<PAGE>
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, 1998
--------------------------------------------
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
For the transition period from to
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Commission file number 333-26137
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Physicians Quality Care, Inc.
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(Exact Name of Registrant as Specified in its Charter)
Delaware 04-3267297
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(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
950 Winter Street, Suite 2410, Waltham, Massachusetts 02154
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(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code (617) 890-5560
------------------------------
Not Applicable
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(Former Name, Former Address and Former Fiscal Year,
if Changed Since Last Report)
Indicate by check [X] 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 [_]
APPLICABLE ONLY TO CORPORATE ISSUERS:
The number of shares outstanding of issuer's common stock, as of
November 9, 1998 was: 26,281,780 shares of Class A Common Stock, $.01 par
value, 2,809,296 shares of Class B-1, $.01 par value, 1,790,704 shares of Class
B-2 Common Stock, $.01 par value, 7,692,309 shares of Class C Common Stock,
$.01 par value, and 2,461,538 shares of Class L Common Stock, $.01 par value.
<PAGE>
PHYSICIANS QUALITY CARE, INC.
FORM 10-Q
TABLE OF CONTENTS
PAGE
----
PART I FINANCIAL INFORMATION
Item 1. Balance Sheets as of September 30, 1998 and
December 31, 1997...................................... 1
Statements of Operations for the three and nine
months ended September 30, 1998 and 1997............... 2
Statements of Cash Flows for the nine months
ended September 30, 1998 and 1997...................... 3
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................... 7
PART II OTHER INFORMATION
Item 4. Submission of Matters to Vote of Security Holders...... 23
Item 6. Exhibits and Reports on Form 8-K....................... 23
Signatures......................................................... 24
Exhibit
Index.............................................................. 25
<PAGE>
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
PHYSICIANS QUALITY CARE, INC.
BALANCE SHEETS
<TABLE>
<CAPTION>
(Unaudited)
September 30, 1998 December 31, 1997
------------------- -----------------
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents $ 5,386,473 $ 8,782,019
Restricted cash 1,235,797 --
Prepaid expenses 14,614 35,175
Due from affiliated physician practices 14,689,090 5,719,421
Other current assets 50,052 69,868
------------ ------------
Total current assets 21,376,026 14,606,483
Investment in long term affiliation agreements, less
accumulated amortization of $1,879,778 and $1,394,987 in
1998 (unaudited) and 1997, respectively 52,612,195 57,340,059
Property and equipment, net 376,559 1,327,860
Other assets 279,418 136,181
------------ ------------
Total assets $ 74,644,198 $ 73,410,583
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable $ 556,660 $ 1,218,766
Accrued compensation 165,653 266,138
Accrued expenses 511,642 628,433
------------ ------------
Total current liabilities 1,233,955 2,113,337
Deferred taxes -- 746,062
Commitments and contingencies -- --
Common stock, subject to put, 18,691,636 and 18,157,982 shares
authorized, issued and outstanding at September 30, 1998
(unaudited) and December 31, 1997, respectively 42,046,807 54,473,947
Stockholders' equity:
Class A common stock, $.01 par value, 135,000,000
shares authorized, 8,602,644 and 8,505,208 shares issued
and 7,590,144 and 7,492,708 outstanding at September 30,
1998 (unaudited) and December 31, 1997, respectively 86,026 85,052
Class B-1 common stock, $.01 par value, 6,727,043
shares authorized, 2,809,296 shares issued and outstanding
at September 30, 1998 (unaudited) and December 31, 1997 28,093 28,093
Class B-2 common stock, $.01 par value 4,287,957
shares authorized, 1,790,704 shares issued and outstanding
at September 30, 1998 (unaudited) and December 31, 1997 17,907 17,907
Class C common stock, $.01 par value, 27,692,309
shares authorized, 7,692,309 shares issued and outstanding
at September 30, 1998 (unaudited) and December 31, 1997 76,923 76,923
Class L Common Stock, $.01 par value 2,461,538 shares authorized, 24,615 --
2,461,538 shares issued and outstanding at September 30, 1998
(unaudited) and no shares issued and outstanding at
December 31, 1997
Additional paid-in capital 57,826,177 49,846,913
Accumulated deficit (26,686,180) (33,967,526)
Less treasury stock, at cost, 1,012,500 shares (10,125) (10,125)
------------ ------------
Total stockholders' equity 31,363,436 16,077,237
------------ ------------
Total liabilities and stockholders' equity $ 74,644,198 $ 73,410,583
============ ============
</TABLE>
See accompanying notes to unaudited financial statements and management's
discussion and analysis of financial condition and results of operations.
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<PAGE>
PHYSICIANS QUALITY CARE, INC.
STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
1998 1997 1998 1997
----------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
Net patient service revenue $20,871,776 $10,611,641 $ 62,674,149 $31,835,290
Less: amounts retained by physician groups 5,711,688 3,495,120 17,642,128 10,962,568
----------- ----------- ------------ -----------
Management fee revenue 15,160,088 7,116,521 45,032,021 20,872,722
Operating expenses:
Nonphysician salaries and benefits 7,078,027 3,261,539 20,640,494 9,475,645
Other practice expenses 6,831,857 3,106,220 20,053,930 8,740,854
Corporate and regional expenses 1,967,460 1,441,844 6,486,101 4,222,235
Depreciation and amortization 853,110 505,011 2,358,491 1,463,372
Provision for bad debts 1,041,852 280,335 2,508,967 835,916
----------- ----------- ------------ -----------
Total expenses 17,772,306 8,594,949 52,047,983 24,738,022
Operating Loss (2,612,218) (1,478,428) (7,015,962) (3,865,300)
Other Income (expense):
Interest income 100,463 274,508 252,021 311,301
Interest expense (14,813) (23,532) (71,940) (129,358)
Loss of investment in subsidiary (183,192) (506,478)
----------- ----------- ------------ -----------
Loss before income taxes (2,709,760) (1,227,452) (7,342,539) (3,683,357)
----------- ----------- ------------ -----------
Income tax benefit 746,063 -- 746,063 --
----------- ----------- ------------ -----------
Net loss (1,963,697) (1,227,452) (6,596,296) (3,683,357)
=========== =========== ============ =============
Net income (loss) available to common stock $16,453,439 $(1,227,452) $ 7,281,344 $(10,362,344)
=========== =========== ============ =============
Net income (loss) per common share $ 0.40 $ (0.04) $ 0.18 $ (0.36)
=========== =========== ============ =============
Net income (loss) per common share assuming
dilution $ 0.32 $ (0.04) $ 0.14 $ (0.36)
=========== =========== ============ =============
Weighted average shares outstanding 41,589,306 33,976,811 40,106,514 28,516,949
=========== =========== ============ =============
Weighted average shares outstanding assuming
dilution 50,685,887 33,976,811 50,264,579 28,516,949
=========== =========== ============ =============
</TABLE>
See accompanying notes to unaudited financial statements and management's
discussion and analysis of financial condition and results of operations.
