Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
(Mark One)
þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended March 31, 2011
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File Number: 001-34171
GRAYMARK HEALTHCARE, INC.
(Exact name of registrant as specified in its charter)
OKLAHOMA (State or other jurisdiction of incorporation or organization) | 20-0180812 (I.R.S. Employer Identification No.) |
210 Park Avenue, Ste. 1350
Oklahoma City, Oklahoma 73102
(Address of principal executive offices)
Oklahoma City, Oklahoma 73102
(Address of principal executive offices)
(405) 601-5300
(Registrant’s telephone number, including area code)
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act 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.þ Yeso No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).o Yeso No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filero | Accelerated filero | Non-accelerated filero | Smaller reporting companyþ | |||
(Do not check if a smaller reporting company) |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).o Yesþ No
As of May 16, 2011, 34,126,022 shares of the registrant’s common stock, $0.0001 par value, were outstanding.
GRAYMARK HEALTHCARE, INC.
FORM 10-Q
For the Quarter Ended March 31, 2011
FORM 10-Q
For the Quarter Ended March 31, 2011
TABLE OF CONTENTS
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
Certain statements under the captions “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Item 1A. Risk Factors,” and elsewhere in this report constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Certain, but not necessarily all, of such forward-looking statements can be identified by the use of forward-looking terminology such as “anticipates,” “believes,” “expects,” “may,” “will,” or “should” or other variations thereon, or by discussions of strategies that involve risks and uncertainties. Our actual results or industry results may be materially different from any future results expressed or implied by such forward-looking statements. Factors that could cause actual results to differ materially include general economic and business conditions; our ability to implement our business strategies; competition; availability of key personnel; increasing operating costs; unsuccessful promotional efforts; changes in brand awareness; acceptance of new product offerings; and adoption of, changes in, or the failure to comply with, and government regulations.
Throughout this report the first personal plural pronoun in the nominative case form “we” and its objective case form “us”, its possessive and the intensive case forms “our” and “ourselves” and its reflexive form “ourselves” refer collectively to Graymark Healthcare, Inc. and its subsidiaries and “Sleep Management Solutions,” or “SMS,” refers to our sleep centers and related service and supply business, and “ApothecaryRx” refers to the discontinued operations of ApothecaryRx, LLC, our subsidiary that operated retail pharmacies through December 2010.
i
Table of Contents
PART I. FINANCIAL INFORMATION
Item 1. | Graymark Healthcare, Inc. Consolidated Condensed Financial Statements. |
The consolidated condensed financial statements included in this report have been prepared by us pursuant to the rules and regulations of the Securities and Exchange Commission. The Consolidated Condensed Balance Sheets as of March 31, 2011 and December 31, 2010, the Consolidated Condensed Statements of Operations for the three month periods ended March 31, 2011 and 2010, and the Consolidated Condensed Statements of Cash Flows for the three months ended March 31, 2011 and 2010, have been prepared without audit. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to those rules and regulations, although we believe that the disclosures are adequate to make the information presented not misleading. It is suggested that these consolidated condensed financial statements be read in conjunction with the financial statements and the related notes thereto included in our latest annual report on Form 10-K.
The consolidated condensed statements for the unaudited interim periods presented include all adjustments, consisting of normal recurring adjustments, necessary to present a fair statement of the results for such interim periods. Because of the influence of seasonal and other factors on our operations, net earnings for any interim period may not be comparable to the same interim period in the previous year, nor necessarily indicative of earnings for the full year.
1
Table of Contents
GRAYMARK HEALTHCARE, INC.
Consolidated Condensed Balance Sheets
(Unaudited)
March 31, | December 31, | |||||||
2011 | 2010 | |||||||
ASSETS | ||||||||
Cash and cash equivalents | $ | 574,054 | $ | 878,796 | ||||
Cash and cash equivalents from discontinued operations | 17,898 | 692,261 | ||||||
Accounts receivable, net of allowances for contractual adjustments and doubtful accounts of $2,433,914 and $2,791,906, respectively | 2,942,103 | 2,892,271 | ||||||
Inventories | 584,700 | 553,342 | ||||||
Current assets from discontinued operations | 1,313,574 | 2,093,571 | ||||||
Other current assets | 415,167 | 468,486 | ||||||
Total current assets | 5,847,496 | 7,578,727 | ||||||
Property and equipment, net | 3,662,648 | 3,870,514 | ||||||
Intangible assets, net | 2,362,508 | 2,400,756 | ||||||
Goodwill | 13,007,953 | 13,007,953 | ||||||
Other assets from discontinued operations | 1,087,614 | 1,101,013 | ||||||
Other assets | 834,546 | 733,589 | ||||||
Total assets | $ | 26,802,765 | $ | 28,692,552 | ||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||||
Liabilities: | ||||||||
Accounts payable | $ | 1,223,139 | $ | 942,020 | ||||
Accrued liabilities | 1,726,148 | 2,357,195 | ||||||
Short-term debt | 734,683 | 12,075 | ||||||
Current portion of long-term debt | 22,732,720 | 22,756,706 | ||||||
Current liabilities from discontinued operations | 1,750,092 | 2,015,277 | ||||||
Total current liabilities | 28,166,782 | 28,083,273 | ||||||
Long-term debt, net of current portion | 360,808 | 436,850 | ||||||
Total liabilities | 28,527,590 | 28,520,123 | ||||||
Equity: | ||||||||
Graymark Healthcare shareholders’ equity: | ||||||||
Preferred stock $0.0001 par value, 10,000,000 authorized; no shares issued and outstanding | — | — | ||||||
Common stock $0.0001 par value, 500,000,000 shares authorized; 28,953,611 issued and outstanding | 2,895 | 2,895 | ||||||
Paid-in capital | 29,543,103 | 29,519,387 | ||||||
Accumulated deficit | (31,055,243 | ) | (29,218,977 | ) | ||||
Total Graymark Healthcare shareholders’ equity (deficit) | (1,509,245 | ) | 303,305 | |||||
Noncontrolling interest | (215,580 | ) | (130,876 | ) | ||||
Total equity (deficit) | (1,724,825 | ) | 172,429 | |||||
Total liabilities and shareholders’ equity | $ | 26,802,765 | $ | 28,692,552 | ||||
See Accompanying Notes to Consolidated Condensed Financial Statements
2
Table of Contents
GRAYMARK HEALTHCARE, INC.
Consolidated Condensed Statements of Operations
For the Three Months Ended March 31, 2011 and 2010
(Unaudited)
2011 | 2010 | |||||||
Net Revenues: | ||||||||
Services | $ | 3,443,496 | $ | 4,672,985 | ||||
Product sales | 1,246,377 | 1,239,050 | ||||||
4,689,873 | 5,912,035 | |||||||
Cost of Services and Sales: | ||||||||
Cost of services | 1,222,944 | 1,452,600 | ||||||
Cost of sales | 408,696 | 400,335 | ||||||
1,631,640 | 1,852,935 | |||||||
Gross Margin | 3,058,233 | 4,059,100 | ||||||
Operating Expenses: | ||||||||
Selling, general and administrative | 3,992,736 | 4,892,600 | ||||||
Bad debt expense | 117,847 | 238,899 | ||||||
Depreciation and amortization | 294,628 | 344,399 | ||||||
4,405,211 | 5,475,898 | |||||||
Other (Expense): | ||||||||
Interest expense, net | (347,482 | ) | (284,231 | ) | ||||
Other expense | (2,229 | ) | — | |||||
Net other (expense) | (349,711 | ) | (284,231 | ) | ||||
Income (loss) from continuing operations, before taxes | (1,696,689 | ) | (1,701,029 | ) | ||||
Provision for income taxes | (9,603 | ) | (47,986 | ) | ||||
Income (loss) from continuing operations, net of taxes | (1,706,292 | ) | (1,749,015 | ) | ||||
Income (loss) from discontinued operations, net of taxes | (214,678 | ) | 283,267 | |||||
Net income (loss) | (1,920,970 | ) | (1,465,748 | ) | ||||
Less: Net income (loss) attributable to noncontrolling interests | (84,704 | ) | (40,799 | ) | ||||
Net income (loss) attributable to Graymark Healthcare | $ | (1,836,266 | ) | $ | (1,424,949 | ) | ||
Earnings per common share (basic and diluted): | ||||||||
Net income (loss) from continuing operations | $ | (0.06 | ) | $ | (0.06 | ) | ||
Income from discontinued operations | (0.01 | ) | 0.01 | |||||
Net income (loss) per share | $ | (0.07 | ) | $ | (0.05 | ) | ||
Weighted average number of common shares outstanding | 28,953,611 | 29,011,675 | ||||||
Weighted average number of diluted shares outstanding | 28,953,611 | 29,011,675 | ||||||
See Accompanying Notes to Consolidated Condensed Financial Statements
3
Table of Contents
GRAYMARK HEALTHCARE, INC.
