ITEM 1. BUSINESS
OVERVIEW
Orthodontic Centers of America, Inc. (“OCA,” “we” or “our”) is a leading provider of integrated business services. Since our founding in 1985, we have focused on providing business services to orthodontic and pediatric dental practices. As of December 31, 2003, we were providing business services to 362 orthodontic and pediatric dental practices throughout the United States and parts of Japan, Mexico, Spain and Puerto Rico.
We offer practices a full range of business, operational and marketing services, as well as complementary Internet-based practice management systems. These services and systems enable practices to focus on providing quality patient care, while increasing productivity and profitability. Currently, our services include:
| • | capital to open new practice locations; | ||
| • | proprietary business and clinical systems that provide timely information that allows practitioners to operate more efficiently; | ||
| • | proprietary financial and operating systems to enhance operational and accounting controls; | ||
| • | effective advertising and marketing plans to help generate new patients; and | ||
| • | proprietary on-line purchasing system and purchasing power to reduce clinical and supply costs. |
To complement our existing focus on orthodontic and pediatric dental practices, we recently initiated a new division called OCA Outsource, through which we intend to provide business services to general dental practices and other dental and medical practices. We believe that general dentists and other healthcare providers, which far outnumber the orthodontists and pediatric dentists in the United States, provide us with an expansive opportunity for growth. We anticipate that OCA Outsource will offer its services in exchange for a monthly fee based on a percentage of the practice’s cash collections. These arrangements would differ from our traditional affiliations.
DESCRIPTION OF SERVICES
OCA provides a comprehensive suite of business services to support practice activities. We are not a healthcare provider and we are not involved in the clinical operations of a practice. The practitioners maintain full control over their practices and set their own standards of practice. OCA handles the business operations of the practice, which allows the practitioner to focus on patient care. Our proprietary business and financial systems provide readily accessible information about the practice in an easy-to-understand format. The following is a summary of the services provided by OCA:
Marketing and Advertising
OCA develops and implements marketing and advertising programs for practices using television, radio, and print media advertising, as well as direct mail campaigns. We tailor the advertising to the particular market and prominently feature the names and locations of the affiliated practice. We also offer a 1-800-4BRACES toll-free telephone number by which calls are automatically routed to an affiliated center located near the caller and a www.4braces.com Internet website where prospective patients can locate an affiliated practice in a specific area. In addition, to supplement the various advertising programs offered, we provide internal marketing programs to assist practices in increasing patient referrals from their existing patients, staff and other dentists.
Financial and Statistical Reporting
Practices can use our Internet-based financial and statistical system to view their operating and financial data. The system provides customized reports for financial and clinical data and performance measures for each practice. Performance statistics and financial data are updated continually. This information is accessible by the
practitioner from any computer connected to the Internet. A practitioner can view his or her practice’s financial information in real-time, 24 hours a day. We provide practices with monthly and quarterly financial data, including analyses of the financial results and recommended changes to improve financial and operating performance.
Centralized Collections
OCA has developed a centralized billing and collection system that frees practices from the day-to-day function of billing and collecting patient fees. This service includes billing patients, as well as insurance companies and other third-party payors.
Purchasing
OCA is one of the single largest purchasers of orthodontic and dental supplies. By leveraging the combined purchasing power of our affiliated practice base, we are able to make bulk purchases of equipment, office furniture, clinical supplies and office supplies in order to reduce costs and associated administrative expenses for practices. OCA negotiates arrangements with suppliers that provide cost savings to practices. We have also implemented an online inventory ordering system that allows practices to order supplies directly from vendors through our private computer network. Our online inventory ordering system contains approximately 35,000 products from over 375 vendors. We charge no additional fees on items sold through our system.
Staffing
OCA employs the support staff for most of its affiliated practices. We do not employ the orthodontists, dentists or other licensed healthcare professionals. Our employees generally include the center manager, front desk personnel and other center support staff, and, except where prohibited by law, the orthodontic and dental assistants. Unlike OCA, we anticipate that OCA Outsource will not employ the practice’s staff.
Other Operational Services
We also employ a number of personnel in our corporate office who provide services for our affiliated practices on a centralized basis. These services include the following:
Operations . Managers in our operations department respond to various questions and requests from practices located within an assigned geographic region, including those relating to inventory, supplies, equipment and financial matters. We provide assistance with the development and expansion of practices, as well as assistance with ownership transitions and recruiting associate-level practitioners. Our operations department also assesses the financial performance of practices and advises practices on how to improve their operations. In addition, our operations department also provides support for our management information systems.
Training . Practice personnel receive initial training regarding our management information systems at our training office in Metairie, Louisiana. We also provide various training programs for our support staff aimed at promoting efficient use of our systems and educating our affiliated practices about best practices in operating their practices. In addition, we offer courses to support staff when we upgrade our software. We also employ training teams which travel to new centers to train a practice’s clinical and business staff with respect to these systems.
Office Leasing and Construction . OCA’s real estate department provides a range of office leasing, construction and other commercial real estate services. Our services include strategically locating office space, procuring favorable leases for office space, designing and arranging for build-outs of state-of-the-art facilities, and providing ongoing service and consultation on facilities management, lease renewal and remodeling.
Information Technology Support . We provide person-to-person technology support for our management information systems and other information technology related support through a call center staffed by support technicians. The center is open from early in the morning to late in the evening to assist practices throughout the country. Technicians are also available during the weekends as needed.
Management and Doctor Information Systems
OCA has developed several proprietary Internet-based information applications to increase the efficiency of practices and enhance our business services. Our information systems improve the frequency, quality, accuracy and efficiency of our affiliated practices’ financial and operational data. We have established a highly efficient and flexible proprietary information technology platform that allows us to actively track and report practice profitability and efficiency, practice performance, consumer trends and marketing/advertising effectiveness. We continue to upgrade our systems so we can continue to provide practices with efficient and effective business services. All of our systems are Internet-based and access is password-protected. These applications were designed and are supported by our information technology department. Each of our information technology systems is described below.