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<PAGE>
PHYSICIANS QUALITY CARE, INC.
STATEMENTS OF CASH FLOW
(UNAUDITED)
<TABLE>
<CAPTION>
For the Nine Months
Ended September 30,
1998 1997
------------ ------------
<S> <C> <C>
OPERATING ACTIVITIES
Net Loss $ (6,596,296) $ (3,683,357)
Adjustments to reconcile net loss to net cash used
in operating activities:
Depreciation and amortization 2,358,491 1,463,372
Deferred Taxes (746,062)
Changes in operating assets and liabilities,
net of effects of business acquisitions:
Increase in due from affiliated physician practices (4,231,175) (5,790,699)
Increase in prepaid expenses and other assets (52,860) (824,661)
Decrease in accounts payable, accrued compensation,
accrued expenses and income taxes payable (737,781) (608,699)
------------ ------------
Net cash used in operating activities (10,005,683) (9,444,044)
INVESTING ACTIVITIES
Purchase of property and equipment (108,922) (1,083,234)
Cash paid for affiliations (50,000) (831,231)
Cash paid for affiliation costs -- (406,097)
Increase in restricted cash (1,235,797) --
Increase in deferred acquisition costs -- (657,632)
------------ ------------
Net cash used in investing activities (1,394,719) (2,978,194)
FINANCING ACTIVITIES
Proceeds from issuance of common stock, net of
issuance costs 8,004,856 30,965,102
Proceeds from note payable -- 3,628,448
Decrease in deferred financing costs -- 18,196
Payments on note payable -- (3,500,000)
Payments on capital lease obligations -- (207,705)
Cash paid for debt issuance cost -- (331,148)
------------ ------------
Net cash provided by financing activities 8,004,856 30,572,893
------------ ------------
Net decrease in cash and cash equivalents (3,395,546) (18,150,655)
Cash and cash equivalents at beginning of period 8,782,019 136,926
------------ ------------
Cash and cash equivalents at end of period $ 5,386,473 $ 18,287,581
============ ============
</TABLE>
See accompanying notes to unaudited financial statements and management's
discussion and analysis of financial condition and results of operations.
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<PAGE>
Physicians Quality Care, Inc.
Notes to Unaudited Financial Statements
Nine Months Ended September 30, 1998 and 1997
(1) Basis of Presentation
---------------------
The accompanying unaudited financial statements of Physicians Quality
Care, Inc., a Delaware corporation (the "Company"), have been prepared in
accordance with generally accepted accounting principles and in accordance with
Rule 10-01 of Regulation S-X.
In the opinion of management, the unaudited interim financial
statements contained in this report reflect all adjustments, consisting of only
normal recurring accruals which are necessary for a fair presentation of the
financial position as of September 30, 1998 and the results of operations for
the three and nine months ended September 30, 1998. The results of operations
for the three and nine month periods ended September 30, 1998 are not
necessarily indicative of results for the full year.
These unaudited financial statements, footnote disclosures and other
information should be read in conjunction with the financial statements and
notes thereto included in the Company's Registration Statement on Form S-1, as
amended (No. 333-26137), and the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997.
The preparation of the financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that effect the amounts reported in the accompanying financial
statements and notes. Actual results could differ from those estimates.
(2) Net Income (Loss) Per Common Share
----------------------------------
Net income of common stock is computed by dividing the net income
(loss) available to common stock by the weighted-average number of shares of
common and common equivalent shares outstanding during each period presented.
The net income (loss) available to common stock for the three and nine months
ended September 30, 1998 and September 30, 1997 reflects the accretion
adjustments for common stock subject to put to fair value at those respective
balance sheet dates. The effect of options and warrants is not considered for
the three and nine months ended September 30, 1997 as it would be antidilutive.
Fully diluted loss per share is not presented because the effect would be
antidilutive.
In February 1997, the Financial Accounting Standards Board (the
"FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 128
"Earnings Per Share", which established standards for computing and presenting
earnings per share ("EPS") and applies to entities with publicly held common
stock or potential common stock. SFAS 128 is effective for financial statements
issued for both interim and annual periods ending after December 31, 1997 and
requires restatement of all prior period EPS data. Under the new requirements
for calculating basic earnings per share, the dilutive effect of stock options
and warrants will be excluded. Diluted earnings per share is very similar to the
previously reported fully diluted earnings per share. The Company has applied
this standard in 1997 and 1998.
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<PAGE>
(3) Pending Accounting Standards
----------------------------
In June 1997, the FASB issued SFAS No. 130 "Reporting Comprehensive
Income," and SFAS No. 131 "Disclosures About Segments of an Enterprise and
Related Information." SFAS No. 130 establishes standards for reporting and
displaying comprehensive income and its components. SFAS No. 131 establishes
standards for public companies to report information about operating segments in
financial statements and supersedes SFAS No. 14 "Financial Reporting for
Segments of a Business Enterprise," but retains the requirements to report
information about major customers. SFAS No. 130 and SFAS No. 131 are effective
for the Company in 1998. The Company does not believe the adoption of these
Statements will have a significant effect on its financial statements.
In November 1997, the Financial Accounting Standards Board's Emerging
Issues Task Force reached a consensus on its Issue 97-2, Consolidation of
Physician Practice Entities which is effective for the Company for its 1998
annual financial statements. The Company is currently evaluating the guidance
contained in the consensus as it affects its current model for its affiliation
structures. However, management does not believe implementation of the
consensus guidance will materially affect the financial position or its net
results of operations.
(4) Contingency
-----------
On June 12, 1997, Jay N. Greenberg, a founder and former executive
vice president of the Company, filed a complaint against the Company in
Massachusetts state court seeking damages of $1.4 million and a declaratory
judgment that 843,750 of the shares registered in Mr. Greenberg's name (out of
1,012,500 shares of Class A Common Stock originally granted to Mr. Greenberg)
have "vested" under his Employment Agreement. The Company and Mr. Greenberg
entered into a Settlement Agreement in April 1998 pursuant to which the Company
confirmed Mr. Greenberg's ownership of 1,012,500 shares of Class A Common Stock
and Mr. Greenberg granted the Company an option to purchase all of such shares.
The purchase price is $1.3 million and increases (commencing October 1997) by
$25,000 for each three month period thereafter. The Company's purchase option
expires on the earlier of (i) October 14, 1999, (ii) upon a public offering of
the capital stock of the Company, or (iii) a change in control. No damages were
awarded and mutual releases were granted.
(5) Letter of Credit
----------------
In connection with the October 1997 acquisition of a 50% interest in
TLC Management Company, a medical management company ("TLC"), and a 50% interest
in Total Quality Practice Management, Inc., a practice management company
providing Medicare risk management services ("Total Quality"), the Company
issued a $1.0 million letter of credit in April 1998. In connection with this
letter of credit, the Company is required to maintain a cash balance of $1
million which is included under the caption "restricted cash" on the balance
sheet.