Consolidated Condensed Statements of Cash Flows
For the Three Months Ended March 31, 2011 and 2010
(Unaudited)
2011 | 2010 | |||||||
Operating activities: | ||||||||
Net income (loss) | $ | (1,836,266 | ) | $ | (1,424,949 | ) | ||
Less: Net income (loss) from discontinued operations | (214,678 | ) | 283,267 | |||||
Net income(loss) from continuing operations | (1,621,588 | ) | (1,708,216 | ) | ||||
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: | ||||||||
Depreciation and amortization | 294,628 | 344,399 | ||||||
Noncontrolling interests | (84,704 | ) | (40,799 | ) | ||||
Stock-based compensation, net of cashless vesting | 23,716 | 307,044 | ||||||
Bad debt expense | 117,847 | 238,899 | ||||||
Changes in assets and liabilities — | ||||||||
Accounts receivable | (167,679 | ) | (60,423 | ) | ||||
Inventories | (31,358 | ) | (42,558 | ) | ||||
Other assets | (47,638 | ) | (132,095 | ) | ||||
Accounts payable | 281,119 | 486,175 | ||||||
Accrued liabilities | (631,047 | ) | (140,227 | ) | ||||
Net cash (used in) operating activities from continuing operations | (1,866,704 | ) | (747,801 | ) | ||||
Net cash provided by operating activities from discontinued operations | 313,533 | 1,220,356 | ||||||
Net cash provided by (used in) operating activities | (1,553,171 | ) | 472,556 | |||||
Investing activities: | ||||||||
Purchase of property and equipment | (51,943 | ) | (67,124 | ) | ||||
Disposal of property and equipment | 3,429 | 8,910 | ||||||
Net cash (used in) investing activities from continuing operations | (48,514 | ) | (58,214 | ) | ||||
Net cash (used in) investing activities from discontinued operations | — | (29,164 | ) | |||||
Net cash (used in) investing activities | (48,514 | ) | (87,378 | ) | ||||
Financing activities: | ||||||||
Debt proceeds | 725,000 | 12,614 | ||||||
Debt payments | (102,420 | ) | (179,537 | ) | ||||
Net cash provided by (used in) financing activities from continuing operations | 622,580 | (166,923 | ) | |||||
Net cash (used in) financing activities from discontinued operations | — | (758,639 | ) | |||||
Net cash provided by (used in) financing activities | 622,580 | (925,562 | ) | |||||
Net change in cash and cash equivalents | (979,105 | ) | (540,385 | ) | ||||
Cash and cash equivalents at beginning of period | 1,571,057 | 1,890,606 | ||||||
Cash and cash equivalents at end of period | 591,952 | 1,350,221 | ||||||
Cash and cash equivalents of discontinued operations at end of period | 17,898 | 789,475 | ||||||
Cash and cash equivalents of continuing operations at end of period | $ | 574,054 | $ | 560,746 | ||||
Cash Paid for Interest and Income Taxes: | ||||||||
Interest expense, continuing operations | $ | 355,000 | $ | 290,000 | ||||
Interest expense, discontinued operations | $ | 1,000 | $ | 346,000 | ||||
Income taxes | $ | 9,000 | $ | 38,000 | ||||
See Accompanying Notes to Consolidated Condensed Financial Statements
4
Table of Contents
GRAYMARK HEALTHCARE, INC.
Notes to Consolidated Condensed Financial Statements
For the Periods Ended March 31, 2011 and 2010
Note 1 — Nature of Business
Graymark Healthcare, Inc. (the “Company”) is organized in Oklahoma and provides diagnostic sleep testing services and care management solutions for people with chronic sleep disorders. In addition, the Company sells equipment and related supplies and components used to treat sleep disorders. The Company’s products and services are used primarily by patients with obstructive sleep apnea, or OSA. The Company’s sleep centers provide monitored sleep diagnostic testing services to determine sleep disorders in the patients being tested. The majority of the sleep testing is to determine if a patient has OSA. A continuous positive airway pressure, or CPAP, device is the American Academy of Sleep Medicine’s, or AASM, preferred method of treatment for obstructive sleep apnea. The Company’s sleep diagnostic facilities also determine the correct pressure settings for patient treatment with positive airway pressure. The Company sells CPAP devices and supplies to patients who have tested positive for sleep apnea and have had their positive airway pressure determined. There are noncontrolling interest holders in some of the Company’s testing facilities, who are typically physicians in the geographical area being served by the diagnostic sleep testing facility.
On September 1, 2010, the Company executed an Asset Purchase Agreement, which was subsequently amended on October 29, 2010, providing for the sale of substantially all of the assets of the Company’s subsidiary, ApothecaryRx, LLC (“ApothecaryRx”). ApothecaryRx operated 18 retail pharmacy stores selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. The final closing of the sale of ApothecaryRx assets occurred in December 2010. As a result of the sale of ApothecaryRx, the related assets, liabilities, results of operations and cash flows of ApothecaryRx have been classified as discontinued operations in the accompanying consolidated condensed financial statements.
Note 2 — Basis of Presentation
As of March 31, 2011, the Company had an accumulated deficit of approximately $31.1 million and reported a net loss of approximately $1.8 for the three months then ending. The Company used approximately $1.9 million in cash from operating activities of continuing operations during the three months ending March 31, 2011. Furthermore, the Company has a working capital deficit of approximately $22.3 million as of March 31, 2011. As noted in Note 6 — Borrowings, the Company is required to make a $3 million principal payment to Arvest Bank by June 30, 2011 and is not in compliance with certain covenants required by its lending agreement with Arvest Bank. The Company made the $3 million principal payment to Arvest Bank on May 12, 2011 from the cash proceeds of the private placement offering and the sale of Nocturna East, Inc. which totaled approximately $4.5 million (see Note 10 — Subsequent Events).
In addition, management expects to raise approximately $13.3 million in a public stock offering during 2011. From the proceeds of the offering, the Company will be required to pay Arvest Bank one-third of the proceeds of the equity offering less $3 million. In the event that the Company is unable to obtain debt or equity financing or the Company is unable to obtain such financing on terms and conditions acceptable to it, the Company may have to cease or severely curtail its operations. This uncertainty raises substantial doubt regarding the Company’s ability to continue as a going concern. Historically, management has been able to raise the capital necessary to fund the operation and growth of the Company. The consolidated condensed financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.
5
Table of Contents
Note 3 — Summary of Significant Accounting Policies
For a complete list of the Company’s significant accounting policies, please see the Company’s Annual Report on Form 10-K for the year ending December 31, 2010.
Interim Financial Information— The unaudited consolidated condensed financial statements included herein have been prepared in accordance with generally accepted accounting principles for interim financial statements and with Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2011 are not necessarily indicative of results that may be expected for the year ended December 31, 2011. The consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended December 31, 2010. The December 31, 2010 consolidated condensed balance sheet was derived from audited financial statements.
Reclassifications— Certain amounts presented in prior years have been reclassified to conform to the current year’s presentation including the assets, liabilities, results of operations and cash flows of ApothecaryRx which are reflected as discontinued operations.
Consolidation— The accompanying consolidated financial statements include the accounts of the Company and its wholly owned, majority owned and controlled subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation.
Use of estimates— The preparation of financial statements in conformity with generally accepted accounting principles requires management of the Company to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Revenue recognition —Sleep center services and product sales are recognized in the period in which services and related products are provided to customers and are recorded at net realizable amounts estimated to be paid by customers and third-party payers. Insurance benefits are assigned to the Company and, accordingly, the Company bills on behalf of its customers. For its sleep diagnostic business, the Company estimates the net realizable amount based primarily on the contracted rates stated in the contracts the Company has with various payors. The Company has used this method to determine the net revenue for the business acquired from somniCare, Inc. and somniTech, Inc. (“Somni”) business since the date of the acquisition in 2009 and for the Company’s remaining sleep diagnostic business since the fourth quarter of 2010. The Company does not anticipate any future changes to this process. In the Company’s historic sleep therapy business, the business has been predominantly out-of-network and as a result, the Company has not had contract rates to use for determining net revenue for a majority of its payors. For this portion of the business, the Company performs a quarterly analysis of actual reimbursement from each third party payor for the most recent 12-months. In the analysis, the Company calculates the percentage actually paid by each third party payor of the amount billed to determine the applicable amount of net revenue for each payor. The key assumption in this process is that actual reimbursement history is a reasonable predictor of the future reimbursement for each payor at each facility. During the fourth quarter of 2010, the Company migrated much of its historic sleep diagnostic business to an in-network position. As a result, commencing with the fourth quarter of 2010, the revenue from the Company’s historic sleep diagnostic business was determined using the process utilized in the Somni business. The Company expects to transition its historic sleep therapy business to the same process currently used for its sleep diagnostic business by the end of 2011. This change in process and assumptions for the Company’s historic sleep therapy business is not expected to have a material impact on future operating results.
For certain sleep therapy and other equipment sales, reimbursement from third-party payers occur over a period of time, typically 10 to 13 months. The Company recognizes revenue on these sales as payments are earned over the payment period stipulated by the third-party payor.
6
Table of Contents
The Company has established an allowance to account for contractual adjustments that result from differences between the amount billed and the expected realizable amount. Actual adjustments that result from differences between the payment amount received and the expected realizable amount are recorded against the allowance for contractual adjustments and are typically identified and ultimately recorded at the point of cash application or when otherwise determined pursuant to the Company’s collection procedures. Revenues in the accompanying consolidated financial statements are reported net of such adjustments.
