loss $(49,910) $(4,142)
========= ========
Basic and diluted loss per share:
Loss from continuing operations $ (9.59) $ (0.36)
Loss from discontinued operations (0.92) (0.51)
--------- --------
Net loss $ (10.51) $ (0.87)
========= ========
Weighted average basic shares outstanding 4,747 4,747
See accompanying Notes to Consolidated Financial Statements.
</TABLE>
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<TABLE>
<CAPTION>
SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998
(IN THOUSANDS, EXCEPT PER SHARE DATA)
1999 1998
--------- --------
<S> <C> <C>
(As restated)
(see Note 7)
Cash flows from operating activities:
Net loss $(49,910) $(4,142)
Adjustments to reconcile net loss to net
cash provided by (used in) operating activities:
Loss from discontinued operations 4,363 2,430
Loss on valuation of assets 24,576 --
Write-off of deferred loan costs 1,953 --
Depreciation and amortization 3,220 3,863
Deferred income taxes 10,569 (1,270)
Changes in operating assets and liabilities:
Accounts receivable (348) (5,225)
Income taxes receivable 5 (343)
Prepaid expenses and other assets 414 465
Accounts payable and accrued expenses 2,044 1,420
Deferred revenue 368 (128)
Claims payable and claims incurred but not reported 1,725 (70)
--------- --------
Net cash provided by (used in) continuing operations (1,021) (3,000)
Net cash provided by (used in) discontinued operations -- (2,779)
--------- --------
Net cash provided by (used in) operating activities (1,021) (5,779)
Cash flows from investing activities:
Purchase of investments available-for-sale (12,854) (2,295)
Proceeds from sales/maturity of investments available for sale 13,830 5,049
Purchase of investments held-to-maturity -- (2,259)
Proceeds from maturity of investments held-to-maturity -- 7,039
Purchases of property and equipment (1,006) (1,799)
Proceeds from sale of property and equipment 3,500 --
Payments received on notes receivable 497 --
Issuance of notes receivable (500) --
Additions to intangibles and other assets (969) --
--------- --------
Net cash provided by (used in) investing activities 2,498 5,735
Cash flows from financing activities:
Payments on notes payable and long-term debt (2,594) (1,394)
Payments on accrued compensation agreement (28) (27)
--------- --------
Net cash provided by (used in) financing activities (2,622) (1,421)
--------- --------
Net increase (decrease) in cash (1,145) (1,465)
Cash balance at beginning of period 3,256 3,652
--------- --------
Cash balance at end of period $ 2,111 $ 2,187
========= ========
See accompanying Notes to Consolidated Financial Statements.
</TABLE>
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SAFEGUARD HEALTH ENTERPRISES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. BASIS OF REPORTING
- ------------------------------
The accompanying unaudited consolidated financial statements of SafeGuard Health
Enterprises, Inc. and subsidiaries (the "Company") for the three months and nine
months ended September 30, 1999 and 1998, have been prepared in accordance with
generally accepted accounting principles applicable to interim periods. The
accompanying financial statements reflect all adjustments that, in the opinion
of management, are necessary for a fair presentation of the Company's financial
position and results of operations for the interim periods. The financial
statements have been prepared in accordance with the regulations of the
Securities and Exchange Commission, and omit certain footnote disclosures and
other information necessary to present the Company's financial position and
results of operations in accordance with generally accepted accounting
principles. These financial statements should be read in conjunction with the
Consolidated Financial Statements and Notes thereto contained in the Company's
Annual Report on Form 10-K/A for the year ended December 31, 1998. Management
believes that the disclosures herein are adequate to make the accompanying
financial statements not misleading.
NOTE 2. DISCONTINUED OPERATIONS
- ----------------------------------
SALE OF DISCONTINUED OPERATIONS
In October 1996 the Company implemented a strategic plan to sell all of the
general dental practices owned by the Company. Four of the general dental
practices were sold during 1996, and the remaining practices were sold during
the first nine months of 1997. The aggregate consideration received by the
Company in the sale of all the general dental practices was $14.6 million of
30-year promissory notes. In April 1998 the Company sold all of its orthodontic
practices in a single transaction for consideration consisting of a $15.0
million 30-year promissory note.
The operating results of the discontinued orthodontic practices for the period
prior to the date of the sale are included in the accompanying statement of
operations under "Discontinued operations". Net revenue of the discontinued
operations, which is reflected under "Discontinued operations," was $1.9 million
during the nine months ended September 30, 1998.
ACCOUNTING TREATMENT OF CERTAIN SALE TRANSACTIONS
Several of the general dental practices were sold to a single purchaser (the
"Purchaser") during the three months ended September 30, 1997 in exchange for
$8.0 million of long-term promissory notes. In April 1998 the Company sold all
of its orthodontic practices to the Purchaser in exchange for $15.0 million of
long-term promissory notes. During 1997 and 1998, the entities that purchased
four other general dental practices from the Company conveyed those practices to
the Purchaser in exchange for the assumption of the related promissory notes
payable to the Company. At the time of the conveyances of these practices to the
Purchaser, the related promissory notes had an aggregate outstanding principal
balance of $1.9 million. During 1997 and 1998, the Company loaned a total of
$1.6 million to the Purchaser, which was used for working capital purposes by
the Purchaser.