Practice Management System. OCA has developed a full-featured practice management system that allows practices to efficiently schedule patients to optimize practitioner time and to maximize the contribution of the clinical staff. This system is also a patient accounting system that tracks patient billing and collections, and monitors the patients’ treatment. This system provides clinical charting and stores digital images as part of the clinical records of the patient. This system also provides practices with important feedback on a daily, real-time basis with respect to key operating data, such as case starts, patient attendance rates, patient conversions and patient past-due amounts.
Payroll System and Employee Benefits . OCA has also developed a system that centralizes payroll-related functions for employees. The system allows us to efficiently manage all the payroll-related functions from one centralized location, and allows employees to review and/or change their personal information. Supervisors can monitor, add and revise employee data, allowing for a virtually paperless wage and benefits system. We also use a biometric fingerprint time clock system through which employees record time and attendance.
Online Purchasing System . OCA developed an online purchasing system, which allows practices to order supplies and equipment directly from vendors. The ordering system is designed to reduce supply costs, associated administrative costs, shipping time and storage requirements, and to improve the accuracy of orders placed and the flow of information between vendors and practices. The system reduces the time that staff would typically devote to inventory management and ordering. This system also provides for images of invoices to be viewed by the practitioner over the Internet, rather than cumbersome paper invoice mailings.
Centralized Collection System . OCA has developed a centralized collection system that frees the practices from the day-to-day function of collecting patient fees. This system also includes working with insurance companies and other third-party payors. We believe that collection of patient fees is often a practice’s area of greatest inefficiency.
Financial and Statistical System . OCA has also developed a practice financial accounting and reporting system that analyzes and reports information gathered through our other information systems. This system provides practices with secure access to real-time performance and financial data about their respective practice from anywhere they can access the Internet. A practitioner can view his or her practice’s financial information in real-time, 24 hours a day. As a management tool, OCA uses this system to identify potential problems with specific practices, to advise the practices in a timely and efficient way and to facilitate decisions about expansion and new locations in particular markets.
CUSTOMERS AND LOCATIONS
Our customer base is currently comprised of orthodontic and pediatric dental practices operating in 46 states and in international locations. We believe our diversified market scope limits our exposure to events or trends that may occur in any individual state or region.
We provide comprehensive business services to these practices under long-term service, consulting and management service agreements in exchange for monthly service fees generally based on a percentage of a practice’s operating profit or patient revenue, plus reimbursement of practice-related expenses. As of December 31, 2003, OCA was providing business services to affiliated practices in the following locations:
| Number of | ||||
| Affiliated | ||||
| Location |
Practices |
|||
United States |
326 | |||
Japan |
26 | |||
Mexico |
4 | |||
Puerto Rico |
3 | |||
Spain |
3 | |||
Total |
362 | |||
Of the 362 affiliated practices as of December 31, 2003, 334 were orthodontic practices and 28 were pediatric dental practices.
The total number of affiliated practices excludes 62 orthodontic and pediatric dental practices that were engaged in litigation with us and for which we had generally ceased to record fee revenue as of December 31, 2003. We were also engaged in litigation with one practice for which we were still recording fee revenue because this practice was still paying service fees to us at December 31, 2003. The total number of affiliated practices above includes 38 other practices that were not engaged in litigation with us but for which we had generally ceased to record fee revenue at December 31, 2003.
We believe that our affiliated pediatric dental practices complement our core affiliated orthodontic practices. They provide a referral source for orthodontic treatment and can operate in an orthodontic center on days that orthodontic treatment is not being provided.
We have expanded our international operations to include Japan, Spain, Mexico and Puerto Rico. We operate our international operations through local management located in each country and business systems that are linked to our corporate headquarters in the United States. Fee revenue from international operations as a percentage of our total fee revenue was 4.0%, 2.1% and 2.4% for 2003, 2002 and 2001, respectively. Long-lived assets located in foreign countries as a percentage of our total long-lived assets was 4.6%, 4.0% and 3.4% as of December 31, 2003, 2002 and 2001, respectively.
GROWTH STRATEGY
Our growth strategy has evolved during our history. During much of the 1990’s, we focused on providing business services exclusively to orthodontic practices in the United States and grew through a combination of affiliations with established practices and development of de novo centers. In the past few years, we have added affiliated pediatric dental practices, as well as international operations. Beginning in 2000, we began to de-emphasize affiliations with established practices, which generally required significant investments in affiliation payments to the practice. We instead began to focus on internal growth of existing affiliated practices and development of de novo centers for existing and new affiliated practices. We also grew by acquiring a competing company, OrthAlliance, Inc., in 2001 and by acquiring certain assets of a former competitor, Apple Orthodontix, Inc., in 2000.
In early 2004, we launched our newest vehicle for growth, OCA Outsource, to complement our core business of providing business services to affiliated orthodontic and pediatric dental practices. Through OCA Outsource, we intend to capitalize on our experience and expertise to provide business services to general dentists and other dental and medical practices. Initially, OCA Outsource will focus on general dental practices and other dental specialties. OCA Outsource provides us with an opportunity to leverage our proprietary systems and services platform over a significantly larger base of practices in diverse areas of dental and medical specialties.
At the same time, we continue to focus on strengthening our market position by expanding our existing affiliated practices. We believe investing resources in our existing affiliated practices will provide a higher return on our investment than affiliating with new practices. We will no longer focus on capital intensive affiliations with established practices in the United States and will only consider entering into these types of affiliations in very limited situations.
OCA’s key strategies for growth are:
Internal Growth From Expanding Affiliated Practices
We are pursuing growth in comparable fee revenue for our existing affiliated practices through the following means:
De Novo Centers, Center Expansions and Center Renovations . We believe that many of our affiliated practices are operating below their potential capacity, which provides opportunities to increase productivity and profitability of existing affiliated practices. We have experienced increased demand among our affiliated practices for more clinical capacity through building new centers and use of licensed professionals. OCA has developed and opened 388 new or de novo centers through December 31, 2003, of which 41 centers opened during 2003. Most of these de novo centers were developed for existing affiliated practitioners seeking to expand their practices. We are currently experiencing significant growth in the development of de novo centers by affiliated practices. We believe that developing new centers provides an opportunity for a favorable return for our affiliated practices and us. We intend to continue to develop additional de novo centers with our existing affiliated practices, and when necessary, to help recruit licensed professionals to practice in these centers.