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<PAGE>
(6) Financing
---------
On July 15, 1998, the Company issued 2,461,538 shares of Class L
Common Stock to certain institutional investors pursuant to a Class L Common
Stock Purchase Agreement. The purchase price was $3.25 for each share of Class
L Common Stock for an aggregate purchase price of approximately $8 million. In
connection with such transaction the rights of the Class B Common Stock in a
liquidation were amended to rank prior to the Class A Common Stock and on an
equal basis with the Class C Common Stock. The exercise price of the
outstanding Class B and Class C Common Stock warrants were reduced by $2.00 per
share to $0.50 and $1.25 per share respectively. No distribution, whether as a
dividend, upon liquidation or otherwise, may be made on any other class of
Common Stock until the holders of the Class L Common Stock have received
dividends or distributions equal to the purchase price of the Class L Common
Stock plus an additional 12% per annum. In connection with the Class L Common
Stock financing, the Company's shareholders approved a Restated Certificate of
Incorporation. The Restated Certificate limits any distribution on capital
stock that constitutes a taxable distribution.
The Class L Common Stock automatically converts into Class A Common
Stock upon the occurrence of a public offering that satisfies certain criteria,
upon a merger, consolidation, liquidation or winding up of the Company or a sale
or other transfer of all or substantially all of the Company's assets, or
certain other conditions brought about by partial redemption of Class L Common
Stock. The Class L Common Stock is also convertible at any time at the option
of the holder. The number of shares of Class A Common Stock into which the
Class L Common Stock is convertible is determined according to a formula and is
based on the value of Class A Common Stock issued pursuant to a realization
event. The number of shares of Class A Common Stock issuable upon conversion
(assuming no accrued and unpaid dividends) ranges between 4,923,077 and
12,603,077.
The proceeds of the sale of Class L Common Stock will be used for
working capital and other corporate purposes.
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<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
This Quarterly Report on Form 10-Q contains forward-looking statements
that involve a number of risks and uncertainties. There are a number of
important factors that could cause the Company's actual results to differ
materially from those indicated by such forward-looking statements. Factors that
might cause such a difference include, but are not limited to, those discussed
under "Factors Affecting Future Operating Results." The following discussion
should be read in conjunction with the Company's Unaudited Financial Statements
and Notes thereto included elsewhere in this documents.
OVERVIEW
The Company is affiliated with and operates multi-specialty medical
practice groups. The first physician affiliation was completed on August 30,
1996 with 32 physicians in the Springfield, Massachusetts area (the "Springfield
Affiliated Group"). On December 11, 1996 the Company consummated the
affiliation with Flagship Health, P.A., a Maryland professional association
("Flagship," and together with Flagship II, the "Flagship Affiliated Group"),
which consisted of 59 physicians in the Baltimore, Maryland area. On December
1, 1997, the Company entered into a long term affiliation agreement with a
physician practice consisting of 58 physicians in the Baltimore, Maryland area.
Additional physicians have been subsequently added to the Springfield Affiliated
Group and the Flagship Affiliated Group (the "Affiliated Groups") during 1997
and 1998. In connection with the affiliation transactions, the assets and
liabilities of the physician practices were transferred to newly formed
professional corporations ("PCs") or professional associations ("PAs")
affiliated with the Company. The Company is working with these groups of
physicians to improve operating practices and to obtain managed care contracts.
On October 24, 1997, the Company acquired a 50% interest in Total Life Care, a
medical management company based in Atlanta, Georgia.
As of September 30, 1998, the Company had affiliations or independent
provider association ("IPA") arrangements with the following physicians:
Maryland Massachusetts Georgia
-------- ------------- --------
Affiliated Physicians:
Primary Care 78 28 0
Specialist 74 14 0
--- --- ---
Total 152 42 0
IPA Physicians: 0 0 334*
* Reflects number of physicians in the IPA network in which the Company has a
50% interest.
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<PAGE>
Under the Company's contractual arrangements with its Affiliated
Groups, the Company can improve its management fee revenues by increasing the
patient care revenue of its Affiliated Groups, through improved billing and
operating efficiency, additional patient encounters, increased capitated
revenues and controlling the expenses of Affiliated Groups. To the extent that
patient revenue increases at a greater rate than practice expenses, the
Company's management fee will increase. Conversely, if PQC is not able to
control practice expenses or assist the Affiliated Groups in increasing patient
care revenue, the Company will earn no or only a limited management fee. Under
the arrangements with the physicians formally associated with Clinical
Associates, P.A. (which became effective on December 1, 1997) the Company earns
a fee based, in part, upon increases in billings, net of bad debts and
discounts, above historical levels, and a reduction in the percentage of revenue
needed to pay practice expense. While this structure causes the Company's
management fee not to be as dependent upon controlling practice expenses, the
Company believes that both increased revenues depend upon affiliated physicians
being motivated by competitive levels of compensation.
The Company's and its Affiliated Groups revenues are derived from
governmental programs, managed care payors and traditional fee-for service
arrangements. The following table sets forth the approximate percentage of the
revenues received by the practices that were affiliated with the Company at and
during the three month period ended September 30, 1998:
Fee for Service Contracts 44%
Medicare 26%
Capitated Managed Care Contracts 28%
Medicaid and Other 2%
---
100%
===
The Company is currently in the process of negotiating changes to the
compensation arrangements and other terms of the Company's Services Agreements
and the affiliated physicians employment agreements. These changes, if
implemented, are intended to provide the Company with sufficient cash flow to
meet its operating costs and to more fully align the economic interests of the
Company and its affiliated physicians. There can be no assurance at this time
if or when such new arrangements will be implemented and if implemented if they
will provide the Company with a positive cash flow.
In connection with the Company's investments in long-term affiliation
agreements, the Company recorded intangible assets which are being amortized
over a period of 25 years. The underlying cash flows derived from the
affiliation agreements have not met the Company's original expectations. The
Company is currently analyzing the likely realization of these intangible assets
in light of current performance and the
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<PAGE>
changes in terms as described above, and anticipates that certain adjustments
will be required to be made in the fourth quarter of 1998. The amounts of these
adjustments are not presently determinable.
RESULTS OF OPERATIONS:
Three Months ended September 30, 1998 and September 30, 1997
------------------------------------------------------------
Net patient revenues of affiliated practices were $20.9 million for the three
months ended September 30, 1998 compared to $10.6 million for the same period a
year ago. The increase of $10.3 million in net revenues was primarily due to the
Flagship II affiliation in December, 1997. Capitated managed care contracts were
28% of revenues for the three months ended September 30, 1998 compared to 11%
for the three months ended September 30, 1997. Capitated contracts have
increased as a source of revenue in 1998 due to the Flagship II affiliation.