Due to uncertainty about the Purchaser's ability to meet its commitments under
the promissory notes, the Company did not treat the sale transactions with the
Purchaser as sales for accounting purposes. Accordingly, the related promissory
notes and the working capital loans are not reflected in the accompanying
financial statements. Instead, the historical cost of the net assets of the
related general dental and orthodontic practices, less the interest payments
received from the Purchaser, is reflected on the Company's balance sheet under
the caption "Assets of discontinued operations transferred under contractual
arrangements." The Company's financial statements do not reflect any gains on
these sale transactions, and do not reflect any interest income on the related
promissory notes. In addition, the carrying value of the promissory notes
related to the four practices that were transferred to the Purchaser was reduced
to the historical cost of the net assets of the related dental practices. This
reduction is included in "Loss from operations to be disposed of" on the
accompanying statements of operations. These assets are also reflected on the
Company's balance sheet under the caption "Assets of discontinued operations
transferred under contractual arrangements." The working capital loans were
treated as expenses at the time the loans were made, which is included in "Loss
from operations to be disposed of" on the accompanying statements of operations.
This accounting treatment more appropriately reflects the economic substance of
the transactions, as distinct from the legal form of the transactions.
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NOTE 3. INVESTMENTS
- ---------------------
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 115,
Accounting for Certain Investments in Debt and Equity Securities, and in
accordance with management's intent, the Company has classified its entire
investment portfolio as "available-for-sale". Investments classified as
available-for-sale are carried at fair value and unrealized gains and losses,
net of applicable income taxes, are reported in a separate caption of
stockholders' equity. At September 30, 1999, the Company had net unrealized
gains of $21,000, which is reflected in stockholders' equity under "Accumulated
other comprehensive income (loss)."
NOTE 4. IMPAIRMENT OF ASSETS
- --------------------------------
INTANGIBLE ASSETS
In March 1995 the FASB issued SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, which is
effective for fiscal years beginning after December 15, 1995. SFAS No. 121
requires an entity to review its long-lived assets for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. If an impairment of a long-lived asset is indicated, an
entity is required to measure the amount of impairment by comparing the fair
value of the asset to its carrying amount, and to recognize the impairment loss
in its statement of operations. SFAS No. 121 also requires an entity to reduce
the carrying value of assets to be disposed of to fair value, less selling
costs.
In accordance with SFAS No. 121, and in view of the significant operating losses
incurred by the Company during the nine months ended September 30, 1999, the
Company reviewed its intangible assets for possible impairment. Based on recent
operating losses, and the currently expected cash flows generated by each of the
Company's intangible assets, the Company concluded that the carrying values of
all of its intangible assets have been impaired. The amount of impairment was
measured by comparing the discounted expected future cash flows related to each
intangible asset to the carrying value of the asset. Based on this comparison,
the Company recorded an impairment loss of $24.6 million during the quarter
ended September 30, 1999. The impairment loss is due to impairment of the
goodwill and non-compete covenant related to the acquisition of First American
Dental Benefits, Inc. in September 1996 ($14.7 million), the goodwill and
non-compete covenant related to the acquisition of Advantage Dental HealthPlans
in May 1997 ($9.3 million), and the insurance license acquisition costs related
to the acquisitions of two insurance companies in 1997 and 1992 ($0.6 million).
ASSETS OF DISCONTINUED OPERATIONS TRANSFERRED UNDER CONTRACTUAL ARRANGEMENTS
"Assets of discontinued operations transferred under contractual arrangements"
consists of the historical cost of the net assets of certain general dental
practices and certain orthodontic practices that were sold by the Company in
1998 and 1997 (see Note 2). During 1999, the Company reached an oral agreement
with the purchaser of those practices (the "Purchaser") and another third party
(the "New Purchaser"), under which the related promissory notes payable to the
Company (the "Notes") would be liquidated. Under this agreement, the Purchaser
would convey the dental and orthodontic practices that comprise the collateral
for the Notes to the New Purchaser, in exchange for proceeds that would be paid
to the Company in satisfaction of the Notes. Based on this agreement, the
Company recorded a $4.4 million charge to earnings (net of income tax benefit of
$2.1 million) during the nine months ended September 30, 1999. This charge to
earnings reduced the carrying value of "Assets of discontinued operations
transferred under contractual arrangements" to the estimated net proceeds that
would be realized from this transaction. During March 2000 the Company entered
into a definitive agreement with respect to this transaction, which is currently
pending regulatory approval.
REAL ESTATE
During the third quarter of 1998, the Company moved its corporate office from a
building owned by the Company in Anaheim, California to leased office space in
Aliso Viejo, California. As a result, the Company made the decision in 1998 to
sell the Anaheim building and certain other assets related to it, including the
land and various building improvements. During the first quarter of 1999, the
Company received a written offer to purchase these assets from the Company.
Based on this offer, and as required by SFAS No. 121, the Company recorded an
impairment loss of $569,000, and accrued closing expenses of $188,000, in the
fourth quarter of 1998. The book value of the building and related assets was
$3.6 million at December 31, 1998, which is reflected on the accompanying
balance sheet under the caption "Assets held for sale." In May 1999, the Company
sold the building for $3.5 million, including $3.0 million in cash and a
promissory note for $500,000. The promissory note bears interest at 10%,
requires monthly interest payments, and matures in May 2000.