Our affiliated practices generally experience increased patient volume when facilities undergo a major renovation or expansion. It has been our experience that maintaining a modern and appealing facility, equipped with appropriate and up-to-date equipment, contributes to profitability. We plan to increase the pace of our investment in this area during 2004.
Recruiting . We actively assist with recruiting licensed professionals for our existing affiliated practices. These associates are often recent graduates of orthodontic or pediatric dental specialist residencies who desire experience in an affiliated practice, under the guidance of a successful practitioner who owns his or her practice. These associates also desire a stable salary before they seek an ownership position in these practices. We have observed a growing interest among new graduates for associate-level positions. These associates find OCA particularly appealing because of the opportunities throughout the country available to them with an identifiable path to practice ownership. During 2003, we and our affiliated practices recruited 15 new associate practitioners. We will continue to recruit more associates to meet the demand for additional professionals for our existing affiliated practices.
Expansion in International Markets
We believe that there are large, untapped markets for dental and healthcare business outsourcing services outside the United States. We believe that Japan and other foreign countries are underserved markets that offer significant opportunities to grow our business. In 1998, we entered the Japanese market and were affiliated with 26 orthodontic practices in Japan as of December 31, 2003. We began operating in Mexico and Puerto Rico in 1999, and were affiliated with four orthodontic practices in Mexico and three orthodontic practices in Puerto Rico as of December 31, 2003. Since our first affiliation in Spain in 2001, we have grown to three affiliated orthodontic practices as of December 31, 2003. We have focused our international expansion on providing business services to orthodontic practices.
During 2003, our Japanese affiliated practices began advertising their services in broadcast media. Because Japan is densely populated, the advertising has created an untapped demand for orthodontics. These marketing campaigns generated prospective patients in areas in which our Japanese affiliated practices do not currently operate. As a result, we are providing our marketing services to practices that currently do not use our comprehensive business services, under a concept that we call “OCAJ Lite”. Under this arrangement, we earn a fee based on the number of patients generated for these practices through our marketing services. We only provide marketing services to these practices, which are not affiliated with us, and do not provide capital or our other business services. These services are provided under agreements that generally have a one year term, with an automatic extension of the term unless earlier terminated. As of December 31, 2003, we were providing OCAJ Lite marketing services to 50 practices in Japan. We expect to continue providing these OCAJ Lite marketing services to Japanese practices until we determine that there is a more favorable return in developing a center in their markets.
We intend to continue expanding our operations in Japan, Mexico, Puerto Rico and Spain and are currently in negotiations to expand into China, Brazil and other countries. Our expansion into any particular country depends upon its regulatory environment, market demographics, advertising media and economic conditions, as well as our ability to attract quality professionals, a management team and other business personnel in that market.
Expansion of Business Services to New Specialties through OCA Outsource
We recently began marketing our suite of business services to practices outside of our traditional customer base of orthodontic and pediatric dental practices through our division called OCA Outsource. Initially, OCA Outsource is focusing on the general dental industry, which includes more than 150,000 general dentists in the United States, and other dental specialties. We intend to eventually begin offering OCA Outsource’s business services to medical practices. We believe expanding into these markets complements our existing markets of orthodontists and pediatric dentists, and provides an opportunity to build upon our 10-year investment in our services platform. In exchange for providing these outsourced business services, OCA would receive a monthly fee based on a percentage of the practice’s cash collections. These arrangements would differ from our traditional affiliations in that the agreements would be for a shorter term (as short as one year) and, among other things, we would not:
| • | employ the staff of the practice, | ||
| • | own the fixed assets used by the practice, | ||
| • | bear practice-related expenses, | ||
| • | engage in mass media advertising on behalf of the practice, or | ||
| • | provide capital funding for expansion to the practice unless we find the terms favorable and the practice agrees to utilize our services during the term of the financing. |
ORTHODONTICS, PEDIATRIC DENTISTRY AND OTHER HEALTHCARE PRACTICES
Orthodontics. Orthodontics is a branch of dentistry that specializes in the diagnosis, prevention and treatment of dental misalignment, and typically involves the use of braces or other corrective appliances. Based on data compiled by the American Association of Orthodontists and data published in the 2003 Journal of Clinical Orthodontic Practice Study (the “2003 JCO Study”), a biennial study of the U.S. orthodontic industry, we estimate that the U.S. orthodontic industry generates in excess of $10 billion in annual gross revenues. Multiple studies conducted in the orthodontic industry have concluded that many more persons could benefit from orthodontic treatment than are receiving it. Based on the findings of a study published by the U.S. Public Health Service in 2000, approximately 25% to 32% of the U.S. population could have benefited from orthodontic treatment in 2000.
Orthodontics is generally an elective procedure, with about 75% of payments for orthodontic services made directly by the patient and standard dental insurance covering about 25%. Managed care represents a small percentage of revenues generated in the orthodontic industry.
According to the 2003 JCO Study, the number of orthodontists practicing in the United States has remained at about 9,000 for the past 10 years. Orthodontists must complete up to three years of postgraduate studies following completion of dental programs. Many dentists who are not orthodontists also perform certain orthodontic services. According to a study published in 1996 by the University of Michigan Department of Orthodontics and Pediatric Dentistry, approximately 76% of the dentists who responded to a survey reported that they provided some orthodontic services to their patients, and 19% of the responding dentists reported that they provided comprehensive orthodontic treatment. This study concluded that slightly less than one third of all U.S. orthodontic patients received orthodontic treatment from general dentists. According to the 2003 JCO Study, 4.7% of orthodontists practicing in the United States are affiliated with a practice management company or other management services organization.
We believe our marketing and advertising strategy has allowed our affiliated orthodontists to generate significantly greater patient volume than the average orthodontist. Our recommended affordable payment plan, which includes no down payment and affordable monthly payments, has enabled our affiliated orthodontic practices
generally to charge lower fees than the average orthodontist. Our systems and office designs, and the efficient use of orthodontic assistants, have enabled our affiliated orthodontists to treat more patients per day than the average orthodontists.