Amounts retained by physician groups, which represents physician salaries and
benefits, increased $2.2 million for the three months ended September 30, 1998
compared to the three months ended September 30, 1997. This is primarily due to
the increase in affiliated physicians from 1997 to 1998. As a percentage of net
patient service revenues, amounts retained by physician groups was 27% for the
three months ended September 30, 1998 compared to 33% for the three months ended
September 30, 1997. This was primarily due to the Flagship II affiliation which
has a lower physician compensation ratio to net revenues than the prior
affiliations.
Nonphysician salaries and benefits, which represents salaries and benefits for
physician practice staff increased by $3.8 million to $7.1 million for the three
months ended September 30, 1998 from $3.3 for the three months ended September
30, 1997. As a percentage of net patient service revenues, nonphysician salaries
and benefits was 34% for the three months ended September 30, 1998 compared to
31% for the three months ended September 30, 1997. Other practice expenses,
which represent all other physician practice expenses, increased $3.7 million
and as a percentage of net revenue to 33% for the three months ended September
30, 1998 compared to 29% for the three months ended September 30, 1997. The
increase in nonphysician salaries and benefits and other practice expenses is
primarily a result of the Flagship II affiliation which has higher
infrastructure expenses. The infrastructure expenses include outside services
and administrative costs associated with capitated managed care contracts.
Corporate and regional expenses increased $525k for the three months ended
September 30, 1998 compared to the three months ended September 30, 1997. This
increase was due to the hiring of corporate and regional staff and related
expenses to support the affiliated practices. Corporate and regional expenses
were 10% of revenues for the three months ended September 30, 1998 compared to
14% for the three months ended September 30, 1997.
Depreciation and amortization expense was $853k for the three months ended
September 30, 1998 compared to $505k for the three months ended September 30,
1997. The increase was due to the Flagship II affiliation completed in
December 1997 and is primarily related to the amortization of intangible assets
from the affiliation transactions.
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<PAGE>
Provision for bad debt expense increased $762k for the three months ended
September 30, 1998 compared to the three months ended September 30, 1997. Bad
debt increased as a percentage of net revenue to 5.0% from 2.7% for the same
periods. The increases in bad debt expense and bad debt as a percentage of net
revenues is due to the Flagship II affiliation and billing mix compared to prior
affiliations.
Interest income decreased for the three months ended September 30, 1998 compared
to the three months ended September 30, 1997 due to a lower level of invested
cash over the entire period.
Loss in investment for the three months ended September 30, 1998 was $183k. The
Company acquired a 50% interest in Total Life Care on October 24, 1997. The
Company has accounted for the transaction using the equity method.
Nine months ended September 30, 1998 and September 30, 1997
- -----------------------------------------------------------
Net patient revenues of affiliated practices for the nine months ended September
30, 1998 were $62.7 million compared to $31.8 million for the same period a year
ago. The increase of $30.9 million in net revenues was primarily due to the
Flagship II affiliation. Capitated managed care contracts were 28% of revenues
for the nine months ended September 30, 1998 compared to 10% for the nine months
ended September 30, 1997. Capitated contracts have increased as a source of
revenue in 1998 due to the Flagship II affiliation.
Amounts retained by physician groups, which represents physician salaries and
benefits, increased $6.7 million for the nine months ended September 30, 1998
compared to the nine months ended September 30, 1997. This is primarily due to
the increase in affiliated physicians from 1997 to 1998. As a percentage of net
patient service revenues, amounts retained by physician groups was 28% for the
nine months ended September 30, 1998 compared to 35% for the nine months ended
September 30, 1997. This was primarily due to the Flagship II affiliation which
has a lower physician compensation ratio to net revenues than the prior
affiliations.
Nonphysician salaries and benefits, which represent salaries and benefits for
physician practice staff increased by $11.2 million to $20.7 million for the
nine months ended September 30, 1998 from $9.5 million for the nine months ended
September 30, 1997. As a percentage of net patient service revenues,
nonphysician salaries and benefits was 33% for the nine months ended September
30, 1998 compared to 30% for the nine months ended September 30, 1997. Other
practice expenses, which represent all other physician practice expenses,
increased $11.3 million and as a percentage of net revenue to 32% for the nine
months ended September 30, 1998 compared to 27% for the nine months ended
September 30, 1997.
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<PAGE>
The increase in nonphysician salaries and benefits and other practice expenses
is primarily a result of the Flagship II affiliation which has higher
infrastructure expenses. The infrastructure expenses include outside services
and administrative costs associated with capitated managed care contracts.
Corporate and regional expenses increased $2.3 million for the nine months
ended September 30, 1998 compared to the nine months ended September 30, 1997.
This increase was due to the hiring of corporate and regional staff and related
expenses to support the affiliated practices. Corporate and regional expenses
were 10% of revenues for the nine months ended September 30, 1998 compared to
13% for the nine months ended September 30, 1997.
Depreciation and amortization expense was $2.4 million for the nine months ended
September 30, 1998 compared to $1.5 million for the nine months ended September
30, 1997. The increase was primarily due to the Flagship II affiliation
completed in December 1997 and is related to the amortization of intangible
assets from the affiliation transactions.
Provision for bad debt expense increased $1.7 million for the nine months
ended September 30, 1998 compared to the nine months ended September 30, 1997.
Bad debt increased as a percentage of net revenue to 4.0% from 2.6% for the same
periods. The increases in bad debt expense and bad debt as a percentage of net
revenues is due to the Flagship II affiliation and billing mix compared to prior
affiliations.
Interest income decreased for the nine months ended September 30, 1998 compared
to the nine months ended September 30, 1997 due to a lower level of invested
cash over the entire period.
Loss in investment for the nine months ended September 30, 1998 was $506k. The
Company acquired a 50% interest in Total Life Care on October 24, 1997. The
Company has accounted for the transaction using the equity method.
LIQUIDITY AND CAPITAL RESOURCES:
Principal capital requirements include payments for affiliation transactions,
related transaction costs, working capital requirements, and the funding of
operating losses. The Company anticipates that its liquidity and capital
requirements will be the same for the short-term and long-term. The Company has
incurred significant operating losses to date and does not have operating cash
flow to fund further losses. The principal sources of capital have been the
issuance of Class B, Class C and Class L Stock to institutional investors, and
the issuance of Class A Common Stock to private investors. Common Stock subject
to put decreased by $18.5 million due to a decrease in fair market value of the
Common Stock (as determined by the Board of Directors) from $3.25 to $2.25.
Capital expenditures are expected to be $2 million for 1998.
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Working capital existing at the date of the affiliation transactions has been
retained in the affiliated groups. Additional working capital is required to
fund growth and manage accounts receivable fluctuations. The affiliated groups
had net accounts receivable of $14.7 million at September 30, 1998 compared to
$11.9 million at December 31, 1997. The $2.8 million increase in accounts
receivable is primarily due to increases in revenues and billing delays caused
by system conversions. Management believes that the increases are temporary and
anticipates that the system conversions will be completed by December 31, 1998.