Due to the nature of the healthcare industry and the reimbursement environment in which the Company operates, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time products or services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on the Company’s operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payers may result in adjustments to amounts originally recorded.
The patient and their third party insurance provider typically share in the payment for the Company’s products and services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the number of out-of-network patients, the Company is not certain of the full amount of patient responsibility at the time of service. Starting in 2010, the Company implemented a process to estimate amounts due from patients prior to service and increase collection of those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.
Cost of Services and Sales— Cost of services includes technician labor required to perform sleep diagnostics, fees associated with interpreting the results of the sleep study and disposable supplies used in providing sleep diagnostics. Cost of sales includes the acquisition cost of sleep therapy products sold. Costs of services are recorded in the time period the related service is provided. Cost of sales is recorded in the same time period that the related revenue is recognized. If the sale is paid for over a specified period, the product cost associated with that sale is recognized over that same period. If the product is paid for in one period, the cost of sale is recorded in the period the product was sold.
Restricted cash— As of March 31, 2011 and December 31, 2010, the Company had long-term restricted cash of approximately $236,000 included in other assets in the accompanying condensed consolidated balance sheets. This amount is pledged as collateral to the Company’s senior bank debt and bank line of credit.
Accounts receivable— The majority of the Company’s accounts receivable is due from private insurance carriers, Medicare/Medicaid and other third-party payors, as well as from patients relating to deductible and coinsurance and deductible provisions of their health insurance policies.
Third-party reimbursement is a complicated process that involves submission of claims to multiple payers, each having its own claims requirements. Adding to this complexity, a significant portion of the Company’s business has historically been out-of-network with several payors, which means the Company does not have defined contracted reimbursement rates with these payors. For this reason, the Company’s systems reported revenue at a higher gross billed amount, which the Company adjusted to an expected net amount based on historic payments. This process continues in the Company’s historic sleep therapy business, but was changed in the fourth quarter of 2010 for the Company’s historic sleep diagnostic business. As a result, the reserve for contractual allowance has been reduced as our systems now report a larger portion of our business at estimated net contract rates. As the Company continues to move more of its business to in-network contracting, the level of reserve related to contractual allowances is expected to decrease. In some cases, the ultimate collection of accounts receivable subsequent to the service dates may not be known for several months. As these accounts age, the risk of collection increases and the resulting reserves for bad debt expense reflect this longer payment cycle. The Company has established an allowance to account for contractual adjustments that result from differences between the amounts billed to customers and third-party payers and the expected realizable amounts. The percentage and amounts used to record the allowance for doubtful accounts are supported by various methods including current and historical cash collections, contractual adjustments, and aging of accounts receivable.
7
Table of Contents
The Company offers payment plans to patients for amounts due from them for the sales and services the Company provides. For patients with a balance of $500 or less, the Company allows a maximum of six months for the patient to pay the amount due. For patients with a balance over $500, the Company allows a maximum of 12 months to pay the full amount due. The minimum monthly payment amount for both plans is $50 per month.
Accounts are written-off as bad debt using a specific identification method. For amounts due from patients, the Company utilizes a collections process that includes distributing monthly account statements. For patients that are not on a payment plan, collection efforts including collection letters and collection calls begin at 90 days from the initial statement. If the patient is on a payment program, these efforts begin 30 days after the patient fails to make a planned payment. For diagnostic patients, the Company submits patient receivables to an outside collection agency if the patient has failed to pay 120 days following service or, if the patient is on a payment plan, they have failed to make two consecutive payments. For therapy patients, patient receivables are submitted to an outside collection agency if payment has not been received between 180 and 270 days following service depending on the service provided and circumstances of the receivable or, if the patient is on a payment plan, they have failed to make two consecutive payments. It is the Company’s policy to write-off as bad debt all patient receivables at the time they are submitted to an outside collection agency. If funds are recovered by a collection agency, the amounts previously written-off are reversed as a recovery of bad debt. For amounts due from third party payors, it is the Company’s policy to write-off an account receivable to bad debt based on the specific circumstances related to that claim resulting in a determination that there is no further recourse for collection of a denied claim from the denying payor.
For the three months ended March 31, 2011 and 2010, the amounts the Company collected in excess of recorded contractual allowances were $45,351 and $111,528, respectively.
Accounts receivable are reported net of allowances for contractual adjustments and doubtful accounts as follows:
March 31, | December 31, | |||||||
2011 | 2010 | |||||||
Allowance for contractual adjustments | $ | 1,419,291 | $ | 1,676,618 | ||||
Allowance for doubtful accounts | 1,014,623 | 1,115,288 | ||||||
Total | $ | 2,433,914 | $ | 2,791,906 | ||||
The activity in the allowances for contractual adjustments and doubtful accounts for the three months ending March 31, 2011 follows:
Contractual | Doubtful | |||||||||||
Adjustments | Accounts | Total | ||||||||||
Balance at December 31, 2010 | $ | 1,676,618 | $ | 1,115,288 | $ | 2,791,906 | ||||||
Provisions | 1,050,222 | 117,847 | 1,168,069 | |||||||||
Write-offs, net of recoveries | (1,307,549 | ) | (218,512 | ) | (1,526,061 | ) | ||||||
Balance at March 31, 2011 | $ | 1,419,291 | $ | 1,014,623 | $ | 2,433,914 | ||||||
8
Table of Contents
The aging of the Company’s accounts receivable, net of allowances for contractual adjustments and doubtful accounts as of March 31, 2011 and December 31, 2010 follows:
March 31, | December 31, | |||||||
2011 | 2010 | |||||||
1 to 60 days | $ | 1,942,865 | $ | 1,890,902 | ||||
61 to 90 days | 271,056 | 282,807 | ||||||
91 to 120 days | 190,514 | 170,435 | ||||||
121 to 180 days | 187,027 | 67,394 | ||||||
181 to 360 days | 160,597 | 186,310 | ||||||
Greater than 360 days | 190,044 | 294,423 | ||||||
Total | $ | 2,942,103 | $ | 2,892,271 | ||||
In addition to the aging of accounts receivable shown above, management relies on other factors to determine the collectability of accounts including the status of claims submitted to third party payors, reason codes for declined claims and an assessment of the Company’s ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan.
Included in accounts receivable are earned but unbilled receivables of approximately $74,000 and $129,000 as of March 31, 2011 and December 31, 2010, respectively. Unbilled accounts receivable represent charges for services delivered to customers for which invoices have not yet been generated by the billing system. Prior to the delivery of services or equipment and supplies to customers, the Company performs certain certification and approval procedures to ensure collection is reasonably assured and that unbilled accounts receivable is recorded at net amounts expected to be paid by customers and third-party payers. Billing delays can occur due to delays in obtaining certain required payer-specific documentation from internal and external sources, interim transactions occurring between cycle billing dates established for each customer within the billing system and new sleep centers awaiting assignment of new provider enrollment identification numbers. In the event that a third-party payer does not accept the claim for payment, the customer is ultimately responsible.
Goodwill and Intangible Assets— Goodwill is the excess of the purchase price paid over the fair value of the net assets of the acquired business. Goodwill and other indefinitely-lived intangible assets are not amortized, but are subject to annual impairment reviews during the fourth quarter, or more frequent reviews if events or circumstances indicate there may be an impairment of goodwill.
Intangible assets other than goodwill which include customer relationships, customer files, covenants not to compete, trademarks and payor contracts are amortized over their estimated useful lives using the straight line method. The remaining lives range from three to fifteen years. The Company evaluates the recoverability of identifiable intangible assets whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.
Earnings (loss) per share— Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted earnings (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted during the period. Dilutive securities having an anti-dilutive effect on diluted earnings (loss) per share are excluded from the calculation.
Recently Adopted and Recently Issued Accounting Guidance
Adopted Guidance
On January 1, 2011, the Company adopted changes issued by the Financial Accounting Standards Board (FASB) to revenue recognition for multiple-deliverable arrangements. These changes require separation of consideration received in such arrangements by establishing a selling price hierarchy (not the same as fair value) for determining the selling price of a deliverable, which will be based on available information in the following order: vendor-specific objective evidence, third-party evidence, or estimated selling price; eliminate the residual method of allocation and require that the consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method, which allocates any discount in the arrangement to each deliverable on the basis of each deliverable’s selling price; require that a vendor determine its best estimate of selling price in a manner that is consistent with that used to determine the price to sell the deliverable on a standalone basis; and expand the disclosures related to multiple-deliverable revenue arrangements. The adoption of these changes had no impact on the Company’s consolidated financial statements, as the Company does not currently have any such arrangements with its customers.
9
Table of Contents
On January 1, 2011, the Company adopted changes issued by the FASB to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose, in the reconciliation of fair value measurements using significant unobservable inputs (Level 3), separate information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). The adoption of these changes had no impact on the Company’s consolidated financial statements.
On January 1, 2011, the Company adopted changes issued by the FASB to the testing of goodwill for impairment. These changes require an entity to perform all steps in the test for a reporting unit whose carrying value is zero or negative if it is more likely than not (more than 50%) that a goodwill impairment exists based on qualitative factors. This will result in the elimination of an entity’s ability to assert that such a reporting unit’s goodwill is not impaired and additional testing is not necessary despite the existence of qualitative factors that indicate otherwise. Based on the most recent impairment review of the Company’s goodwill (2010 fourth quarter), the adoption of these changes had no impact on the Company’s consolidated financial statements.