Pediatric Dentistry. Pediatric dentistry is a dental specialty involving comprehensive, preventative and therapeutic oral healthcare for infants and children through adolescence, including those with special healthcare needs. In 2002, there were approximately 3,800 active pediatric dentists in the United States. Pediatric dentists must complete a specialty degree program following dental school, which is typically two years in length. Approximately 200 students are admitted each year to 62 pediatric dental specialty training programs in the United States. Approximately one-third of the programs are hospital-based with an emphasis on primary care dentistry for well and ill children. The remaining approximately two-thirds are based in dental schools.
The American Academy of Pediatric Dentistry reports that pediatric dentistry training opportunities have increased from approximately 142 per year in 1989 to approximately 200 per year in 2001, primarily due to additional funding from the U.S. Health Resources and Services Administration. At present, some states have fewer than 10 pediatric dentists. The U.S. Bureau of Census projects that between 1998 and 2025, the number of children under the age of 15 in the United States will increase by 8.9 million. We believe that there will be an increased demand for the services of pediatric dentists in the future.
General Dentistry and Other Healthcare Practices. Dentistry involves the diagnosis and treatment of diseases, injuries and malformations of the teeth and mouth. The practice of dentistry includes improving a patient’s appearance by using a variety of cosmetic dental procedures, and the performance of surgical procedures such as implants and extractions. There are approximately 150,000 dentists in private practice in the United States. More than 80% of dentists are general practitioners. About 20% are dental specialists who limit their practices to one of the nine recognized dental specialty areas: public health dentistry, endodontics, oral and maxillofacial pathology, oral and maxillofacial radiology, oral and maxillofacial surgery, orthodontics and dentofacial orthopedics, pediatric dentistry, periodontics and prosthodontics.
Physicians diagnose and treat medical conditions. There are about 800,000 physicians practicing in the United States. The two general kinds of physicians are primary care physicians and specialists. About 33% of physicians are primary care physicians. If a patient has a specific problem that the primary care doctor does not have the knowledge or expertise to fully treat, he or she will refer the patient to a specialist. Specialists make up the remaining 66% of physicians. Specialties include general surgery, cardiology, orthopedics, pediatrics, obstetrics and gynecology, ophthalmology, gastroenterology and many others. Physicians typically work in clinics, hospitals or private practices. Physicians also become members of medical groups or independent practice associations.
SERVICE AGREEMENTS WITH AFFILIATED PRACTICES
OCA provides business services to an affiliated practice under an agreement with an affiliated orthodontist or pediatric dentist and/or his or her wholly-owned professional entity. The form of agreement used for a particular affiliated practice is based upon the dental regulatory provisions of the state in which the affiliated practice is located. In most states, we use a form of service agreement, with some minor variations from state to state. In a small number of states with particularly stringent laws relating to the practice of dentistry, we use a consulting agreement, which also varies somewhat from state to state. OrthAlliance and its affiliated practices are parties to service, management service and consulting agreements that differ in some respects from the service and consulting agreements that OCA has historically used. The terms of these agreements typically range from 20 to 40 years, with most ranging from 20 to 25 years.
During 2003, approximately 95% of our fee revenue was attributable to service and management service agreements, with the remainder being attributable to consulting agreements. None of our affiliated practices accounted for more than 10% of our fee revenue in 2003.
OCA Service and Consulting Agreements
OCA Service Agreements. OCA’s general form of service agreement is generally between one of our subsidiaries and an affiliated practitioner and their wholly-owned professional entity. Under these service agreements, we provide affiliated practices with a comprehensive range of business services in exchange for
monthly service fees. Monthly service fees represent reimbursement of practice-related expenses that we incur in providing services to an affiliated practice, a portion of the practice’s operating profit and, in some cases, hourly-based service fees. We are also to be reimbursed for the affiliated practice’s share of operating losses for newly-developed or de novo centers and depreciation expense related to property, equipment and improvements used in the operation of the practice. Excluding reimbursement of practice-related expenses and any hourly-based service fees, service fees based on the operating profits of the affiliated practice generally range from 40% to 50% of a mature practice’s cash operating profits. In some cases, this is after reduction for any hourly-based service fees or hourly-based amounts retained by the affiliated practice. The terms of OCA’s service agreements range from 20 to 40 years, with most terms ranging from 20 to 25 years.
If a service agreement terminates prior to the end of its term due to either our or the affiliated practice’s breach, the non-breaching party generally has the option of purchasing the breaching party’s interest in the practice-related assets, including all equipment and improvements, for a purchase price determined under a formula provided for in the agreement. Under circumstances where, following termination, we purchase the affiliated practice’s interest in the practice assets and convey the assets to another practice, the original practice is generally prohibited from competing with the new practice within a specified area. In addition, if termination is due to the affiliated practice’s breach, the service agreement generally provides that the affiliated practice must refund us the unamortized portion of any amounts that we paid in consideration of the practice’s affiliation with us, generally based on a straight-line 25 year amortization period. In some cases, an affiliated practice may terminate a service agreement without cause after a specified period of time, subject to substitution of another affiliated practitioner and an obligation not to compete within a specified area.
OCA Consulting Agreements. OCA’s form of consulting agreement is generally between one of our subsidiaries and an affiliated practitioner and their wholly-owned professional entity. The types of services we provide to an affiliated practice under OCA’s general form of consulting agreements are generally similar to the services we provide under OCA’s form of service agreements. The service fees paid to us by the affiliated practice under the consulting agreements are a combination of cost-based types of fees, flat monthly fees and hourly fees. Some consulting agreements have shorter terms than the service agreements. Some do not give us a right to purchase the practice’s interest in the practice assets following termination, and some require more limited non-competition agreements from the affiliated practice after termination of the consulting agreement than do most of the service agreements. In addition, the consulting agreements emphasize that the affiliated practitioner has ultimate control and authority over his or her practice’s business management, including such matters as advertising, the hiring and termination of staff and the purchase of equipment and supplies.