Liquidity has continued to decrease due to operating losses. There can be no
assurance that the institutional investors, who have previously been a source of
capital, will continue to fund the operations through the purchase of additional
equity.
During 1998 and 1997 the Company paid an aggregate consideration of $1.5 and
$23.6 million, respectively, in connection with affiliation transactions. Of
that amount $50k in 1998 and $7.8 million in 1997 was paid in cash and $1.5
million in 1998 and $15.8 million in 1997 was paid in Class A Common Stock. The
majority of the consideration has been ascribed to intangible assets.
As of September 30, 1998, intangible assets net of amortization costs,
represented $53 million of the total assets of $75 million. The Company is
amortizing the intangible assets over 25 years.
In July 1998, the Company issued 2,461,538 shares of Class L Common Stock for an
aggregate purchase price of approximately $8,000,000. The Class L Common Stock
automatically converts into Class A Common Stock upon the occurrence of (i) a
Qualified Public Offering (as defined in the Company's Restated Certificate of
Incorporation), (ii) upon a merger, consolidation, liquidation or winding up of
the Company or a sale or other transfer of all or substantially all of the
Company's assets, or (iii) if less than 30% of the shares of Class L Common
Stock issued in the transaction remain outstanding, subject, in each case, to
approval of two thirds of the Class B and C Directors, voting as a single class.
The Class L Common Stock is also convertible any time at the option of the
holder. The number of shares of Class A Common Stock into which the Class L
Common Stock is convertible is determined pursuant to a formula. Based on that
formula, each share of Class L Common Stock is initially convertible into
between two and five shares of Class A Common Stock. No distribution, whether as
a dividend, upon liquidation or otherwise, can be made on any other class of
Common Stock until the holders of the Class L Common Stock have received
dividends or distributions equal to the purchase price of the Class L Common
Stock plus an amount sufficient to generate an internal rate of return thereon
equal to 12% per annum (compounded). In connection with such financing, the
exercise price on the outstanding Class B and Class C warrants were reduced to
$0.50 and $1.25, respectively.
Of the common stock outstanding at September 30, 1998, 18,691,636 shares of
Class A Common are subject to a put option which provided for the purchase of
the shares at fair value upon the death of the holder. In addition, 1,029,749
shares are subject to a fair value put option back to the Company at the later
of the physician shareholder's retirement or June 1998.
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These Class A Common Shares have been recorded at fair value on the accompanying
balance sheet. Under the stockholder agreements as of December 31, 1997, the
Company has the right to repurchase 15,471,063 shares of Class A Common Stock
for fair value if the physician shareholder's termination of employment is
without cause or is by resignation, and for the lower of cost or fair value if
termination is with cause. The terms of such repurchase provisions may not
permit the Company to fully recover its physician affiliation payments or
reflect the cost of affiliation transactions at the time of termination. As
of September 30, 1998 one physician shareholder has terminated his employment
agreement. No physician shareholder has repurchased any practice assets. All of
the put and call provisions expire on the completion of an initial public
offering with net proceeds of $50 million and which meets certain other
criteria. In addition, the Flagship II physicians have the right to require the
Company to repurchase through a five year non-interest bearing note 4.8 million
shares of Class A Common Stock at $3.00 per share if the Company has not
completed an underwritten initial public offering prior to December 1, 2001. The
Class A Common Stock is subject to a number of restrictions in the stockholder
agreements and will not trade until the occurrence of an offering. The Company
has not recorded a compensation expense for these puts and calls and believes it
is a nonpublic entity for compensation accounting purposes.
IMPACT OF YEAR 2000
The Company is aware of issues associated with the programming code in
existing computer systems as the year 2000 approaches. The "Year 2000" problem
is pervasive and complex, as virtually every computer operation will be affected
in the same way by the rollover of the two digit year value to 00. The issue is
whether computer systems will properly recognize date sensitive information when
the year changes to 2000. Systems that do not properly recognize such
information could generate erroneous data or cause a system to fail.
The Company is utilizing both internal and external resources to
identify, correct or reprogram, and test its systems for Year 2000 compliance.
It is currently anticipated that all reprogramming efforts will be completed by
July 31, 1999, allowing adequate time for testing. A preliminary assessment has
indicted that some of the Company's older personal computers and ancillary
software programs may not be Year 2000 compatible. The Company intends to
either replace or modify these computers and programs. The cost of this
replacement in not expected to be material as the shelf life of the Company's
personal computers is three to five years. The present financial systems are
all Year 2000 compliant. The practice management system is 80% compliant and
the Company plans to move to a new version of the software which is 100%
compliant as part of its reprogramming efforts which will be completed by July
31, 1999. This upgrade is provided under the Company's current software
maintenance agreement with its software vendor. All new software purchased will
be 100% compliant.
The Company is also obtaining confirmations from the Company's primary
vendors that plans are already in place to address processing of transactions in
the Year 2000. However, there can be no assurance that the systems of other
companies on which the Company's systems rely also will be converted in a timely
fashion or that any such failure to convert by another
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company would not have an adverse effect on the Company's systems. Management is
in the process of completing the assessment of the Year 2000 compliance costs.
However, based on currently available information (excluding the possible impact
of vendor systems which management currently is not in a position to evaluate)
as noted above, management does not believe that these costs will have a
material effect on the Company's earnings.
FACTORS AFFECTING FUTURE OPERATING RESULTS
LACK OF OPERATING HISTORY; HISTORY OF OPERATING LOSSES
The Company's historical financial condition and results of operations
may not be indicative of the Company's results of operations and financial
condition for future periods. The Company has incurred losses of each of its
fiscal years through 1997. The Company expects to incur operating losses for at
least the immediate future and to fund such operating losses through the
issuance of additional equity and debt securities. See "-- Need for Substantial
Additional Capital." There can be no assurance that the Company will achieve or
maintain profitability.
NEED FOR SUBSTANTIAL ADDITIONAL CAPITAL
The Company will require substantial capital resources to obtain the
necessary scale to become profitable and to fulfill its business plan.
Additional funds will be required to fund the acquisition, integration,
operation and expansion of affiliated practices, capital expenditures including
the development of the information systems to manage such practices, operating
losses and general corporate purposes.
The Company has no committed external sources of capital. Without the
consent of the director elected by the stockholders of the Class B-1 Common
Stock (the "Class B-1 Director"), the director elected by the stockholders of
the Class B-2 Common Stock (the "Class B-2 Director," and together with the
Class B-1 Director of the "Class B Directors") and the directors elected by the
holders of Class C Common Stock (the "Class C Directors"), the Company may not
obtain additional financing through external borrowings or the issuance of
additional securities. The issuance of additional capital stock could have an
adverse effect on the value of the shares of common stock held by the existing
stockholders. There can be no assurance that the Class B Directors and Class C
Directors will approve such capital raising activities or that the Company will
be able to raise additional capital when needed on satisfactory terms or at all.