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NOTE 5. SHORT-TERM AND LONG-TERM DEBT
- ------------------------------------------
Short-term and long-term debt consisted of the following (in thousands):
SEPTEMBER 30, DECEMBER 31,
1999 1998
--------------- --------------
Bank line of credit $ 7,045 $ 8,000
Senior notes payable 32,500 32,500
Other notes payable 255 1,894
--------------- --------------
Total debt 39,800 42,394
Less - current portion (255) (9,894)
--------------- --------------
Long-term debt $ 39,545 $ 32,500
=============== ==============
In September 1997 the Company issued $32.5 million of unsecured senior notes
payable. The senior notes are payable in annual installments of $6.5 million on
each September 30, beginning in 2001, with a final maturity date of September
30, 2005. The interest rate on the notes was fixed at 8.91% at September 30,
1999.
In January 1998 the Company entered into an $8 million revolving credit facility
with a bank, under which $7.0 million was outstanding at September 30, 1999. The
outstanding balance under the credit facility is payable in full on January 29,
2000. The interest rate on the facility as of September 30, 1999, was equal to
the bank's prime rate plus 3.0% (11.0% at September 30, 1999). The loan is
secured by all assets of the Company, including accounts receivable, real
estate, other fixed assets, intangible assets, and a negative pledge on the
stock of all the Company's subsidiaries.
In May 1999 the Company executed restructured credit agreements with respect to
both the senior notes payable and the revolving credit facility. The
restructured agreements provide for changes in interest rates and modifications
to the financial covenants and reporting requirements, as well as required
principal repayments. In connection with the execution of the restructured
agreements, the Company obtained waivers for all prior and existing defaults and
events of default under the previous credit agreements through May 28, 1999. In
connection with the restructured agreements, the Company issued warrants to
purchase 382,000 shares of common stock for $4.51 per share to the holder of the
senior notes payable. The warrants are exercisable at any time from January 1,
2000 to December 31, 2003. The warrants were cancelled in connection with the
transaction completed on March 1, 2000 (see Note 8).
In connection with the restructured senior notes payable and revolving credit
facility, the Company is subject to various loan covenant requirements. The
Company was not in compliance with those requirements as of September 30, 1999.
See Note 8 for a description of a transaction completed on March 1, 2000,
pursuant to which the Company expects that the entire outstanding balance under
the senior notes payable and the revolving credit facility will be converted
into equity securities. In connection with this transaction, the holder of the
senior notes payable and the bank lender agreed not to demand or accept any
payment under the credit agreements, and not to take any enforcement actions of
any kind under the agreements until April 30, 2001. Accordingly, the outstanding
balances under the senior notes payable and the revolving credit facility are
classified as long-term as of September 30, 1999.
NOTE 6. INCOME TAXES
- -----------------------
During the three months ended September 30, 1999, the Company recorded a charge
to earnings to establish a valuation allowance against its deferred tax assets.
The amount of the allowance is equal to the total amount of the Company's
deferred tax assets. The Company's deferred tax assets have been fully reserved
due to uncertainty about whether they will be realized in the future, primarily
due to operating losses incurred by the Company in 1998 and 1999 and the
existence of significant net operating loss carry-forwards.
NOTE 7. RESTATEMENTS
- ----------------------
Subsequent to the issuance of the Company's 1998 financial statements the
Company's management determined that certain prepaid expenses, fixed assets,
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accrued liabilities and deferred revenue balances were not properly stated.
Additionally, the Company's management determined that the accounting treatment
applied to certain sale transactions of discontinued orthodontic and general
dental practices that occurred during 1998 and 1997 was not appropriate. As a
result, the quarterly financial statements as of and for the three months and
nine months ended September 30, 1998, have been restated from the amounts
previously reported.
The effects of the restatement are as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 1998 SEPTEMBER 30, 1998
---------------------- ----------------------
AS AS
PREVIOUSLY AS PREVIOUSLY AS
REPORTED RESTATED REPORTED RESTATED
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Premium revenue $ 24,004 $ 23,504 $ 72,939 $ 72,340
Health care services expense 16,539 16,539 49,258 49,258
Selling, general and administrative 7,567 7,920 20,964 22,392
---------- ---------- ---------- ----------
Operating income (loss) (102) (955) 2,717 690
Investment and other income 199 (948) 1,703 (217)
Interest expense (1,020) (1,020) (2,915) (2,915)
---------- ---------- ---------- ----------
Income (loss) before income taxes (923) (2,923) 1,505 (2,442)
Income tax expense (benefit) (300) (988) 757 (730)
---------- ---------- ---------- ----------
Income (loss) before
discontinued operations (623) (1,935) 748 (1,712)
Income (loss) from discontinued
operations -- (122) (620) (2,430)
Income (loss) on disposal of
orthodontic and dental practices -- -- 1,834 --
---------- ---------- ---------- ----------
Net income (loss) $ (623) $ (2,057) $ 1,962 $ (4,142)
========== ========== ========== ==========
Basic an diluted earnings (loss) per share:
Income (loss) from continuing
operations $ (0.13) $ (0.41) $ 0.16 $ (0.36)
Income (loss) from discontinued
operations -- (0.02) 0.25 (0.51)
---------- ---------- ---------- ----------
Net income (loss) $ (0.13) $ (0.43) $ 0.41 $ (0.87)
========== ========== ========== ==========
Weighted average basic shares
outstanding 4,747 4,747 4,747 4,747
</TABLE>
NOTE 8. SUBSEQUENT EVENTS
- -------- ------------------
In December 1999, a shareholder lawsuit against the Company was filed, which
alleges that the Company and certain of its officers violated certain securities
laws by issuing a series of alleged false and misleading statements concerning
the Company's publicly reported revenues and earnings during a specified class
period. The Company has directors and officers liability insurance and intends
to vigorously defend this litigation. In the opinion of the Company's
management, the ultimate outcome of this matter will not have a material adverse
effect on the Company's financial position or results of operations.