OrthAlliance Agreements
OrthAlliance Service Agreements. OrthAlliance’s form of service agreement is generally between OrthAlliance or one of its subsidiaries and a professional entity that is owned by an affiliated practitioner. Under OrthAlliance’s service agreements, OrthAlliance generally must provide or arrange for certain services for its affiliated practices, and advise and assist the practices with respect to certain other services. These services are generally similar to those provided under OCA’s service agreements. OrthAlliance is generally responsible for paying certain practice expenses, for which it is to be reimbursed by the affiliated practice. If the practice’s collections are insufficient to fund the practice’s current practice expenses, then OrthAlliance is generally obligated to fund these expenses.
Under these service agreements, OrthAlliance earns service fees that are generally based on one of the following three fee structures. The first fee structure is based on a designated percentage (generally about 17.0%) of the applicable practice’s practice revenue, less any adjustments for uncollectible accounts, professional courtesies and other activities, contractual allowances and discounts that do not generate a fee. These fees are to be earned by OrthAlliance on an accrual basis of accounting and received on a cash basis. The fees are subject, in some cases, to a minimum dollar amount of annual service fees during the first five years of the agreement. The second fee structure is based on a designated percentage (generally about 17.0%) of the applicable practice’s practice revenue, less any adjustments for uncollectible accounts, professional courtesies and other activities, contractual allowances and discounts that do not generate a fee. These fees are to be earned by OrthAlliance on an accrual basis of accounting and received on a cash basis. The fees are subject to annual adjustments based upon improvements in the affiliated practice’s operating margin in the most recent calendar year as compared with the immediately preceding calendar year. In some cases, the fees are subject to a minimum dollar amount of annual service fees
during the first five years of the agreement. The third fee structure is based on a fixed dollar fee with annual fixed dollar increases for each year of the term of the service agreement.
The terms of OrthAlliance’s service agreements are generally for 20, 25 or 40 years. Either party generally may terminate a service agreement if the other party materially breaches the agreement, subject to a cure period. Upon the expiration or termination of the service agreement, the affiliated practice may, and in certain circumstances must, repurchase for cash, at net book value, certain assets, including all equipment, and assume certain liabilities of OrthAlliance related to the affiliated practice.
OrthAlliance Consulting Agreements. OrthAlliance’s form of consulting agreement is generally between OrthAlliance or one of its subsidiaries and a professional entity that is owned by an affiliated practitioner. Under OrthAlliance’s consulting agreements, OrthAlliance generally must provide certain specified services to its affiliated practices, provide other services at the request of the practices and consult with or advise the affiliated practices with respect to other services. These services are generally similar to those provided under OCA’s service agreements. Under these consulting agreements, OrthAlliance earns a consulting fee based on one of the three fee structures described above with respect to OrthAlliance’s service agreements.
Certain provisions of OrthAlliance’s consulting agreements are substantially similar to those of OrthAlliance service agreements, including those provisions relating to OrthAlliance’s obligation to pay and advance funds for practice expenses, assignment, indemnification, termination of the consulting agreement, repurchase of assets and assumption of liabilities by the affiliated practice upon expiration or termination.
OrthAlliance Management Service Agreements. OrthAlliance’s general form of management service agreement is generally between OrthAlliance or one of its subsidiaries and a professional corporation or other entity that is owned by an affiliated practitioner. Under OrthAlliance’s management service agreements, OrthAlliance is generally to provide for a wide range of services for its affiliated practices, including providing facilities, equipment, support personnel, utilities, supplies, bookkeeping, marketing and billing and collections services.
OrthAlliance’s management service agreements generally provide for a service fee that varies from month to month depending on the particular practice’s practice revenue and operating expenses. Service fees are calculated based on two grids set forth in the management service agreement that determine the portion of practice revenue, on a cash basis, that is to be retained by the affiliated practice. One grid determines a percentage of practice revenue, on a cash basis, to be retained by the affiliated practice based on the amount of such practice revenue during the prior calendar quarter. Pursuant to this grid, OrthAlliance’s service fees generally decrease as a percentage of practice revenue if the affiliated practice’s practice revenue increases, and the service fees generally increase as a percentage of practice revenue if the affiliated practice’s practice revenue decreases. The other grid determines an offsetting or additional percentage of such practice revenue to be retained by the affiliated practice, based on the practice’s operating expenses during the prior calendar quarter. Pursuant to this grid, OrthAlliance’s service fees generally increase as a percentage of practice revenue if the affiliated practice’s operating expenses increase, and the service fees generally decrease as a percentage of practice revenue if the affiliated practice’s operating expenses decrease. The management service agreements generally provide for maximum service fees of 19.5% of the practice’s practice revenue on a cash basis. A few of OrthAlliance’s management service agreements provide for a fixed percentage service fee.
Certain provisions of OrthAlliance’s management service agreements are substantially similar to those of OrthAlliance’s service agreements, including those provisions relating to repurchase of assets and assumption of liabilities by the affiliated practice upon expiration or termination, assignment, indemnification and termination of the management service agreement, except that the agreement generally does not terminate upon a change of control of OrthAlliance. The management service agreement also generally provides that the affiliated practice will maintain the confidentiality of certain information and not compete against OrthAlliance for a specified period of years within a specified geographic area based on the location of the affiliated practices. The affiliated practice is also required to enforce the terms of its employment agreements with affiliated orthodontists, as to which OrthAlliance is to be a third party beneficiary.
OrthAlliance Employment Agreements . OrthAlliance’s affiliated practices are generally required to enter into employment agreements with each orthodontist or pediatric dentist who owns or becomes an owner of an affiliated practice or who provides orthodontic or dental services through an affiliated practice for more than 10 days
a month. These employment agreements generally provide that the affiliated practitioner will perform professional services for the affiliated practice for a period of at least five years, subject to prior termination for cause. The affiliated practice may generally terminate the employment agreement for cause upon the practitioner’s death, incapacity, willful misconduct, conviction for a felony, or chronic alcoholism or drug addiction. An affiliated practitioner may generally terminate an employment agreement for cause in the event of a material breach by the affiliated practice. The terms of these employment agreements generally renew automatically for additional one-year terms unless a party provides the other party with at least one year’s prior written notice of termination. The employment agreements also generally provide that, following termination or expiration of the employment agreement, the affiliated practitioner will not compete for a period of two years in the market in which the affiliated practice operates an office and will limit the methods of advertising in the area in which an affiliated practice is located.