On January 1, 2011, the Company adopted changes issued by the FASB to the disclosure of pro forma information for business combinations. These changes clarify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. Also, the existing supplemental pro forma disclosures were expanded to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The adoption of these changes had no impact on the Company’s consolidated financial statements.
Note 4 — Discontinued Operations
On September 1, 2010, the Company executed an Asset Purchase Agreement, which was subsequently amended on October 29, 2010, (as amended, the “Agreement”) providing for the sale of substantially all of the assets of the Company’s subsidiary, ApothecaryRx (the “ApothecaryRx Sale”). ApothecaryRx operated 18 retail pharmacy stores selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. The final closing of the sale of ApothecaryRx assets occurred in December 2010. As a result of the sale of ApothecaryRx, the related assets, liabilities, results of operations and cash flows of ApothecaryRx have been classified as discontinued operations in the accompanying consolidated financial statements.
Under the Agreement, the consideration for the ApothecaryRx assets being purchased and liabilities being assumed is $25,500,000 plus up to $7,000,000 for inventory (“Inventory Amount”), but less any payments remaining under goodwill protection agreements and any amounts due under promissory notes which are assumed by buyer (the “Purchase Price”). For purposes of determining the Inventory Amount, the parties agreed to hire an independent valuator to perform a review and valuation of inventory being purchased from each pharmacy location; the independent valuator valued the Inventory Amount at approximately $3.8 million. The resulting total Purchase Price was $29.3 million. Of the Purchase Price, $2,000,000 was deposited in an escrow fund (the “Indemnity Escrow Fund”) pursuant to the terms of an indemnity escrow agreement. All proceeds from the sale of ApothecaryRx were deposited in a restricted account at Arvest Bank. Of the proceeds, $22,000,000 was used to reduce outstanding obligations under the Company’s credit facility with Arvest Bank.
Generally, in December 2011 (the 12-month anniversary of the final closing date of the sale of ApothecaryRx), 50% of the remaining funds held in the Indemnity Escrow Fund will be released, subject to deduction for any pending claims for indemnification. All remaining funds held in the Indemnity Escrow Fund, if any, will be released in May 2012 (the 18-month anniversary of the final closing date of the sale), subject to any pending claims for indemnification. Of the $2,000,000 Indemnity Escrow Fund, $1,000,000 is subject to partial or full recovery by the buyer if the average daily prescription sales at the buyer’s location in Sterling, Colorado over a six-month period after the buyer purchases the ApothecaryRx location in Sterling, Colorado does not increase by a certain percentage of the average daily prescription sales by the ApothecaryRx Sterling, Colorado location (the “Retention Rate Earnout”).
10
Table of Contents
The operating results of ApothecaryRx and the Company’s other discontinued operations (discontinued internet sales division and discontinued film operations) for the three months ended March 31, 2011 and 2010 are summarized below:
2011 | 2010 | |||||||
Revenues | $ | — | $ | 21,693,439 | ||||
Income (loss) before taxes — ApothecaryRx | $ | (206,966 | ) | $ | 285,157 | |||
Income (loss) before taxes — other | (7,712 | ) | (1,890 | ) | ||||
Income tax (provision) | — | — | ||||||
Income (loss) from discontinued operations | $ | (214,678 | ) | $ | 283,267 | |||
The balance sheet items for ApothecaryRx and the Company’s other discontinued operations as of March 31, 2011 and December 31, 2010 are summarized below:
March 31, | December 31, | |||||||
2011 | 2010 | |||||||
Cash and cash equivalents | $ | 17,898 | $ | 692,261 | ||||
Accounts receivable, net of allowances | 34,247 | 675,501 | ||||||
Inventories | 68,438 | 68,267 | ||||||
Indemnity Escrow Fund | 1,000,000 | 1,000,000 | ||||||
Other current assets | 210,889 | 349,803 | ||||||
Total current assets | 1,331,472 | 2,785,832 | ||||||
Fixed assets, net | 87,614 | 101,013 | ||||||
Indemnity Escrow Fund | 1,000,000 | 1,000,000 | ||||||
Total noncurrent assets | 1,087,614 | 1,101,013 | ||||||
Total assets | $ | 2,419,086 | $ | 3,886,845 | ||||
Payables and accrued liabilities | $ | 1,750,092 | $ | 2,015,277 | ||||
Note 5 — Goodwill and Other Intangibles
The carrying amount of goodwill as of March 31, 2011 and December 31, 2010 follows:
March 31, | December 31, | |||||||
2011 | 2010 | |||||||
Gross amount | $ | 20,516,894 | $ | 20,516,894 | ||||
Accumulated impairment losses | (7,508,941 | ) | (7,508,941 | ) | ||||
Carrying value | $ | 13,007,953 | $ | 13,007,953 | ||||
Goodwill and intangible assets with indefinite lives must be tested for impairment at least once a year. Carrying values are compared with fair values, and when the carrying value exceeds the fair value, the carrying value of the impaired asset is reduced to its fair value. The Company tests goodwill for impairment on an annual basis in the fourth quarter or more frequently if management believes indicators of impairment exist. The performance of the test involves a two-step process. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. The Company generally determines the fair value of its reporting units using the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the Company performs the second step of the goodwill impairment test to determine the amount of impairment loss. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill.
11
Table of Contents
The carrying amount of intangible assets as of March 31, 2011 and December 31, 2010 follows:
March 31, | December 31, | |||||||
2011 | 2010 | |||||||
Gross amount | $ | 6,076,000 | $ | 6,076,000 | ||||
Accumulated impairment losses | (3,243,056 | ) | (3,243,056 | ) | ||||
Carrying value | $ | 2,832,944 | $ | 2,832,944 | ||||
Intangible assets as of March 31, 2011 and December 31, 2010 include the following:
Useful | March 31, 2011 | December 31, | ||||||||||||||||
Life | Carrying | Accumulated | 2010 | |||||||||||||||
(Years) | Value | Amortization | Net | Net | ||||||||||||||
Customer relationships | Indefinite | $ | 1,046,000 | $ | — | $ | 1,046,000 | $ | 1,046,000 | |||||||||
Customer relationships | 8 – 15 | 1,139,333 | (253,408 | ) | 885,925 | 908,000 | ||||||||||||
Trademark | 10 – 15 | 229,611 | (43,602 | ) | 186,009 | 191,533 | ||||||||||||
Covenants not to compete | 3 – 15 | 228,000 | (153,371 | ) | 74,629 | 82,111 | ||||||||||||
Payor contracts | 15 | 190,000 | (20,055 | ) | 169,945 | 173,112 | ||||||||||||
Total | $ | 2,832,944 | $ | (470,436 | ) | $ | 2,362,508 | $ | 2,400,756 | |||||||||
Amortization expense for the three months ended March 31, 2011 and 2010 was approximately $38,000 and $251,000, respectively. Amortization expense for the next five years related to these intangible assets is expected to be as follows:
Twelve months ended March 31, | ||||
2012 | $ | 157,000 | ||
2013 | 142,000 | |||
2014 | 132,000 | |||
2015 | 132,000 | |||
2016 | 125,000 |
Note 6 — Borrowings
The Company’s long-term debt as of March 31, 2011 and December 31, 2010 are as follows:
Maturity | March 31, | December 31, | ||||||||||
Rate (1) | Date | 2011 | 2010 | |||||||||
Senior bank debt | 6% | May 2014 | $ | 8,000,000 | $ | 8,000,000 | ||||||
Bank line of credit | 6% | Aug. 2015 | 14,396,935 | 14,396,935 | ||||||||
Notes payable on equipment | 6 – 14% | April 2012 – Dec. 2013 | 381,412 | 417,249 | ||||||||
Sleep center notes payable | 3.75 – 8.75% | July 2011 – Jan. 2015 | 179,319 | 225,124 | ||||||||
Seller financing | 7.65% | Sept. 2012 | 78,414 | 90,662 | ||||||||
Notes payable on vehicles | 7.5% | Nov. 2012 – Dec. 2013 | 57,447 | 63,586 | ||||||||
Total borrowings | 23,093,528 | 23,193,556 | ||||||||||
Less: Current portion of long-term debt | (22,732,720 | ) | (22,756,706 | ) | ||||||||
Long-term debt | $ | 360,808 | $ | 436,850 | ||||||||
(1) | Effective rate as of March 31, 2011 |
12
Table of Contents
The Company’s short-term debt as of March 31, 2011 and December 31, 2010 are as follows:
Maturity | March 31, | December 31, | ||||||||||||||
Rate (1) | Date | 2011 | 2010 | |||||||||||||
Note payable | 6 | % | Aug. 2011 | $ | 725,000 | $ | — | |||||||||
Insurance premium financing | 2.97 | % | Nov. 2011 | 9,683 | 12,075 | |||||||||||
Short-term debt | $ | 734,683 | $ | 12,075 | ||||||||||||
(1) | Effective rate as of March 31, 2011 |
At March 31, 2011, future maturities of long-term debt were as follows:
Twelve months ended March 31, | ||||
2012 | $ | 22,733,000 | ||
2013 | 213,000 | |||
2014 | 129,000 | |||
2015 | 19,000 | |||
2016 | — | |||
Thereafter | — |
In May 2008 and as amended in May 2009 and July 2010, the Company entered into a loan agreement with Arvest Bank consisting of a $30 million term loan (the “Term Loan”) and a $15 million line of credit to be used for future acquisitions (the “Acquisition Line”); collectively referred to as the “Credit Facility”. The Term Loan was used by the Company to consolidate certain prior loans to the Company’s subsidiaries SDC Holdings LLC (“SDC Holdings”) and ApothecaryRx LLC. The Term Loan and the Acquisition Line bear interest at the greater of the prime rate as reported in the Wall Street Journal or the floor rate of 6%. The rate on the Term Loan is adjusted annually on May 21. The rate on the Acquisition Line is adjusted on the anniversary date of each advance or tranche. The Term Loan matures on May 21, 2014 and requires quarterly payments of interest only. Commencing on September 1, 2011, the Company is obligated to make quarterly payments of principal and interest calculated on a seven-year amortization based on the unpaid principal balance on the Term Loan as of June 1, 2011. Each advance or tranche of the Acquisition Line will become due on the sixth anniversary of the first day of the month following the date of the advance or tranche. Each advance or tranche is repaid in quarterly payments of interest only for three years and thereafter, quarterly principal and interest payments based on a seven-year amortization until the balloon payment on the maturity date of the advance or tranche. The Credit Facility is collateralized by substantially all of the Company’s assets and is personally guaranteed by various individual shareholders of the Company. The Company has also agreed to maintain certain financial covenants including a Debt Service Coverage Ratio of not less than 1.25 to 1 and Minimum Net Worth, as defined.