On March 1, 2000, the Company entered into an agreement with an investor group
(the "Investors"), the holder of the senior notes payable (the "Senior Note
Holder"), and its revolving line of credit lender (the "Bank"). Under this
agreement, the Investors loaned $8.0 million to the Company in the form of notes
payable due April 30, 2001, which bear interest at 10% annually. The Investors,
the Senior Note Holder, and the Bank agreed to convert the new $8.0 million
loan, the outstanding balance of $32.5 million under the senior notes payable,
and the outstanding balance of $7.0 million under the revolving line of credit
to convertible preferred stock, subject to regulatory approval. Under this
agreement, both the Senior Note Holder and the Bank agreed not to demand or
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<PAGE>
accept any payment under the credit agreements, and not to take any enforcement
actions of any kind under the agreements until April 30, 2001.
The convertible preferred stock would not accrue dividends of any kind, and
would be convertible into common stock at the option of the holder. The
convertible preferred stock would entitle the holder to one vote for each share
of common stock into which the preferred stock is convertible, with respect to
all matters voted on by the common stockholders of the Company. As a result of
this transaction, after regulatory approval is obtained, the existing
stockholders of the Company would own approximately 14% of the common stock
interests of the Company. Under this agreement, the Company agreed to place new
directors on its board of directors, who represent the Investors, the Senior
Note Holder and the Bank, and who, collectively, constitute a majority of the
board of directors. The conversion of the Company's outstanding debt to
convertible preferred stock, as described above, is currently pending regulatory
approval.
ITEM 1. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995
The Private Securities Litigation Reform Act of 1995 (the "1995 Act") provides a
"safe harbor" for forward-looking statements, as long as those statements are
identified as forward-looking and are accompanied by meaningful cautionary
statements identifying important factors that could cause actual results to
differ materially from those discussed in the statement. The Company desires to
take advantage of these safe harbor provisions. The statements contained in this
Management's Discussion and Analysis of Financial Condition and Results of
Operations concerning expected growth, the outcome of business strategies,
future operating results and financial position, economic and market events and
trends, future premium levels, future dental health care expense levels, the
Company's ability to control health care, selling, general and administrative
expenses, items discussed under the heading "Year 2000" and all other statements
that are not historical facts, are forward looking statements. Words such as
expects, projects, anticipates, intends, plans, believes, seeks or estimates, or
variations of such words and similar expressions are also intended to identify
forward-looking statements. These forward-looking statements are subject to
significant uncertainties and contingencies, many of which are beyond the
control of the Company. Actual results may differ materially from those
projected in the forward-looking statements, which statements involve risks and
uncertainties. The Company's ability to expand its business is affected by
competition, not only in benefit program choices, but also the number of dental
plan competitors in the markets in which the Company operates. Certain large
employer groups and other purchasers of commercial dental health care services
continue to demand minimal premium rate increases, while limiting the number of
choices offered to employees. In addition, securing cost effective contracts
with dentists may become more difficult in part due to the increased competition
among dental plans for dentist contracts. Other risks include the Company's
potential inability to obtain waivers and/or extensions from its lenders,
whether or not the Company enters into any extraordinary transaction, changes in
the Company's operating or expansion strategy, or failure to consummate proposed
resale of dental offices and/or promissory notes. The Company's profitability
depends, in part, on its ability to maintain effective control over health care
costs, while providing members with quality dental care. Factors such as levels
of utilization of dental health care services, new technologies, specialists
costs, and numerous other external influences may effect the Company's operating
results. Any critical unresolved Year 2000 issues at the Company or its vendors
could have a material adverse effect on the Company's results of operations,
liquidity or financial condition. The Company's expectations for the future are
based on current information and evaluation of external influences. Changes in
any one factor could materially impact the Company's expectations relating to
premium rates, benefits plans offered, membership growth, the percentage of
health care expenses, and as a result, profitability and therefore, effect the
forward-looking statements which may be included in these reports. In addition,
past financial performance is not necessarily a reliable indicator of future
performance. An investor should not use historical performance alone to
anticipate future results or future period trends.
-9-
<PAGE>
Summary of Results of Operations
The following table shows the Company's results of operations as a percentage of
revenue, and is used in the period-to-period comparisons discussed below.