In July 1998, the Company issued 2,461,538 shares of Class L Common Stock for an
aggregate consideration of $8 million to finance the Company's working capital
shortfall and its ongoing operations. Because of the Company's working capital
requirements and operating losses, as well as a general change in the market
valuation of physician management companies, the terms of the Class L Common
Stock financing were less favorable to the Company than its prior institutional
offerings. If the Company is not able to eliminate its operating losses, the
Company will need additional working capital in the future. Additional capital
may also be needed to finance the expansion of the Company's operations. The
Company may not be able to obtain such additional financing when needed or may
not be able to do so on favorable terms. The failure to obtain additional
financing when needed and on appropriate terms could have a material adverse
effect on the Company.
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RISK THAT FUTURE AFFILIATION TRANSACTIONS WILL NOT BE CONSUMMATED;
COSTS OF AFFILIATION TRANSACTIONS
There can be no assurance that any future affiliation transactions
will be consummated. In consummating future affiliation transactions, the
Company will rely upon certain representations, warranties and indemnities made
by sellers with respect to the affiliation transaction, as well as its own due
diligence investigation. There can be no assurance that such representations
and warranties will be true and correct, that the Company's due diligence will
uncover all material adverse facts relating to the operations and financial
condition of the affiliated medical practices or that all of the conditions to
the Company's obligations to consummate these future affiliations will be
satisfied. Any material misrepresentations could have a material adverse effect
on the Company's financial condition and results of operations.
The Company has incurred approximately $2.9 million and $567,000
during 1996 and 1997, respectively, in accounting, legal and other costs in
developing its affiliation structure and completing its initial affiliation
transactions. The Company's ability to enter into affiliation transactions with
a significant number of physicians and to achieve positive cash flow will be
adversely affected unless it is able to reduce the expenses associated with
future transactions. There can be no assurance that the Company will be able to
reduce transaction costs on a per affiliated physician basis in the future.
DEPENDENCE UPON AFFILIATED MEDICAL PRACTICES
Although the Company does not and will not employ physicians or
control the medical aspects of the practices of the physicians employed by the
Springfield Affiliated Group, the Flagship Affiliated Group or similar
Affiliated Groups, the Company's revenue and profitability are directly
dependent on the revenue generated by the operation and performance of and
referrals among the affiliated medical practices. The compensation to the
Company under its Services Agreements with the Affiliated Groups is based upon a
percentage of the profits of revenues generated by the Affiliated Groups'
practices with a substantial portion of the profits or revenues being allocated
to the physicians until threshold levels of income or revenues, based upon the
physicians' historical compensation or billings, are achieved. Accordingly, the
performance of affiliated physicians affected the Company's profitability and
the success of the Company depends, in part, upon an increase in net revenues
from the practice of affiliated physicians compared to historical levels. The
inability of the Company's Affiliated Groups to attract and retain patients, to
manage patient care effectively and to generate sufficient revenue or a material
decrease in the revenues of the Affiliated Groups would have a material adverse
effect on the financial performance of the Company. To the extent that the
physicians affiliated with the Company are concentrated in a limited number of
target markets, as is currently the case in western Massachusetts and Maryland,
deterioration in the economies of such markets could have a material adverse
effect upon the Company.
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RISKS RELATED TO EXPANSION OF OPERATIONS
Integration Risks. The Company has completed affiliation transactions
with the Springfield Affiliated Group and the Flagship Affiliated Group, and is
seeking to enter into Affiliates with additional physicians. In the Springfield
and Greater Baltimore-Annapolis areas and in other potential affiliation
markets, the Company is integrating physician practice groups that have
previously operated independently. The Company is still in the process of
integrating its affiliated practices. The Company may encounter difficulties in
integrating the operations of such physician practice groups and the benefits
expected from such affiliations may not be realized. Any delays or unexpected
costs incurred in connection with integrating such operations could have an
adverse effect on the Company's business, operating results or financial
condition.
While each Affiliation conforms to PQC's overall business plan, the
profitability, location and culture of the physician practices that have been
combined into Affiliated Groups are different in come respects. PQC's
management faces a significant challenge in its efforts to integrate and expand
the business of the Affiliated Groups. Because of limited working capital and
operating losses, the Company has recently reduced the size of its corporate
staff. While intended to improve the efficiency and cost of its operations,
such reduction may also make it more difficult for the Company to manage its
operations and growth. The need for management to focus upon such integration
and future Affiliations may limit resources available for the day-to-day
management of the Company's business. While management of the Company believes
that the combination of these practices will serve to strengthen the Company,
there can be no assurance that management's efforts to integrate the operations
of the Company will be successful. The profitability of the Company is largely
dependent on its ability to develop and integrate networks of physicians from
the affiliated practices, to manage and control costs and to realize economies
of scale. There can be no assurance that there will not be substantial costs
associated with such activities or that there will not be other material adverse
effects on the financial results of the Company as a result of these integration
and affiliation activities.
The Company may continue to pursue an aggressive growth strategy
through affiliations and internal development for the foreseeable future. The
Company's ability to pursue new growth opportunities successfully will depend on
many factors, including, among others, the Company's ability to identify
suitable growth opportunities and successfully integrate affiliated or acquired
businesses and practices. There can be no assurance that the Company will
anticipate all of the changing demands that expanding operations will impose on
its management, management information systems and physician network. Any
failure by the Company to adapt its systems and procedures to those changing
demands could have a material adverse effect on the operating results and
financial condition of the Company.
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NEED TO HIRE AND RETAIN ADDITIONAL PHYSICIANS
The success of the Company is dependent upon its ability to affiliate
with a significant number of qualified physicians and the willingness of such
affiliated physicians to maintain and enhance the productivity of their
practices following affiliation with PQC. The market for affiliation with
physicians is highly competitive, and the Company expects this competition to
increase. The Company competes for physician affiliations with many other
entities, some of which have substantially greater resources, greater name
recognition and a longer operating history than the Company and some of which
offer alternative affiliation strategies which the Company may not be able to
offer. In addition, under current law the Company has no or only limited
ability to enforce restrictive covenants in the employment agreements with the
physicians with whom the Company affiliates. The Company is subject to the risk
that physicians who receive affiliation payments may discontinue such
affiliation with the Company, resulting in a significant loss to the Company and
decrease in the patient base associated with such affiliated physicians. There
can be no assurance that PQC will be able to attract and retain a sufficient
number of qualified physicians. If the Company were unable to affiliate with and
retain a sufficient number of physicians, the Company's operating results and
financial condition would be materially adversely affected. A material increase
in costs of affiliations could also adversely affect PQC and its stockholders.
RISK OF INABILITY TO MANAGE EXPANDING OPERATIONS
The Company is seeking to expand its operations rapidly, which, if
successful, will create significant demands on the Company's administrative,
operational and financial personnel and systems. There can be no assurance that
the Company's systems, procedures, controls and staffing will be adequate to
support the proposed expansion of the Company's operations. Because of limited
working capital and operating losses, the Company has recently reduced the size
of its corporate staff. While intended to improve the efficiency and cost of
its operations, such reduction may also make it more difficult for the Company
to manage it operations and growth. The Company's future operating results will
substantially depend on the ability of its officers and key employees to
integrate the management of the Affiliated Groups, to implement and improve
operational, financial control and reporting systems and to manage changing
business conditions.