OrthAlliance Amendments . In connection with the OrthAlliance merger and subsequent integration of the OrthAlliance affiliated practices, we entered into amendments to our service, consulting and management service agreements with many of OrthAlliance’s affiliated practices. As of December 31, 2003, 57 OrthAlliance affiliated practices had entered into amendments to their service, consulting or management service agreements with OrthAlliance and their employment agreements with affiliated practitioners. These amendments provide that the affiliated practice will use our proprietary computer software and business systems in connection with the business functions of the practice. In addition, the affiliated practices are to maintain the current status of the advertisement or non-advertisement, as the case may be, of the practice to the general public, unless we otherwise agree. The affiliated practices also agreed to continue to employ the affiliated orthodontists or pediatric dentists for a minimum period following the OrthAlliance merger. The affiliated practitioners also agreed to guarantee the performance of his or her professional corporation under the service, consulting and management service agreement during the term of his or her employment. Some of the amendments provide for an enhanced covenant not to compete, require that the affiliated practice will take certain actions to transition the practice to another orthodontist or pediatric dentist upon departure of the affiliated practitioner and extend the term of the OrthAlliance service, consulting or management service agreement. The amendments to the employment agreements include OrthAlliance as a third party beneficiary of the covenant not to compete, and provide for continued employment of the affiliated practitioner for a period of at least three years following the OrthAlliance merger.
In connection with these amendments, we offered certain incentives to these affiliated practitioners, through which they may be granted shares of our common stock or promissory notes. For additional information about those incentive programs, please see Note 10 to our Consolidated Financial Statements included elsewhere in this Report.
Patient Fees Receivable
We generally earn service fees under our service and consulting agreements as a percentage of the operating profits of OCA’s affiliated practices or as a percentage of patient revenue of OrthAlliance’s affiliated practices, plus reimbursement of practice-related expenses. We generally collect service fees as patient fees are collected on behalf of our affiliated practices and deposited into a bank account we establish and maintain.
Many of our affiliated practices pledge their patient fees receivable arising from providing orthodontic or pediatric dental services. These patient fees receivable include billed receivables, which represent amounts owed for orthodontic and pediatric dental services for which the patient has been billed, and unbilled receivables, which represent amounts owed for services that have been provided but for which the patient has not yet been billed. Laws governing the practice of dentistry (including orthodontics and pediatric dentistry) and the policies of state dental boards in states in which we operate generally restrict our ability to own these patient fees receivable. These laws and policies require that patient fees receivable be billed and collected in the name of the affiliated practice and that, at least initially, collections from patient fees receivable belong to the practice. This restricts our ability to sell, factor or transfer these pledged patient fees receivable.
We are generally responsible for the billing and collecting of patient fees receivable for many of our affiliated practices, which services are done in the name of the affiliated practice. Once funds are collected in payment of patient fees receivable, the funds are generally deposited into a bank account we establish and maintain. We generally have sole signatory authority over these bank accounts and the exclusive responsibility for any disbursements; however, in certain cases, the affiliated practice also has signatory power over a bank account. Many
of our affiliated practices agree that they will not modify, close or withdraw any funds from these bank accounts. We routinely sweep funds deposited into these accounts into our central bank account on a regular basis.
Under OCA’s general form of service agreement, collections from patient fees receivable are included in determining a practice’s cash operating profits for purposes of calculating amounts retained by an affiliated practice under the terms of the applicable service agreement. Generally, under these service agreements an affiliated practice retains 50% to 60% of the practice’s cash operating profits (in some cases after reduction for any hourly-based service fees earned by OCA or hourly-based amounts retained by the affiliated practice).
GOVERNMENT REGULATION
Dentistry, including the specialties of orthodontics and pediatric dentistry, is a highly regulated profession. In general, regulation of healthcare, including dentistry, is increasing.
Each state and country in which we operate has laws which impose licensing requirements on dentists, including orthodontists and pediatric dentists. While the requirements and prohibitions relative to the practice of dentistry under such laws generally apply equally to the practice of orthodontics and pediatric dentistry, in order for a dentist to hold him or herself out to the public as an orthodontic or pediatric dental specialist, in many jurisdictions the dentist must meet additional requirements providing for certification as a specialist.
The dental practice laws of virtually all states prohibit non-dentists (such as us) from engaging in the practice of any branch of dentistry, including pediatric dentistry and orthodontics. In many states, the practice of dentistry is defined to include the employment of dentists, and in states with laws of that type, we are prohibited from employing dentists of any type (which would include orthodontists and pediatric dentists). In some states, the practice of dentistry is defined to include managing, maintaining or operating any kind of dental office. In states with laws of that type, non-dentists (such as us) may provide business services to a dentist, but, depending on how the legal authorities in the applicable state interpret the law, the dentist may be required to retain control over and responsibility for the management, maintenance and operations of his or her dental practice. A number of states define the practice of dentistry to include the ownership of a dental office and/or dental equipment, or may allow a non-dentist (such as us) to lease a dental office and/or dental equipment to a dentist only under a bona-fide lease agreement under which the office and/or equipment remain under the care, custody and control of the dentist throughout the term of the lease. The dental practice laws of many states also prohibit dentists and orthodontists from splitting fees with non-dentists and non-orthodontists. In some states, these laws have been interpreted to prohibit dentists from paying fees to management companies that are based on a percentage of patient revenues or collections. The dental practice laws of some states also prohibit entities that are classified as dental referral services from being reimbursed by dentists on a per referral basis.
Some state dental practice laws or regulations specifically regulate agreements between dentists (including orthodontists and pediatric dentists) and practice management companies. In general, these laws and regulations allow dentists and orthodontists to enter into such agreements only if the practice management company does not directly or indirectly interfere with the dentist’s exercise of his or her independent professional judgment and if the dentist has control over all clinical aspects of his or her practice, as well as business decisions that closely relate to clinical issues. Some states require that the management or service fees paid under such agreements be reasonable and not be based on the management company’s referral of patients to the dentist or orthodontist.