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
1999 1998 (1) 1999 1998 (1)
-------- -------- ------- --------
<S> <C> <C> <C> <C>
Premium revenue 100.0% 100.0% 100.0% 100.0%
Health care services expense 70.9 70.4 70.0 68.1
Selling, general and administrative expense 42.2 33.7 39.7 31.0
Loss on impairment of assets 102.1 -- 34.2 --
-------- -------- ------- --------
Operating income (loss) (115.2) (4.1) (43.9) 0.9
Investment and other income (0.6) (4.0) 2.5 (0.3)
Interest expense (11.7) (4.3) (6.7) (4.0)
-------- -------- ------- --------
Loss before income taxes and discontinued operations (127.5) (12.4) (48.1) (3.4)
Income tax expense (benefit) 50.8 (4.2) 15.2 (1.0)
-------- -------- ------- --------
Loss before discontinued operations (178.3) (8.2) (63.3) (2.4)
Loss from discontinued operations (4.5) (0.5) (6.1) (3.3)
-------- -------- ------- --------
Net loss (182.8)% (8.7)% (69.4)% (5.7)%
======== ======== ======= ========
<FN>
(1) As restated. See Note 7 to the accompanying financial statements.
</TABLE>
Subsequent to the issuance of the Company's 1998 financial statements the
Company's management determined that certain prepaid expenses, fixed assets,
accrued liabilities and deferred revenue balances were not properly stated.
Additionally, the Company's management determined that the accounting treatment
applied to certain sale transactions of discontinued orthodontic and general
dental practices that occurred during 1998 and 1997 was not appropriate. As a
result, the quarterly financial statements as of and for the three months and
nine months ended September 30, 1998, have been restated from the amounts
previously reported. The significant effects of the restatement have been
presented in Note 7 to the accompanying financial statements and have been
reflected herein.
Three Months Ended September 30, 1999 Compared to Three Months Ended September
30, 1998
Premium revenue increased by $561,000, or 2.4%, from $23.5 million in 1998 to
$24.1 million in 1999. The average membership for which the Company provided
dental coverage decreased by approximately 53,000 members, or 5.7%, from 935,000
members during 1998 to 883,000 during 1999. The decrease in the average number
of members is primarily due to the loss of a single large customer, which
accounted for over 50,000 members, effective January 1, 1999. Premium revenue
increased by 2.4% even though average membership decreased by 5.7%. This was
primarily due to a shift in the product mix toward indemnity plans, which have
higher premium rates than managed care plans, increases in premium rates, and a
shift in the product mix toward managed care plans with higher benefit levels
and higher premium rates.
Health care services expense increased by $535,000, or 3.2%, from $16.5 million
in 1998 to $17.1 million in 1999. Health care services expense as a percentage
of premium revenue (the "loss ratio") increased from 70.4% in 1998 to 70.9% in
1999. This increase is primarily due to an increase in the loss ratio in the
Company's managed care business, which is due to an increase in specialist
referral claims and an increase in supplemental payments to capitated providers,
both as a percentage of managed care premium revenue. The increase in specialist
referral claims is primarily due to a shift in the managed care product mix
toward richer benefit plans that include coverage of more specialist services.
The increase in supplemental payments is due to the fact that the richer benefit
plans also cover more services for which general dentists receive supplemental
payments from the Company, in addition to the monthly capitation payments.
-10-
<PAGE>
Selling, general and administrative ("SG&A") expenses increased by $2.2 million,
or 28.1%, from $7.9 million in 1998 to $10.1 million in 1999. SG&A expenses as a
percentage of premium revenue increased from 33.7% in 1998 to 42.2% in 1999.
This increase relates primarily to an accrual for a lease commitment on unused
office space, an increase in amortization related to internally developed
software, and an increase in occupancy costs related to the company's relocation
of its corporate headquarters in September 1998.
Loss on impairment of intangible assets increased from zero in 1998 to $24.6
million in 1999. The loss on impairment is primarily due to a reduction in the
carrying value of the goodwill and non-compete covenants related to the
acquisition of First American Dental Benefits, Inc. in 1996 and the acquisition
of Advantage Dental HealthPlans in 1997. The amount of the impairment loss was
determined in accordance with Accounting Principles Board Opinion No. 17, as
discussed in Note 4 to the accompanying financial statements.
Investment and other income (losses) was a loss of $147,000 in 1999, compared to
a loss of $948,000 in 1998. The net losses in both periods were due to realized
losses on the sale of investments.
Interest expense increased by $1.8 million, or 174.6%, from $1.0 million in 1998
to $2.8 million in 1999. This increase was primarily due to deferred loan costs
that were charged to expense during the third quarter of 1999. The entire
balance of deferred loan costs was charged to expense because the Company was
not in compliance with the covenant requirements related to the senior notes
payable and the revolving credit facility as of September 30, 1999, and
therefore, the outstanding balances were due and payable.
The loss before income taxes and discontinued operations increased by $28.1
million, from $2.9 million in 1998 to $30.7 million in 1999. The loss before
income taxes and discontinued operations as a percentage of premium revenue
increased from 12.4% in 1998 to 127.5% in 1999. The increase in the loss was
primarily due to the $24.6 million loss on impairment of intangible assets, and
a $2.2 million increase in SG&A expenses, as discussed above.