DEPENDENCE UPON THE GROWTH OF NUMBERS OF COVERED LIVES
The Company is also largely dependent on the continued increase in the
number of covered lives under managed care and capitated contracts. This growth
may come from affiliation with additional physicians, increased enrollment with
managed care payors currently contracting with the Affiliated Groups and
additional agreements with managed care payors. A decline in covered lives or
an inability to increase the number of covered lives under contractual
arrangement with managed care or capitated payors could have a material adverse
effect on the operating results and financial condition of the Company.
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POTENTIAL REGULATORY RESTRAINTS UPON THE COMPANY'S OPERATIONS
The healthcare industry is subject to extensive federal and state
regulation. Changes in the regulations or interpretations of existing
regulations could have a material adverse effect on the Company's business,
financial condition and results of operations.
RISKS OF CAPITATED CONTRACTS
The physician groups with which the Company is affiliated and proposes
to affiliate are parties to certain capitated contracts with third party payors,
such as insurance companies. The Company intends to seek to expand the
capitated patient base of its Affiliated Groups, particularly for Medicare
enrollees. In general, risk contracts pay a flat dollar amount per enrollee in
exchange for the physician's obligation to provide or arrange for the provision
of a broad range of healthcare services (including in-patient care) to the
enrollee. A significant difference between a full risk capitated contract and
traditional managed care contracts is that the physician is sometimes
responsible for both professional physician services and many other healthcare
services, e.g., hospital, laboratory, nursing home and home health. The
physician is not only the "gatekeeper" for enrollees, but is also financially at
risk for over-utilization and for the actuarial risk that certain patients may
consume significantly more healthcare resources than average for patients of
similar age and sex (such patients are referred to herein as "high risk
patients").
While physicians often purchase reinsurance to cover some of the
actuarial risk associated with high risk patients, such insurance typically does
not apply with respect to the risk of over-utilization until a relatively high
level of aggregate claims has been experienced and therefore does not completely
protect against any capitation risk assumed. If over-utilization occurs with
respect to a given physician's enrollees (or the physician's panel of enrollees
includes a disproportionate share of high risk patients not covered by
reinsurance), the physician is typically penalized by failing to receive some or
all of the physician's compensation under the contract that is contingent upon
the attainment of negotiated financial targets, or the physician may be required
to reimburse the payor for excess costs. In addition, a physician may be liable
for over-utilization by other physicians in the same "risk pool" and for
utilization of ancillary, in-patient hospital and other services when the
physician has agreed contractually to manage the use of those services. Except
for a small amount of coverage maintained by Flagship, neither the Company nor
the Affiliated Groups currently maintain any reinsurance arrangement and, to
date, the Affiliated Groups have not experienced losses from participation in
risk pools or incurred any material penalties or obligations with respect to
excess costs under capitated contracts. The Company is pursuing a strategy of
seeking increased participation in capitated contracts for all of its affiliated
physicians. As the percentage of the Company's revenues derived from capitated
contracts increases, the risk of the Company experiencing losses under capitated
contracts increases. As the revenues from capitated contracts become of
increasing importance to PQC and its Affiliated Groups, the Company will review
the financial attractiveness of reinsurance arrangements.
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Medical providers, such as the Affiliated Groups, are experiencing
increasing pricing pressure in negotiating capitated contracts while facing
increased demands on the quality of their services. If these trends continue,
the costs of providing physician services could increase while the level of
reimbursement could grow at a lower rate or decrease. Because the Company's
financial results are dependent upon the profitability of such capitated
contracts, the Company's results will reflect the financial risk associated with
such capitated contracts. Liabilities or insufficient revenues under capitated
and other risk-sharing arrangements could have a material adverse effect on the
Company.
RISKS OF CHANGES IN PAYMENT FOR MEDICAL SERVICES
The profitability of the Company may be adversely affected by Medicare
and Medicaid regulations, cost containment decisions of third party payors and
other payment factors over which PQC and its Affiliated Groups have no control.
The federal Medicare program has undergone significant legislative and
regulatory changes in the reimbursement and fraud and abuse areas, including the
adoption of the resource-based relative value scale schedule for physician
compensation under Medicare, which may have a negative impact on PQC's revenue.
Efforts to control the cost of healthcare services are increasing. PQC's
Affiliated Groups contract with provider networks, managed care organization and
other organized healthcare systems, which often provided fixed fee schedules or
capitation payment arrangements which are lower than standard charges. Future
profitability in the changing healthcare environment, with differing methods of
payment for medical services, is likely to be affected significantly by
management of healthcare costs, pricing of services and agreements with payors.
Because PQC derives its revenues generated by its affiliated physician groups,
further reductions in payment to physicians generally or other changes in
payment for healthcare services could have an adverse effect on the Company.
EXPOSURE TO PROFESSIONAL LIABILITY; LIABILITY INSURANCE
In recent years, physicians, hospitals and other participants in the
healthcare industry have become subject to an increasing number of lawsuits
alleging medical malpractice, negligent credentialing of physicians, and related
legal theories. Many of these lawsuits involve large claims and substantial
defense costs. There can be no assurance that the Company will not become
involved in such litigation in the future. Through its management of practice
locations and provision of non-physician healthcare personnel, the Company could
be named in actions involving care rendered to patients by physicians or other
practitioners employed by Affiliated Groups. In addition, to the extent that
affiliated physicians are subject to such claims, the physicians may need to
devote time to defending such claims, adversely affecting their financial
performance for the Company, and potentially having an adverse effect upon their
reputations and client base. The Company and the Affiliated Groups maintain
professional and general liability insurance, which is currently maintained at
$1 million per occurrence and $3 million annually for each affiliated physician.
Nevertheless, certain types of risks and liabilities are not covered by
insurance, and there can be no assurance that the limits of coverage will be
adequate to cover losses in all instances.
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CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
Physician groups which operated as PCs in Springfield prior to
affiliating with the Company were merged into the Springfield Affiliated Group,
with stockholders of each PC receiving shares of Class A Common Stock of the
Company and cash in exchange for their capital stock in the PC. Physician
groups which operated as PAs in the greater Baltimore-Annapolis area prior to
affiliating with the Company were similarly merged into the Flagship Affiliated
Group, with stockholders of each PA receiving shares of Class A Common Stock of
the Company and cash in exchange for their capital stock in the PA. Each such
merger is intended to qualify as a "reorganization" under Section 368(a) of the
Internal Revenue Code of 1986, as amended, in which case no gain or loss would
generally be recognized by the PC or PA or the stockholders (other than as cash
received) of the PC or PA. The Company has not sought or obtained a ruling from
the Internal Revenue Service or an opinion of counsel with respect to the tax
treatment of the mergers of PCs or PAs into the Springfield or Flagship
Affiliated Groups. The Company does not believe that the Internal Revenue
Service is issuing rulings at this time on transactions using the Company's
affiliation structure. If a merger were not to so qualify, the exchange of
shares would be taxable to the stockholders of the PC or PA, and the
consideration (net of asset basis) issued in connection with the merger would be
taxable to the Affiliated Group into which such PC or PA was merged. Because of
such tax liability, failure of a merger or mergers to qualify as tax-free
reorganizations could have a material adverse effect on the applicable
Affiliated Group and the Company. Also, the inability to structure future
Affiliations on a tax-deferred basis may adversely affect the Company's ability
to attract additional physicians.