Advertising by dentists is also regulated under many states’ dental practice laws. The laws of some states prohibit advertising of orthodontic and dental services under a trade or corporate name and require that all advertisements be in the name of the practitioner. In addition, the laws of a number of states have specific requirements that pertain to the advertising of a dental specialty, including orthodontics and pediatric dentistry. A number of states also regulate the use of promotional gift items, the use of models in advertisements, the advertising of prices and discounts and the use of testimonials in advertising.
In addition to the state dental practice laws, the practice of dentistry, including the specialties of orthodontics and pediatric dentistry, is regulated by various state and federal laws and regulations that are applicable to healthcare providers and healthcare operations in general. A number of states have enacted anti-kickback laws that prohibit payments or other remuneration for the referral of patients to all types of licensed healthcare providers, including orthodontists (which laws are in addition to the similar prohibitions found in some state dental practice
laws). In addition, federal and state laws regulate health maintenance organizations and other managed care organizations, for which orthodontists and pediatric dentists may be providers.
There are currently numerous laws at the state and federal levels addressing patient privacy concerns. Federal regulations issued pursuant to the Health Insurance Portability and Accountability Act of 1996, or HIPAA, contain, among other measures, provisions that require many organizations, including dental practices, to implement very significant and potentially expensive new computer systems, employee training programs and business procedures. The federal regulations are intended to encourage electronic commerce in the healthcare industry.
On August 14, 2002, the Department of Health and Human Services published final revisions to standards for the privacy of individually identifiable information. The final revisions did not alter the compliance date of April 14, 2003 for the majority of the requirements in the privacy regulations. These privacy standards apply to all health plans, all health care clearinghouses and health care providers that transmit health information in an electronic form in connection with the standard transactions. Several of our affiliated practices are covered entities under the final rule. The privacy standards apply to individually identifiable information held or disclosed by a covered practice in any form, whether communicated electronically, on paper or orally. These standards impose extensive new administrative requirements on these practices. They require compliance with rules governing the use and disclosure of health information. They create new rights for patients in their health information, such as the right to amend their health information, and they require these practices to impose these rules, by contract, on any business associate to whom they disclose such information in order to perform functions on their behalf including us. In addition, these practices will continue to remain subject to any state laws that are more restrictive than the privacy regulations issued under HIPAA. These state laws vary by state and could impose additional penalties.
On February 20, 2003, the Department of Health and Human Services finalized a rule that establishes, in part, standards to protect the confidentiality, availability and integrity of health information by health plans, health care clearinghouses and health care providers that receive, store, maintain or transmit health and related financial information in electronic form, regardless of format. These security standards require dental practices to establish and maintain reasonable and appropriate administrative, technical and physical safeguards to ensure the integrity, confidentiality and the availability of electronic health and related financial information. The security standards were designed to protect electronic information against reasonably anticipated threats or hazards to the security or integrity of the information and to protect the information against unauthorized use or disclosure. Although the security standards do not reference or advocate a specific technology, and covered health care providers, plans and clearinghouses have the flexibility to choose their own technical solutions, the security standards will require dental practices to implement significant new systems, business procedures and training programs. Dental practices must comply with these security regulations by April 21, 2005.
A violation of these regulations could result in civil monetary penalties of $100 per incident, up to a maximum of $25,000 per person per year per standard. HIPAA also provides for criminal penalties of up to $50,000 and one year in prison for knowingly and improperly obtaining or disclosing protected health information, up to $100,000 and five years in prison for obtaining protected health information under false pretenses, and up to $250,000 and ten years in prison for obtaining or disclosing protected health information with the intent to sell, transfer or use such information for commercial advantage, personal gain or malicious harm. Because there is no history of enforcement efforts by the federal government at this time, it is not possible to ascertain the likelihood of enforcement efforts in connection with the HIPAA regulations or the potential for fines and penalties which may result from the violation of the regulations.
We expect that compliance with these standards will require significant commitment and action by us and certain of our affiliated practices. Because some of the regulations are proposed regulations, we cannot predict the total financial impact of the regulations on us or our affiliated practices.
Some of our affiliated practices receive payment of fees through Medicaid programs. The Social Security Act includes provisions addressing false statements, illegal remuneration and other fraud, including a statute commonly referred to as the federal anti-kickback statute. The federal anti-kickback statute prohibits providers and others from, among other things, soliciting, receiving, offering or paying, directly or indirectly, any remuneration in return for either making a referral for a service or item covered by Medicaid or other federal health care program or ordering or arranging for or recommending the order of any covered service or item. Violations of the federal anti-kickback statute are punishable by a fine of up to $50,000 or imprisonment for each violation, as well as damages up to three times the total amount of remuneration. The U.S. government is authorized
to impose criminal, civil and administrative penalties on any person or entity that files a false claim for payment from Medicaid programs. Claims filed with private insurers can also lead to criminal and civil penalties. While the criminal statutes are generally reserved for instances of fraudulent intent, the U.S. government is applying its criminal, civil and administrative penalty statutes in an ever-expanding range of circumstances. For example, the government has taken the position that a pattern of claiming reimbursement for unnecessary services violates these statutes if the claimant merely should have known the services were unnecessary, even if the government cannot demonstrate actual knowledge. In addition, over the past several years, the U.S. government has accused an increasing number of health care providers of violating the federal False Claims Act. The False Claims Act prohibits a person from knowingly presenting, or causing to be presented, a false or fraudulent claim to the U.S. government. The statute defines “knowingly” to include not only actual knowledge of a claim’s falsity, but also reckless disregard for or intentional ignorance of the truth or falsity of a claim. Under the “qui tam,” or whistleblower, provisions of the False Claims Act, private parties may bring actions on behalf of the U.S. government. These private parties, are entitled to share in any amounts recovered by the government through trial or settlement. Both direct enforcement activity by the government and whistleblower lawsuits have increased significantly in recent years.
We are also subject to various state insurance statutes and regulations that prohibit us from submitting inaccurate, incorrect or misleading claims on behalf of our affiliated practices. We believe that our affiliated practices are in compliance with all state insurance laws and regulations regarding the submission of claims. We cannot assure you, however, that none of our practices’ insurance claims will ever be challenged. If we were found to be in violation of a state’s insurance laws or regulations, we could be forced to discontinue the violative practice, which could have an adverse effect on our business and operating results, and we could be subject to fines and criminal penalties.