Income tax expense was $12.2 million in 1999, compared to an income tax benefit
of $988,000 in 1998. The income tax expense in 1999 primarily represents a
charge to earnings to establish a deferred tax asset valuation allowance that is
equal to the entire balance of the Company's net deferred tax assets. This
valuation allowance was established due to uncertainty about whether the
deferred tax assets will be realized in the future, primarily due to operating
losses incurred by the Company in 1999 and 1998 and the existence of significant
net operating loss carry-forwards. See Note 6 to the accompanying financial
statements.
The net loss from discontinued operations increased from $122,000 in 1998 to
$1.1 million in 1999. The loss in 1999 is primarily due to a reduction in the
carrying value of the net assets related to certain discontinued operations,
which are reflected on the accompanying balance sheet under "Assets of
discontinued operations transferred under contractual arrangements." During
1999, the Company recorded a charge to earnings to reduce the carrying value of
these assets to the estimated net proceeds from the sale of these assets to a
third party pursuant to a transaction that is currently pending regulatory
approval. See Note 4 to the accompanying financial statements.
Nine Months Ended September 30, 1999 Compared to Nine Months Ended September 30,
1998
Premium revenue decreased by $423,000, or 0.6%, from $72.3 million in 1998 to
$71.9 million in 1999. The average membership for which the Company provided
dental coverage decreased by approximately 65,000 members, or 6.9%, from 943,000
members during 1998 to 878,000 during 1999. The decrease in the average number
of members is primarily due to the loss of a single large customer, which
accounted for over 50,000 members, effective January 1, 1999. Premium revenue
decreased by only 0.6% even though average membership decreased by 6.9%. This
was primarily due to a shift in the product mix toward indemnity plans, which
have higher premium rates than managed care plans, increases in premium rates,
and a shift in the product mix toward managed care plans with higher benefit
levels and higher premium rates.
Health care services expense increased by $1.0 million, or 2.1%, from $49.3
million in 1998 to $50.3 million in 1999. Health care services expense as a
percentage of premium revenue (the "loss ratio") increased from 68.1% in 1998 to
70.0% in 1999. This increase is primarily due to an increase in the loss ratio
in the Company's managed care business, which is due to an increase in
specialist referral claims and an increase in supplemental payments to capitated
providers, both as a percentage of managed care premium revenue. The increase in
specialist referral claims is primarily due to a shift in the managed care
product mix toward richer benefit plans that include coverage of more specialist
services. The increase in supplemental payments is due to the fact that the
richer benefit plans also cover more services for which general dentists receive
supplemental payments from the Company, in addition to the monthly capitation
payments.
Selling, general and administrative ("SG&A") expenses increased by $6.2 million,
or 27.7%, from $22.4 million in 1998 to $28.6 million in 1999. SG&A expenses as
a percentage of premium revenue increased from 31.0% in 1998 to 39.7% in 1999.
This increase relates primarily to an accrual for a lease commitment on unused
office space, an increase in amortization related to internally developed
software, and an increase in occupancy costs related to the company's relocation
of its corporate headquarters in September 1998.
-11-
<PAGE>
Loss on impairment of intangible assets increased from zero in 1998 to $24.6
million in 1999. The loss on impairment is primarily due to a reduction in the
carrying value of the goodwill and non-compete covenants related to the
acquisition of First American Dental Benefits, Inc. in 1996 and the acquisition
of Advantage Dental HealthPlans in 1997. The amount of the impairment loss was
determined in accordance with Accounting Principles Board Opinion No. 17, as
discussed in Note 6 to the accompanying financial statements.
Investment and other income was $1.8 million in 1999, compared to a net loss of
$217,000 in 1998. This change was primarily due to realized gains on the sale of
investments in 1999, compared to realized losses on the sale of investments in
1998.
Interest expense increased by $2.0 million, or 66.4%, from $2.9 million in 1998
to $4.9 million in 1999. This increase was primarily due to deferred loan costs
that were charged to expense during the third quarter of 1999. The entire
balance of deferred loan costs was charged to expense because the Company was
not in compliance with the covenant requirements related to the senior notes
payable and the revolving credit facility as of September 30, 1999, and
therefore, the outstanding balances were due and payable.
The loss before income taxes and discontinued operations increased by $32.2
million, from $2.4 million in 1998 to $34.6 million in 1999. The loss before
income taxes and discontinued operations as a percentage of premium revenue
increased from 3.4% in 1998 to 48.1% in 1999. The increase in the loss was
primarily due to the $24.6 million loss on impairment of intangible assets, and
a $6.2 million increase in SG&A expenses, as discussed above.
Income tax expense was $10.9 million in 1999, compared to an income tax benefit
of $730,000 in 1998. The income tax expense in 1999 primarily represents a
charge to earnings to establish a deferred tax asset valuation allowance that is
equal to the entire balance of the Company's net deferred tax assets. This
valuation allowance was established due to uncertainty about whether the
deferred tax assets will be realized in the future, primarily due to operating
losses incurred by the Company in 1999 and 1998 and the existence of significant
net operating loss carry-forwards. See Note 6 to the accompanying financial
statements.