As of March 31, 2011, the Company’s Debt Service Coverage Ratio is less than 1.25 to 1 and the Company does not meet the Minimum Net Worth requirement. Arvest Bank has waived the Debt Service Coverage Ratio and Minimum Net Worth requirements through June 30, 2011 assuming the Company makes a $3 million principal payment by June 30, 2011. The Company made the $3 million principal payment to Arvest Bank on May 12, 2011 from the cash proceeds of the private placement offering and the sale of Nocturna East, Inc. which totaled approximately $4.5 million (see Note 10 — Subsequent Events). If by June 30, 2011, the Company prepays Arvest Bank approximately $1.1 million, which represents all principal and interest payments due to Arvest Bank between July 1, 2011 and December 31, 2011, Arvest Bank will waive the Debt Service Coverage Ratio and Minimum Net Worth requirements through December 31, 2011. There is no assurance that Arvest Bank will waive the Debt Service Coverage Ratio and Minimum Net Worth requirements beyond June 30, 2011 or December 31, 2011. Due to the non-compliance of these waivers and the associated contingent nature of achieving compliance before June 30, 2011, the associated debt has been classified as current on the accompanying consolidated condensed balance sheets.
13
Table of Contents
On March 16, 2011, the Company executed a promissory note with Valiant Investments, LLC in the amount of $1,000,000 (the “Valiant Note”). The note bears interest at 6%. All accrued interest and principal are due at the maturity of the Note on August 1, 2011. The proceeds from the note will be drawn through a series of advances and will be used for working capital. As of March 31, 2011, there is $725,000 outstanding on the note which is included in short-term debt in the accompanying condensed consolidated balance sheets. Valiant Investments, LLC is controlled by Mr. Roy T. Oliver, one of the Company’s greater than 5% shareholders and affiliates. The promissory note is subordinate to the Company’s credit facility with Arvest Bank. Subsequent to March 31, 2011, the Valiant Note was fully-funded and in May 2011, the Valiant Note was converted to common stock in conjunction with a private placement stock offering (see Note 10 — Subsequent Events).
On March 11, 2011, the Company received the consent of Arvest Bank to obtain the Valiant Note and requirements for payments of interest and principal on the Valiant Note and Arvest Bank will waive the debt service coverage ratio and minimum net worth covenants through December 31, 2011 on the following conditions:
• | On or before June 30, 2011, the Company will pay to Arvest Bank the greater of $3 million or one-third of the proceeds of any public equity offering (the Company made a $3 million payment to Arvest on May 12, 2011); |
• | On or before June 30, 2011, the Company will pay Arvest Bank a fee equal to 0.25% of the outstanding loan balance as of June 30, 2011; |
• | If the Company is not in compliance with the debt service coverage ratio and minimum net worth covenants on December 31, 2011, the Company will pay Arvest Bank a fee equal to 0.50% of the then outstanding balance of the loan (which does not cure any default in such covenants); |
• | On June 30, 2011, the Company will prepay all interest and principal payments due to Arvest Bank between July 1, 2011 and December 31, 2011; |
• | On June 30, 2011, if the Company has received at least $15 million in proceeds from a public equity offering then the Company will escrow with Arvest all principal and interest payments due to Arvest between January 1, 2012 and June 30, 2012; |
• | The Company may not repay any amounts on the Valiant Note before August 1, 2011 except that the Company may repay such loan in full if the Company has received more than $10 million in proceeds from a public equity offering and if the Company has received less than $10 million from a public equity offering then the Company will be permitted to make interest payments only on such loan; and |
• | The $1 million Valiant Note is subordinated to Arvest Bank’s credit facility in all respects. |
Note 7 — Commitments and Contingencies
Legal Issues:The Company is exposed to asserted and unasserted legal claims encountered in the normal course of business. Management believes that the ultimate resolution of these matters will not have a material adverse effect on the operating results or the financial position of the Company. During the three months ended March 31, 2011 and 2010, the Company did not incur any costs in settlement expenses related to its ongoing asserted and unasserted legal claims.
Note 8 — Fair Value Measurements
Recurring Fair Value Measurements:The carrying value of the Company’s financial assets and financial liabilities is their cost, which may differ from fair value. The carrying value of cash held as demand deposits, money market and certificates of deposit, accounts receivable, short-term borrowings, accounts payable and accrued liabilities approximated their fair value. The fair value of the Company’s long-term debt, including the current portion approximated its carrying value. Fair value for long-term debt was estimated based on market prices of similar debt instruments and values of comparable borrowings.
14
Table of Contents
Note 9 — Related Party Transactions
On March 16, 2011, the Company executed a promissory note with Valiant Investments, LLC in the amount of $1,000,000. The note bears interest at 6%. All accrued interest and principal are due at the maturity of the Note on August 1, 2011. The proceeds from the note will be drawn through a series of advances and will be used for working capital. As of March 31, 2011, there is $725,000 outstanding on the note which is included in short-term debt in the accompanying condensed consolidated balance sheets. Valiant Investments, LLC is controlled by Mr. Roy T. Oliver, one of the Company’s greater than 5% shareholders and affiliates. The promissory note is subordinate to the Company’s credit facility with Arvest Bank. Subsequent to March 31, 2011, the Valiant Note was fully-funded and in May 2011, the Valiant Note was converted to common stock in conjunction with a private placement stock offering (see Note 10 — Subsequent Events).
As of March 31, 2011, the Company had approximately $354,000 on deposit at Valliance Bank. Valliance Bank is controlled by Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates. In addition, the Company is obligated to Valliance Bank under certain sleep center capital notes totaling approximately $104,000 and $110,000 at March 31, 2011 and December 31, 2010, respectively. The interest rates on the notes are fixed and range from 4.25% to 8.75%. Non-controlling interests in Valliance Bank are held by Mr. Stanton Nelson, the Company’s chief executive officer and Mr. Joseph Harroz, Jr., a director of the Company. Mr. Nelson and Mr. Harroz also serve as directors of Valliance Bank.
The Company’s corporate headquarters and offices and the executive offices of SDC Holdings are occupied under a 60-month lease with Oklahoma Tower Realty Investors, LLC, requiring monthly rental payments of approximately $10,000. Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates, controls Oklahoma Tower Realty Investors, LLC (“Oklahoma Tower”). During the three months ended March 31, 2011 and 2010, the Company incurred approximately $30,000 in lease expense under the terms of the lease. Mr. Stanton Nelson, the Company’s chief executive officer, owns a non-controlling interest in Oklahoma Tower Realty Investors, LLC.
Note 10 — Subsequent Events
Management evaluated all activity of the Company and concluded that no subsequent events have occurred that would require recognition in the consolidated financial statements or disclosure in the notes to the consolidated financial statements, except the following:
On May 4, 2011, the Company executed subscription agreements with existing accredited investors or their affiliates to sell 5,172,411 shares of the Company’s common stock in a private placement. The proceeds of the private placement were approximately $3 million ($0.58 per share). The proceeds included $2 million in cash and $1 million from the conversion of the Valiant Note. In conjunction with the private placement, each investor received a warrant to purchase one share of common stock for each common share purchased pursuant to the subscription agreement. The warrants are exercisable for the purchase of one share of common stock for $0.45 beginning November 4, 2011 and on or before May 4, 2014.