NEW MANAGEMENT; DEPENDENCE ON KEY PERSONNEL
The current management structure and the senior management team of the
Company have been in place for a relatively short time. The Company's future
success depends, in large part, on the continued service of its senior
management team, including Jerilyn P. Asher, the Chief Executive Officer, and
Eugene M. Bullis, Chief Operating Officer, Senior Vice President and Chief
Financial Officer, and PQC's ability to continue to attract, motivate and
retain highly qualified senior management and employees. The Company has
employment agreements with Ms. Asher and Mr. Bullis. The Company does not
maintain key person life insurance with respect to Ms. Asher and Mr. Bullis. As
a development stage company, PQC has experienced some turnover in staff,
including two of the founding officers. Although the Company has entered into
employment agreements with certain of its other executives that contain
covenants not to compete with the Company, there can be no assurance that the
Company will be able to retain such key executives or its senior managers and
employees. The inability to hire and retain qualified personnel or the loss of
the services of personnel could have a material adverse effect upon the
Company's business and future business prospects.
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RISK OF THE UNAVAILABILITY OF THE EQUITY FACILITY
The remaining amount under the Class B and Class C Stock Purchase
Agreement (the "Equity Facility") with certain institutional investors
("Institutional Investors") is only available with the consent of the
Institutional Investors and there can be no assurance that the Institutional
Investors will be willing to provide additional capital when needed by the
Company. The Equity Facility and the Class L Common Stock Purchase Agreement
also restrict the sources of capital available to the Company without the
consent of the Institutional Investors. Except for the Equity Facility, the
Company has no committed external sources of capital. Except with the consent
of the director elected by the Institutional Investors, the Company may not
obtain additional financing through external borrowings or the issuance of
additional securities. The Institutional Investors also have received warrants
to purchase a substantial number of shares of Class A Common Stock. These
warrants, as amended in connection with the Class L Common Stock financing, are
exercisable at $.50 or $1.25 per share, which exercise price may be
substantially below the fair market value of the Class A Common Stock at the
time of exercise. In addition, the Class L Common Stock is convertible into
Class A Common Stock on the basis of a formula, which would, as of July 15,
1998, result in conversion at least equal to two shares of Class A Common Stock
for each share of Class L Common Stock. Any additional equity issuance could
have an adverse effect on the value of the shares of Class A Common Stock held
by the then existing stockholders.
RISKS FROM PUT AND OTHER RIGHTS HELD BY CERTAIN STOCKHOLDERS
Each physician and management stockholder who is a party to the
Stockholders Agreement, dated as of August 30, 1996 (the "Stockholder's
Agreement"), has the right to require PQC to purchase the Common Stock owned by
such stockholder at fair market value upon their death or disability. Pursuant
to the Stockholders Agreement, fair market value, as determined by the Board of
Directors, reflects arm's length private sale. In determining the fair
market value, the Board is to consider recent arm's length sales by the Company
and the stockholders, as well as other factors considered relevant. While the
Stockholders Agreement does not limit the Board's discretion, such other factors
may include changes, since the last arm's length sale, in the Company's
financial conditions or prospects and any valuation studies conducted by
management of the Company or independent valuation experts. Under the
Stockholder Agreement, the Board is not permitted to discount the fair market
value of the Common Stock to reflect the fact that the Common Stock being sold
constitutes less than a majority of the outstanding shares. The put option is
only triggered by death or disability (and in a few instances retirement) and
will terminate upon the completion of a public offering which results in at
least $50.0 million in gross revenues to the Company and which meets certain
other criteria. The physicians affiliated with Clinical Associates have the
right to require the Company to repurchase their Common Stock at $3.00 per share
(in the form of a five-year, non-interest bearing note) in the event that the
Company has not completed an underwritten initial public offering before
December 1, 2001. The exercise of such right could have a material adverse
effect upon the Company. To the extent that the "put options" are likely to be
exercised, the Company expects to fund such repurchases from working capital,
the Equity Facility or other sources.
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AMORTIZATION OF INTANGIBLE ASSETS
In connection with its affiliations, the Company has recorded, and is
expected to continue to record, a significant amount of intangible assets as the
consideration paid to physicians exceeds the value of the practice assets. At
December 31, 1997, the Company had intangible assets of approximately $57.3
million reflected on its balance sheet as long-term affiliation agreements. The
Company amortizes such intangible assets over a 25-year period. The amortization
of these intangible assets, while not affecting the Company's cash flow, has an
ongoing negative impact upon the Company's earnings. Amortization of intangible
assets contributed approximately $1,292,000 to the Company's net loss of $5.7
million during the year ended December 31, 1997 and $1,594,000 to the Company's
loss of $6.6 million during the nine months ended September 30, 1998.
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PART II
OTHER INFORMATION
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company held its annual meeting on September 23, 1998. The only item
considered by shareholders at the meeting was the election of Directors. The
following Directors were the only nominee for election and received the votes
set forth below:
For Eligible to Vote
--- ----------------
Jerilyn Asher 13,710,855 26,281,780
Eugene Bullis 13,680,022 26,281,780
Stephen G. Pagliuca 2,809,296 2,809,296
Marc Wolpow 1,790,704 1,790,704
Timothy T. Weglicki 6,118,464 7,692,309
John D. Stobo, Jr. 6,118,464 7,692,309
Ira T. Fine, M.D. 26,040,851 38,226,331
Arlan F. Fuller, M.D. 26,040,851 38,226,331
Leslie S.T. Fang, M.D. 26,010,018 38,226,331
Alphonse F. Calvanese, M.D. 26,199,188 38,226,331
Paul Z. Bodnar, M.D. 26,482,943 38,226,331
Richard Maffezzoli, M.D. 26,482,943 38,226,331
Dana H. Frank, M.D. 26,388,358 38,226,331
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits
27 FINANCIAL DATA SCHEDULE
(b) REPORTS ON FORM 8-K: None
-23-
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
Date: November 13, 1998 PHYSICIANS QUALITY CARE, INC.
By: /s/ Eugene M. Bullis
-------------------------------
Eugene M. Bullis
Chief Operating Officer,
Chief Financial Officer
and Senior Vice President
-24-
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