The net loss from discontinued operations increased from $2.4 million in 1998 to
$4.4 million in 1999. The loss in 1999 is primarily due to a $6.5 million
reduction (before income tax effect of $2.1 million) in the carrying value of
the net assets related to certain discontinued operations, which are reflected
on the accompanying balance sheet under "Assets of discontinued operations
transferred under contractual arrangements." During 1999, the Company recorded a
$6.5 million charge to earnings to reduce the carrying value of these assets to
the estimated net proceeds from the sale of these assets to a third party
pursuant to a transaction that is currently pending regulatory approval. See
Note 4 to the accompanying financial statements. The net loss in 1998 consists
of $2.4 million of operating losses related to the discontinued operations that
were sold in 1998.
Liquidity and Capital Resources
Net cash used by operating activities was $1.0 million during the nine months
ended September 30, 1999, compared to $5.7 million during the same period in
1998. The decrease in net cash used in operating activities was primarily due to
$2.8 million of net cash used in discontinued operations in 1998. Although the
net loss increased from $4.1 million in 1998 to $50.2 million in 1999,
substantially all of the increase was due to non-cash expenses. Net cash
provided by investing activities was $2.5 million during 1999, compared to $5.7
million during 1998. The Company sold certain long-term assets in both 1999 and
1998, as shown on the accompanying statements of cash flows, to meet it cash
requirements in both periods. Net cash used in financing activities was $2.6
million during 1999, compared to $1.4 million during 1998. The cash used in
financing activities consisted primarily of debt payments in both periods.
The Company's total short-term and long-term debt decreased from $42.4 million
at December 31, 1998, to $39.8 million at September 30, 1999, due to payments of
$2.6 million during 1999. The payments included $1.6 million paid to the former
owners of acquired businesses in connection with non-competition agreements, and
a $1.0 million reduction in the balance outstanding under the revolving credit
facility. Outstanding debt at September 30, 1999 consists of $32.5 million of
senior notes payable, an outstanding balance of $7.0 million under a revolving
credit facility, and a $255,000 note payable to the former owner of an acquired
business in connection with a non-competition agreement.
-12-
<PAGE>
In September 1997 the Company issued $32.5 million of unsecured senior notes
payable. The senior notes are payable in annual installments of $6.5 million on
each September 30, beginning in 2001, with a final maturity date of September
30, 2005. The interest rate on the notes was fixed at 8.91% at September 30,
1999.
In January 1998 the Company entered into an $8 million revolving credit facility
with a bank, under which $7.0 million was outstanding at September 30, 1999. The
outstanding balance under the credit facility was payable in full on January 29,
2000. The interest rate on the facility as of September 30, 1999, was equal to
the bank's prime rate plus 3.0% (11.0% at September 30, 1999). The loan is
secured by all assets of the Company, including accounts receivable, property
and equipment, intangible assets, and a negative pledge on the stock of all the
Company's subsidiaries.
In May 1999 the Company executed restructured credit agreements with respect to
both the senior notes payable and the revolving credit facility. The
restructured agreements provide for changes in interest rates and modifications
to the financial covenants and reporting requirements, as well as required
principal repayments. In connection with the execution of the restructured
agreements, the Company obtained waivers for all prior and existing defaults and
events of default under the previous credit agreements through May 28, 1999. In
connection with the restructured agreements, the Company issued warrants to
purchase 382,000 shares of common stock for $4.51 per share to the holder of the
senior notes payable. The warrants are exercisable at any time from January 1,
2000 to December 31, 2003. Those warrants were cancelled in March 2000 in
connection with the transaction described below.
In connection with the restructured senior notes payable and revolving credit
facility, the Company is subject to various loan covenant requirements. The
Company was not in compliance with those requirements as of September 30, 1999.
The Company completed a transaction on March 1, 2000, as discussed below,
pursuant to which the Company expects that the entire outstanding balance under
the senior notes payable and the revolving credit facility will be converted
into equity securities. In connection with this transaction, the holder of the
senior notes payable and the bank lender agreed not to demand or accept any
payment under the credit agreements, and not to take any enforcement actions of
any kind under the agreements until April 30, 2001. Accordingly, the outstanding
balances under the senior notes payable and the revolving credit facility are
classified as long-term as of September 30, 1999.
On March 1, 2000, the Company entered into an agreement with an investor group
(the "Investors"), the holder of the senior notes payable (the "Senior Note
Holder"), and its revolving line of credit lender (the "Bank"). Under this
agreement, the Investors loaned $8.0 million to the Company in the form of notes
payable due April 30, 2001, which bear interest at 10% annually. The Investors,
the Senior Note Holder, and the Bank all agreed to convert the new $8.0 million
loan, the outstanding balance of $32.5 million under the senior notes payable,
and the outstanding balance of $7.0 million under the revolving line of credit,
to convertible preferred stock, subject to regulatory approval. Under this
agreement, both the Senior Note Holder and the Bank agreed not to demand or
accept any payment under the credit agreements, and not to take any enforcement
actions of any kind under the agreements until April 30, 2001.