On May 10, 2011, the Company executed an Asset Purchase Agreement (“Agreement”) with Daniel I. Rifkin, M.D., P.C. providing for the sale of substantially all of the assets of the Company’s subsidiary, Nocturna East, Inc. (“East”) for $2,500,000. In conjunction with the sale of East assets, the Management Services Agreement (“MSA”) under which the Company provides certain services to the sleep centers owned by Independent Medical Practices (“IMA”) including billing and collections, trademark rights, non-clinical sleep center management services, equipment rental fees, general management services, legal support and accounting and bookkeeping services will be terminated. The Company’s decision to sell the assets of East was primarily based on management’s determination that the operations of East no longer fit into the Company’s strategic plan of providing a full continuum of care to patients due to significant regulatory barriers that limit the Company’s ability to sell CPAP devices and other supplies at the East locations. Management’s decision to sell the East assets was also influenced by the Company’s current cash needs.
15
Table of Contents
The operating results of East for the three months ended March 31, 2011 and 2010 are summarized below:
2011 | 2010 | |||||||
Revenues | $ | 485,892 | $ | 585,609 | ||||
Income (loss), before taxes | $ | 63,706 | $ | 182,979 | ||||
The balance sheet items for East as of March 31, 2011 and December 31, 2010 are summarized below:
March 31, | December 31, | |||||||
2011 | 2010 | |||||||
Cash and cash equivalents | $ | 81,392 | $ | 239,141 | ||||
Accounts receivable, net of allowances | 527,198 | 294,423 | ||||||
Other current assets | 21,159 | 30,171 | ||||||
Total current assets | 629,749 | 563,735 | ||||||
Fixed assets, net | 271,665 | 227,667 | ||||||
Intangible assets, net | 1,085,685 | 1,087,000 | ||||||
Goodwill | 163,730 | 163,730 | ||||||
Total noncurrent assets | 1,521,080 | 1,478,397 | ||||||
Total assets | $ | 2,150,829 | $ | 2,042,133 | ||||
Payables and accrued liabilities | $ | 179,305 | $ | 125,325 | ||||
After the consummation of the Agreement, the historical financial information for East will be classified as discontinued operations in the Company’s consolidated financial statements.
16
Table of Contents
Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations. |
Overview
Graymark Healthcare, Inc. is organized under the laws of the State of Oklahoma and is one of the largest providers of care management solutions to the sleep disorder market based on number of independent sleep care centers and hospital sleep diagnostic programs operated in the United States. We provide a comprehensive diagnosis and care management solutions for patients suffering from sleep disorders.
We provide diagnostic sleep testing services and care management solutions, or SMS, for people with chronic sleep disorders. In addition, we provide therapy services (delivery and set up of CPAP equipment together with training related to the operation and maintenance of CPAP equipment) and the sale of related disposable supplies and components used to maintain the CPAP equipment. Our products and services are used primarily by patients with obstructive sleep apnea, or OSA. Our sleep centers provide monitored sleep diagnostic testing services to determine sleep disorders in the patients being tested. The majority of the sleep testing is to determine if a patient has OSA. A continuous positive airway pressure, or CPAP, device is the American Academy of Sleep Medicine’s, or AASM, preferred method of treatment for obstructive sleep apnea. Our sleep diagnostic facilities also determine the correct pressure settings for patient CPAP devices via titration testing. We sell CPAP devices and disposable supplies to patients who have tested positive for sleep apnea and have had their positive airway pressure determined.
As of March 31, 2011, we operated 98 sleep diagnostic and therapy centers in 11 states; 24 of which are located in our facilities with the remaining centers operated under management agreements. There are certain noncontrolling interest holders in some of our testing facilities, who are typically physicians in the geographical area being served by the diagnostic sleep testing facility.
Our sleep management solution is driven by our clinical approach to managing sleep disorders. Our clinical model is led by our staff of medical directors who are board-certified physicians in sleep medicine, who oversee the entire life cycle of a sleep disorder from initial referral through continuing care management. Our approach to managing the care of our patients diagnosed with OSA is a key differentiator for us. We believe our overall patient CPAP usage compliance rate, as articulated by the Medicare Standard of compliance requirements, is approximately 80%, compared to a national compliance rate of between 17 and 54%. Five key elements support our clinical approach:
• | Referral:Our medical directors, who are board-certified physicians in sleep medicine, have forged strong relationships with referral sources, which include primary care physicians, as well as physicians from a wide variety of other specialties and dentists. |
• | Diagnosis:We own and operate sleep testing clinics that diagnose the full range of sleep disorders including OSA, insomnia, narcolepsy and restless legs syndrome. |
• | CPAP Device Supply:We sell CPAP devices, which are used to treat OSA. |
• | Re-Supply:We offer a re-supply program for our patients and other CPAP users to obtain the required components for their CPAP devices that must be replaced on a regular basis. |
• | Care Management:We provide continuing care to our patients led by our medical directors who are board-certified physicians in sleep medicine and their staff. |
Our clinical approach increases the long-term compliance of our patients, and enables us to manage a patient’s sleep disorder care throughout the life cycle of the disorder, thereby allowing us to generate a long-term, recurring revenue stream. We generate revenues via three primary sources: providing the diagnostic tests and related studies for sleep disorders through our sleep diagnostic centers, the sale of CPAP devices, and the ongoing re-supply of components of the CPAP device that need to be replaced. In addition, as a part of our ongoing care management program, we monitor the patient’s sleep disorder and as the patient’s medical condition changes, we are paid for additional diagnostic tests and studies.
17
Table of Contents
In addition, we believe that our clinical approach to comprehensive patient care, provides higher quality of care and achieves higher patient compliance. We believe that higher compliance rates are directly correlated to higher revenue generation per patient compared to our competitors through increased utilization of our resupply or PRSP program and a greater likelihood of full reimbursement from federal payors and those commercial carriers who have adopted federal payor standards.
Private Placement Offering and Sale of Nocturna East, Inc.
On May 4, 2011, we executed subscription agreements with existing accredited investors or their affiliates to sell 5,172,411 shares of the Company’s common stock in a private placement. The proceeds of the private placement were approximately $3 million ($0.58 per share). The proceeds included $2 million in cash and $1 million from the conversion of the Valiant Note. In conjunction with the private placement, each investor received a warrant to purchase one share of common stock for each common share purchased pursuant to the subscription agreement. The warrants are exercisable for the purchase of one share of common stock for $0.45 beginning November 4, 2011 and on or before May 4, 2014.
On May 10, 2011, we executed an Asset Purchase Agreement (“Agreement”) with Daniel I. Rifkin, M.D., P.C. providing for the sale of substantially all of the assets of our subsidiary, Nocturna East, Inc. (“East”) for $2,500,000. In conjunction with the sale of East assets, the Management Services Agreement (“MSA”) under which the Company provides certain services to the sleep centers owned by Independent Medical Practices (“IMA”) including billing and collections, trademark rights, non-clinical sleep center management services, equipment rental fees, general management services, legal support and accounting and bookkeeping services will be terminated. Our decision to sell the assets of East was primarily based on our determination that the operations of East no longer fit into our strategic plan of providing a full continuum of care to patients due to significant regulatory barriers that limit our ability to sell CPAP devices and other supplies at the East locations. Our decision to sell the East assets was also influenced by our current cash needs.
Going Concern
As of March 31, 2011, we had an accumulated deficit of approximately $31.1 million and reported a net loss of approximately $1.8 for the three months then ending. We used approximately $1.9 million in cash to fund our operating activities from continuing operations during the three months ending March 31, 2011. Furthermore, we have a working capital deficit of approximately $22.3 million as of March 31, 2011. We are required to make a $3 million principal payment to Arvest Bank by June 30, 2011 and we are currently not in compliance with certain covenants required by our lending agreement with Arvest Bank. We made the $3 million principal payment to Arvest Bank on May 12, 2011 from the cash proceeds of the private placement offering and the sale of Nocturna East, Inc. which totaled approximately $4.5 million.
In the event that we are unable to obtain additional debt or equity financing or we are unable to obtain such financing on terms and conditions acceptable to us, we may have to cease or severely curtail our operations. This uncertainty raises substantial doubt regarding our ability to continue as a going concern. Historically, we have been able to raise the capital necessary to fund our operations and growth. Our consolidated financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.
Discontinued Operations
On September 1, 2010, we executed an Asset Purchase Agreement, which was subsequently amended on October 29, 2010, (as amended, the “Agreement”) providing for the sale of substantially all of the assets of the Company’s subsidiary, ApothecaryRx to Walgreens. ApothecaryRx operated 18 retail pharmacies selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. The final closing of the sale of ApothecaryRx’s assets occurred in December 2010. As a result of the sale of ApothecaryRx’s assets, the remaining assets, and liabilities, results of operations and cash flows of ApothecaryRx have been classified as discontinued operations for financial statement reporting purposes.
18
Table of Contents
Under the Agreement, the consideration for the ApothecaryRx assets purchased and liabilities assumed is $25,500,000 plus up to $7,000,000 for inventory (“Inventory Amount”), but less any payments remaining under goodwill protection agreements and any amounts due under promissory notes which are assumed by buyer (the “Purchase Price”). For purposes of determining the Inventory Amount, the parties agreed to hire an independent valuator to perform a review and valuation of inventory being purchased from each pharmacy location. We received approximately $24.5 million in net proceeds from the sale of assets of which $2.0 million was deposited into an indemnity escrow account (the “Indemnity Escrow Fund”) as previously agreed pursuant to the terms of an indemnity escrow agreement. These proceeds are net of approximately $1.0 million of security deposits transferred to the buyer and the assumption by the buyer of liabilities associated with goodwill protection agreements and promissory notes. We also received an additional $3.8 million for the sale of inventory to Buyer at 17 of our pharmacies with the inventory for the remaining pharmacy being sold as part of the litigation settlement. We used $22.0 million of the proceeds to pay-down our senior credit facility.