Based on our familiarity with the operations of our affiliated practices, we believe that our activities do not violate the dental practice laws or regulations of the states in which we operate, as those laws have been interpreted by the applicable legal authorities in the past, or other state or federal laws or regulations generally applicable to healthcare providers and operations, as such laws and regulations relate to our activities. We regularly monitor developments in these laws and regulations, and note that, in two states, courts have ruled that OrthAlliance’s service agreements with certain affiliated practices violated the dental practice laws of those states. We are appealing each of these decisions. Future changes in the interpretation of these laws and regulations, the enactment of more stringent laws and regulations or other changes in the business and regulatory environment could require us to change the structure and terms of our existing contractual relationships with our affiliated practices, how the services of our affiliated practices are marketed and advertised, or other aspects of our operations. In addition, the laws and regulations of some states and countries could restrict expansion of our operations in those jurisdictions. While we plan to structure all of our future agreements, operations and marketing in accordance with applicable laws and regulations, our arrangements could be successfully challenged and any required changes could have a material adverse effect on our operations, prospects or profitability.
The operations of our affiliated practices must also meet federal, state and local regulatory standards related to the safety and health of clinic employees and the maintenance of safe premises (in addition to laws and regulations related to the practice of dentistry and to healthcare providers in general). Historically, those standards have not had an adverse effect on the operations of our affiliated practices. Based on our familiarity with the operations of our affiliated practices, we believe that our affiliated practices generally comply in all material respects with applicable federal, state and local laws and regulations relating to safety and health.
COMPETITION
We believe that our experienced management team and our broad, integrated suite of business services and systems provides us with a competitive advantage. A few smaller or regional companies also provide business or
support services to orthodontic practices. Several companies provide business services to general dental practices, including some practices that include orthodontic and pediatric dental components. We also compete with providers of individual business services for orthodontic, dental and other healthcare practices, such as information technology and software vendors and providers of personnel and payroll services, billing and collections services, patient financing services, clinic fixed asset financing, purchasing systems and other business services. Other companies could enter our industry and compete with us.
Our affiliated practices compete with orthodontists and pediatric dentists who operate in single and multiple offices. Our affiliated practices also compete with general dentists who provide certain orthodontic services and dental treatment to children. The provision of orthodontic services by general dentists has increased in recent years.
EMPLOYEES
At December 31, 2003, we employed 3,092 persons in the United States, including 2,589 full-time employees and approximately 140 employees in our corporate offices. In addition, we employed 204 persons, including 152 full-time employees, in locations outside the United States. Our employees are not represented by a collective bargaining agreement. We consider our relationship with our employees to be good. We do not employ our affiliated practitioners or other licensed professionals.
INSURANCE
We maintain general liability and property insurance. The cost of insurance coverage varies, and the availability of some coverage has fluctuated in recent years. While we believe, based upon our claims experience, that our current insurance coverage is adequate for our current operations, our coverage may not be sufficient for all future claims and may not continue to be available in adequate amounts or at reasonable rates. Our affiliated practices purchase and maintain their own malpractice liability insurance coverage. Many of our affiliated practices are contractually required to use reasonable efforts to have us named as an additional insured party on their respective insurance policies.
SERVICE AND TRADEMARKS
We registered the service mark “Orthodontic Centers of America”, in both typed form and with design, on the Supplemental Register of the U.S. Patent and Trademark Office in 1998. We also have applications pending before the U.S. Patent and Trademark Office to register the mark “Orthodontic Centers of America”, the mark “OCA” and the mark “OCA Outsource”, each in both typed form and with design, on the Principal Register of the U.S. Patent and Trademark Office.
We also own a number of other trademarks and service marks that are registered, or for which applications for registration are pending, with the U.S. Patent and Trademark Office, including: “Dial 4-Braces”, “FAAB”, “Finishing Touch”, “First Impressions”, “Kids-Smile Pediatric Dental Centers”, “Orthodontic Centers of America Share A Smile!”, “Professional Smile Salon”, “Single-Source Business Services”, “Thank You For Making Me Smile”, “1-800-4BRACES” and “4braces.com”.
Registrations of trademarks and service marks with the U.S. Patent and Trademark Office generally may be renewed and continue indefinitely, provided that we continue to use these trademarks or service marks and file appropriate maintenance and renewal documentation with the U.S. Patent and Trademark Office at times required by the federal trademark laws and regulations.
EXECUTIVE OFFICERS
For information about our executive officers, please see “Item 10. Directors and Executive Officers of the Registrant.”
AVAILABLE INFORMATION
Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are available free of charge on our website at www.4braces.com. These reports are accessible under the “Investors” caption of the Company’s website and are available as soon as reasonably practicable after such reports are electronically filed with or furnished to the Securities and Exchange Commission. Our Internet website and the information contained in or connected to that website are not incorporated into this Report.
RECENT DEVELOPMENT
On March 3, 2004, our Board of Directors adopted a stockholder rights plan. To implement the rights plan, the Board of Directors declared a dividend distribution of one preferred stock purchase right per outstanding share of common stock, payable to all stockholders of record as of March 3, 2004. The rights were distributed as a non-taxable dividend and will expire on March 2, 2014. The rights will automatically trade with our underlying common stock and no separate preferred stock certificates will be distributed. The rights to acquire preferred stock are not immediately exercisable and will become exercisable only if a person or group acquires or commences a tender offer for 20% or more of our common stock. If a person or group acquires or commences a tender offer for 20% or more of our common stock, each holder of these rights, except the acquirer, will be entitled to exercise a right for one one-thousandth of a share of our newly-created Series A Junior Participating Preferred Stock at an exercise price of $40.00 or a number of shares of our common stock equal to twice the exercise price of the rights divided by the market value of our common stock at the time of such acquisition. In addition, in the event of certain business combinations, the rights permit their holders to purchase the number of shares of the acquirer’s common stock equal to twice the exercise price of the rights divided by the market value of the acquirer’s common stock at the time of such acquisition. Our Board of Directors may terminate the rights plan at any time or redeem the rights for $0.00001 per right at any time before a person acquires 20% or more of our common stock.