The convertible preferred stock would not accrue dividends of any kind, and
would be convertible into an aggregate of 30.0 million shares of common stock of
the Company, at the option of the holder. The convertible preferred stock would
entitle the holder to one vote for each share of common stock into which the
preferred stock is convertible, with respect to all matters voted on by the
common stockholders of the Company. As a result of this transaction, after
regulatory approval is obtained, the existing stockholders of the Company would
own approximately 13.7% of the common stock interests of the Company. Under this
agreement, the Company agreed to place new directors on its board of directors,
who represent the Investors, the Senior Note Holder and the Bank, and who,
collectively, constitute a majority of the board of directors.
Year 2000 Compliance
The Year 2000 issue results from computer programs that use two digits rather
than four to define the applicable year. Any of the Company's computer programs
that have time-sensitive software, and that use two digits to define the
applicable year, may recognize a date using "00" as the year 1900 rather than
the year 2000. This could result in a system failure or miscalculations causing
a disruption of operations, including among other things, a temporary inability
to process transactions, send invoices, or engage in normal business activities.
The Company relies heavily upon information technology, including its primary
transaction processing systems, its telephones, its building access control
systems, heating and ventilation equipment, and other computerized systems, to
conduct its business. The Company also has numerous business relationships with
employer groups and other customers, dental health care providers, other
vendors, financial institutions, and other third parties, including state
regulators, who are reliant upon information technology to conduct their
businesses. There can be no assurance that none of these entities will
-13-
<PAGE>
experience business disruptions related to the Year 2000 issue that could, in
turn, cause business disruptions for the Company.
The Company believes it has adequately modified its information systems so that
dates in the year 2000 are properly recognized by all of its significant
applications. As of March 31, 2000, the Company has experienced no significant
impact on its business related to the Year 2000 issue, from either its own
information systems or those of third parties with which it does business.
Impact of Inflation
The Company's operations are potentially impacted by inflation, which can affect
premium rates, health care services expense, and selling, general and
administrative expenses. The Company expects that its earnings will be
positively impacted by inflation in premium rates, because premium rates for
dental benefit plans in general have been increasing due to inflation in recent
years. The Company expects that its earnings will be negatively impacted by
inflation in health care costs, because fees charged by dentists and other
dental providers have been increasing due to inflation in recent years. The
impact of inflation on the Company's health care expenses is mitigated to some
extent by the fact that 45-50% of total health care services expense is
comprised of capitation payments to providers. In addition, most of the
Company's selling, general and administrative expenses are impacted by general
inflation in the economy.
ITEM 2. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is not subject to a material amount of risk related to changes in
interest rates or foreign currency exchange rates.
PART I. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is subject to various claims and legal actions in the ordinary
course of business. The Company believes that all pending claims either are
adequately covered by insurance maintained by its contracted dental providers or
by the Company, or will not have a material adverse effect on the Company's
results of operations or financial position. In December 1999, a shareholder
lawsuit against the Company was filed, which alleges that the Company and
certain of its officers violated certain securities laws by issuing a series of
alleged false and misleading statements concerning the Company's publicly
reported revenues and earnings during a specified class period. The Company has
directors and officers liability insurance and intends to vigorously defend this
litigation. In the opinion of the Company's management, the ultimate outcome of
this matter will not have a material adverse effect on the Company's financial
position or results of operations.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Please see Note 5 to the accompanying consolidated financial statements herein.
ITEM 5. OTHER INFORMATION
Please see information set forth in Notes 4 and 5 of Notes to Consolidated
Financial Statements herein, and the section on Risk Factors in Part I., Item 2.
-14-
<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) EXHIBITS
EXHIBIT DESCRIPTION
------- -----------
10.18 Default Forbearance Agreement and Irrevocable Power of
Attorney, dated as of February 12, 1999 (1)
27.1 Financial Data Schedule
(1) Referenced, disclosed and filed as an exhibit to Company's Annual Report
on Form 10-K for the year ended December 31, 1998.
(B) REPORTS ON FORM 8-K.
A report on Form 8-K was filed with the Securities and Exchange Commission (the
"SEC") on July 7, 1999, to report that the Company had entered into a definitive
agreement (the "Agreement") with an investor group led by CAI Partners and
Company and Jack R. Anderson. Under the Agreement, the investor group agreed to
invest $40 million into the Company through the purchase of $20 million of
convertible preferred stock and convertible subordinated debentures and $20
million of 10-year senior notes.
A report on Form 8-K was filed with the SEC on September 20, 1999. This Form 8-K
reported that the Company's common stock had been removed from the NASDAQ
National Market on September 1, 1999, due to the Company's inability to meet the
relevant minimum tangible net worth requirement.
The above-described reports on Form 8-K are hereby incorporated by reference in
this Quarterly Report on Form 10-Q for the quarter ended September 30, 1999.
-15-
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Aliso
Viejo, State of California, on the 14th day of April, 2000.
SAFEGUARD HEALTH ENTERPRISES, INC.
By: /s/ James E. Buncher
-----------------------
James E. Buncher
President and Chief Executive Officer
(Principal Executive Officer)
By: /s/ Dennis L. Gates
----------------------
Dennis L. Gates
Senior Vice President and Chief Financial
Officer
(Chief Accounting Officer)