Generally, in December 2011 (the 12-month anniversary of the final closing date of the sale of ApothecaryRx), 50% of the remaining funds held in the Indemnity Escrow Fund will be released, subject to deduction for any pending claims for indemnification. All remaining funds held in the Indemnity Escrow Fund will be released in May 2012 (the 18-month anniversary of the final closing date of the sale), subject to any pending claims for indemnification. Of the $2,000,000 Indemnity Escrow Fund, $1,000,000 is subject to partial or full recovery by the buyer if the average daily prescription sales, at the buyer’s location in Sterling, Colorado over the six-month period after the purchase does not maintain a certain level of the average daily prescription sales (the “Retention Rate Earnout”).
Results of Operations
The following table sets forth selected results of our operations for the three months ended March 31, 2011 and 2010. The following information was derived and taken from our unaudited financial statements appearing elsewhere in this report.
Comparison of the Three Month Periods Ended March 31, 2011 and 2010
For the Three Months Ended | ||||||||
March 31, | ||||||||
2011 | 2010 | |||||||
Net Revenues: | ||||||||
Services | $ | 3,443,496 | $ | 4,672,985 | ||||
Product sales | 1,246,377 | 1,239,050 | ||||||
4,689,873 | 5,912,035 | |||||||
Cost of services | 1,222,944 | 1,452,600 | ||||||
Cost of sales | 408,696 | 400,335 | ||||||
Selling, general and administrative | 3,992,736 | 4,892,600 | ||||||
Bad debt expense | 117,847 | 238,899 | ||||||
Depreciation and amortization | 294,628 | 344,399 | ||||||
Net other expense | 349,711 | 284,231 | ||||||
Loss from continuing operations, before taxes | (1,696,689 | ) | (1,701,029 | ) | ||||
Provision for income taxes | (9,603 | ) | (47,986 | ) | ||||
Loss from continuing operations, net of taxes | (1,706,292 | ) | (1,749,015 | ) | ||||
Discontinued operations, net of taxes | (214,678 | ) | 283,267 | |||||
Net loss | (1,920,970 | ) | (1,465,748 | ) | ||||
Less: Noncontrolling interests | (84,704 | ) | (40,799 | ) | ||||
Net loss attributable to Graymark Healthcare | $ | (1,836,266 | ) | $ | (1,424,949 | ) | ||
19
Table of Contents
Discussion of Three Month Periods Ended March 31, 2011 and 2010
Services revenuesdecreased $1.2 million (a 26.3% decrease) during the three months ended March 31, 2011 compared with the first quarter of 2010. The decline in revenues from sleep diagnostic services at existing locations compared to the first quarter of 2010 was comprised of:
• | $0.5 million due to lower volumes; | ||
• | $0.5 million due to lower average revenue per sleep study performed; |
• | $0.1 million related to a reduction in the monthly management fee related to our Management Services Agreement (MSA); and |
• | $0.1 million due to lower revenues in our clinic operations. |
We typically see lower volumes early in the first quarter as insurance plans roll to a new calendar year resulting in coverage changes and the resetting of annual deductable minimums. During the first quarter of 2011, this seasonal decline was accentuated by a series of severe weather events at our locations in Kansas, Iowa, South Dakota, Oklahoma and Texas in January and February of 2011. As a result of the severe weather, several of our labs were forced to close on multiple days during those months, contributing to reduced volumes in the first quarter.
Product revenuesfrom our sleep therapy business were flat as increased volumes were offset by lower average reimbursement for both CPAP set-ups and resupply sales.
During the first quarter of 2011 we focused on driving referral volume in our sleep diagnostic centers by making several key management changes in our sales team and implementing new sales incentive initiatives. These changes and initiatives produced significantly higher sleep study volumes in March 2011 and we expect that trend to continue in the second quarter of 2011.
Cost of servicesdecreased $0.2 million (a 15.8% decrease) during the three months ended March 31, 2011 compared with the first quarter of 2010. The decrease in cost of services was primarily due to decreased sleep study volumes and operational efficiencies including a decrease in technician labor cost per sleep study performed and the renegotiation and resulting reduction of professional interpretation fees.
Cost of services as a percent of net revenues was 35.5% and 31.1% during the three months ended March 31, 2011 and 2010, respectively. The increase in cost of services as a percent of net revenues was primarily due to lower average reimbursement related to our sleep diagnostic services which was partially offset by operational efficiencies.
Cost of salesfrom our sleep therapy business was flat as increased volumes were offset by lower average reimbursement for both CPAP set-ups and resupply sales.
Cost of sales as a percent of net revenues was 32.8% and 32.3% during the three months ended March 31, 2011 and 2010, respectively. The slight increase in cost of sales as a percent of net revenues was primarily due to lower average reimbursement which was offset by a reduction of our product costs.
Selling, general and administrativeexpenses decreased $0.9 million (an 18.4% decrease) during the three months ended March 31, 2011, compared with the first quarter of 2010. The decrease in selling, general and administrative expenses was primarily due to:
• | a decrease in operating expenses in our sleep diagnostic business of $0.7 million compared to the first quarter of 2010 primarily due to the implementation of several cost reduction initiatives including staff reductions, renegotiating of facility leases and consolidation of non-profitable facilities during the last three quarters of 2010 and the first quarter of 2011. |
• | an increase in operating expense in our sleep therapy business of $0.3 million as we expanded our infrastructure in order to gain operating efficiencies and prepare for continued growth in this business unit; and |
• | a decrease in overhead incurred at the parent-company level due to decreased stock option expense of $0.3 million and $0.2 million related to reductions in executive labor expenses due to staff reductions. |
20
Table of Contents
Depreciation and amortizationrepresents the depreciation expense associated with our fixed assets and the amortization attributable to our intangible assets. Depreciation and amortization was consistent between the first quarter of 2011 and 2010.
Bad debt expensedecreased $0.1 million during the three months ended March 31, 2011, compared with the first quarter of 2010.The decrease is primarily due to onetime adjustments in the first quarter of 2010 related to the Somni acquisition.
Net other expenserepresents interest expense on borrowings reduced by interest income earned on cash and cash equivalents. Net other expense decreased approximately $0.1 million during the three months ended March 31, 2011 compared with the first quarter of 2010. The decrease is due to payment of our senior debt at Arvest bank of $22 million in the fourth quarter of 2010 related to the sale of substantially all the assets of ApothecaryRx.
Income from discontinued operationsrepresents the net income (loss) from the pharmacy operations of ApothecaryRx. In September 2010, we entered into an agreement to sell substantially all of the assets of ApothecaryRx. The closing of the sale of ApothecaryRx occurred in December 2010. As a result of the sale of ApothecaryRx, the related assets, liabilities, results of operations and cash flows of ApothecaryRx have been classified as discontinued operations. In addition, we have discontinued operations related to our discontinued internet sales division and discontinued film operations. The results of ApothecaryRx and our other discontinued operations for the three months ended March 31, 2011 and 2010 follows:
2011 | 2010 | |||||||
Revenues | $ | — | $ | 21,693,439 | ||||
Income (loss) before taxes — ApothecaryRx | $ | (206,966 | ) | $ | 285,157 | |||
Income (loss) before taxes — other | (7,712 | ) | (1,890 | ) | ||||
Income tax (provision) | — | — | ||||||
Income (loss) from discontinued operations | $ | (214,678 | ) | $ | 283,267 | |||
The net loss from discontinued operations during the three months ended March 31, 2011 is primarily comprised of tax, accounting and other professional fees, wind-down expenses related to the remaining ApothecaryRx operations, an allowance for potential sales tax liability related to an open sales tax audit and an allowance for revenue recapture related to various third party payor audits.
Noncontrolling interestswere allocated approximately $84,000 of net loss during the three months ended March 31, 2011 compared with the first quarter of 2010 when noncontrolling interests were allocated approximately $41,000 in net income. Noncontrolling interests are the equity ownership interests in our SDC Holdings subsidiaries that are not wholly-owned.
Net income (loss) attributable to Graymark Healthcare.Our operations resulted in a net loss of approximately $1.8 million (39% of approximately $4.7 million in net revenues) during the first quarter of 2011, compared to a net loss of approximately $1.4 million (24% of approximately $5.9 million in net revenues) during the first quarter of 2010.
Liquidity and Capital Resources
Generally our liquidity and capital resources needs are funded from operations, loan proceeds and equity offerings. As of March 31, 2011 our liquidity and capital resources included cash and cash equivalents of $0.6 million, a working capital deficit of $22.3 million and $0.3 million available under our credit facility with Valiant Investments, LLC. As of December 31, 2010, our liquidity and capital resources included cash and cash equivalents of $1.6 million and a working capital deficit of $20.5 million.
21
Table of Contents
Cash used in operating activities from continuing operations was $1.9 million during the three months ended March 31, 2011 compared to $0.7 million during the first quarter of 2010. During the three months ended March 31, 2011 the primary uses of cash from operating activities from continuing operations were cash required to fund net losses from continuing operations of $1.3 million, a net reduction of accounts payable and accrued liabilities of $0.4 million, and an increase of accounts receivable of $0.2 million. During the three months ended March 31, 2010, the primary uses of cash from operating activities from continuing operations were cash required to fund net losses from continuing operations of $0.9 million, increase in accounts receivable of $0.1 million, increase in other assets of $0.1 million. The primary sources of cash from operating activities from continuing operations during the first quarter of 2010 was a net increase in accounts payable and accrued liabilities of $0.3 million.
Cash provided by discontinued operations for the three months ended March 31, 2011 was $0.3 million compared to $1.2 million for the first quarter of 2010.
Net cash used in investing activities from continuing operations during the three months ended March 31, 2011 was approximately $49,000 compared to approximately $58,000 for the first quarter of 2010.
Net cash used in investing activities from discontinued operations during the three months ended March 31, 2010 was approximately $29,000.
Net cash provided by financing activities from continuing operations during the three months ended March 31, 2011 was $0.6 million compared to net cash used in financing activities of $0.2 million during the first quarter of 2010. During the three months ended March 31, 2011, the primary source of cash from financing activities from continuing operations were proceeds from our credit facility with Valiant Investments, LLC of $0.7 million and the primary use of cash were debt payments totaling $0.1 million. During the three months ended March 31, 2010, the primary use of cash from financing activities from continuing operations was debt payments totaling $0.2 million.
On September 1, 2010, we executed an Asset Purchase Agreement, which was subsequently amended on October 29, 2010, (as amended, the “Agreement”) providing for the sale of substantially all of the assets of the Company’s subsidiary, ApothecaryRx to Walgreens. ApothecaryRx operated 18 retail pharmacy stores selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. The final closing of the sale of ApothecaryRx’s assets occurred in December 2010. As a result of the sale of ApothecaryRx’s assets, the related assets, liabilities, results of operations and cash flows of ApothecaryRx have been classified as discontinued operations.
Under the Agreement, the consideration for the ApothecaryRx assets purchased and liabilities assumed is $25,500,000 plus up to $7,000,000 for inventory (“Inventory Amount”), but less any payments remaining under goodwill protection agreements and any amounts due under promissory which are assumed by buyer (the “Purchase Price”). For purposes of determining the Inventory Amount, the parties agreed to hire an independent valuator to perform a review and valuation of inventory being purchased from each pharmacy location. We received approximately $24.5 million in net proceeds from the sale of assets of which $2.0 million was deposited into an indemnity escrow account (the “Indemnity Escrow Fund”) as previously agreed pursuant to the terms of an indemnity escrow agreement. These proceeds are net of approximately $1.0 million of security deposits transferred to the buyer and the assumption by the buyer of liabilities associated with goodwill protection agreements and promissory notes. We also received an additional $3.8 million for the sale of inventory to Buyer at 17 of our pharmacies with the inventory for the remaining pharmacy being sold as part of the litigation settlement. Of the proceeds, $22 million was used to reduce outstanding obligations under our credit facility with Arvest Bank. We are required to pay Arvest Bank an additional $3.0 million by June 30, 2011. We are currently in discussions with Arvest Bank regarding this payment and our compliance with required financial covenants.
22
Table of Contents
On the 12-month anniversary of the final closing date of the sale of ApothecaryRx, 50% of the funds held in the Indemnity Escrow Fund (currently $1.0 million) will be released, subject to deduction for any pending claims for indemnification. All remaining funds held in the Indemnity Escrow Fund, if any, will be released on the 18- month anniversary of the final closing date of the sale, subject to any pending claims for indemnification. Of the $2,000,000 Indemnity Escrow Fund, $1,000,000 is subject to partial or full recovery by the buyer if the average daily prescription sales at the buyer’s location in Sterling, Colorado over a six-month period after the purchase does not maintain percentage certain level of average daily prescription sales (the “Retention Rate Earnout”).
As of March 31, 2011, we had an accumulated deficit of approximately $31.1 million and reported a net loss of approximately $1.8 for the three months then ending. We used approximately $1.9 million in cash from operating activities of continuing operations during the three months ending March 31, 2011. Furthermore, we have a working capital deficit of approximately $22.3 million as of March 31, 2011. We are required to make a $3 million principal payment to Arvest Bank by June 30, 2011 and we are currently not in compliance with certain covenants required by our lending agreement with Arvest Bank. We made the $3 million principal payment to Arvest Bank on May 12, 2011 from the cash proceeds of the private placement offering and the sale of Nocturna East, Inc. assets which totaled approximately $4.5 million. The excess proceeds from the private placement offering and sale of Nocturna East, Inc. assets will be used to fund our working capital needs. In addition, by June 30, 2011, we may prepay Arvest Bank approximately $1.1 million, which represents all principal and interest payments due to Arvest Bank between July 1, 2011 and December 31, 2011. If we make the prepayment, Arvest Bank will waive our Debt Service Coverage Ratio and Minimum Net Worth requirements through December 31, 2011.
Arvest Credit Facility
Effective May 21, 2008, we and each of Oliver Company Holdings, LLC, Roy T. Oliver, The Roy T. Oliver Revocable Trust, Stanton M. Nelson, Vahid Salalati, Greg Luster, Kevin Lewis, Roger Ely and, Lewis P. Zeidner (the “Guarantors”) entered into a Loan Agreement with Arvest Bank (the “Arvest Credit Facility”). The Arvest Credit Facility consolidated the prior loan to our subsidiaries, SDC Holdings and ApothecaryRx in the principal amount of $30 million (referred to as the “Term Loan”) and provided an additional credit facility in the principal amount of $15 million (the “Acquisition Line”) for total principal of $45 million. The Loan Agreement was subsequently amended in January 2009 (the “Amendment”), May 2009, July 2010 and December 2010. As of December 31, 2010, the outstanding principal amount of the Arvest Credit Facility was $22,396,935. See “Loan Agreement” below for a description of a recent consent granted by Arvest in March 2011.
Personal Guaranties.The Guarantors unconditionally guarantee payment of our obligations owed to Arvest Bank and our performance under the Loan Agreement and related documents. The initial liability of the Guarantors as a group is limited to $15 million of the last portion or dollars of our obligations collected by Arvest Bank. The liability of the Guarantors under the guaranties initially was in proportion to their ownership of our common stock shares as a group on a several and not joint basis. In conjunction with the employment termination of Mr. Luster, we agreed to obtain release of his guaranty. The Amendment released Mr. Luster from his personal guaranty and the personal guaranties of the other Guarantors were increased, other than the guaranties of Messrs. Salalati and Ely. During the third quarter of 2010, Mr. Oliver and Mr. Nelson assumed the personal guaranty of Mr. Salalati.
Furthermore, the Guarantors agreed to not sell, transfer or otherwise dispose of or create, assume or suffer to exist any pledge, lien, security interest, charge or encumbrance on our common stock shares owned by them that exceeds, in one or an aggregate of transactions, 20% of the respective common stock shares owned at May 21, 2008, except after notice to Arvest Bank. Also, the Guarantors agreed to not sell, transfer or permit to be transferred voluntarily or by operation of law assets owned by the applicable Guarantor that would materially impair the financial worth of the Guarantor or Arvest Bank’s ability to collect the full amount of our obligations.
23
Table of Contents
Maturity Dates.Each advance or tranche of the Acquisition Line will become due on the sixth anniversary of the first day of the month following the date of advance or tranche (the “Tranche Note Maturity Date”). The Term Loan will become due on May 21, 2014. The following table outlines the contractual due dates of each tranche of debt under the Acquisition Line:
Tranche | Amount | Maturity Date | ||||||
#1 | $ | 1,054,831 | 6/1/2014 | |||||
#2 | 5,217,241 | 7/1/2014 | ||||||
#3 | 1,536,600 | 7/1/2014 | ||||||
#4 | 1,490,739 | 7/1/2014 | ||||||
#5 | 177,353 | 12/1/2014 | ||||||
#6 | 4,920,171 | 8/1/2015 | ||||||
Total | $ | 14,396,935 | ||||||
Interest Rate.The outstanding principal amounts of Acquisition Line and Term Loan bear interest at the greater of the prime rate as reported in the “Money Rates” section ofThe Wall Street Journal(the “WSJ Prime Rate”) or 6% (“Floor Rate”). Prior to June 30, 2010, the Floor Rate was 5%. The WSJ Prime Rate is adjusted annually, subject to the Floor Rate, then in effect on May 21 of each year of the Term Loan and the anniversary date of each advance or tranche of the Acquisition Line. In the event of our default under the terms of the Arvest Credit Facility, the outstanding principal will bear interest at the per annum rate equal to the greater of 15% or the WSJ Prime Rate plus 5%.
Interest and Principal Payments.Provided we are not in default, the Term Note is payable in quarterly payments of accrued and unpaid interest on each September 1, December 1, March 1, and June 1. Commencing on September 1, 2011, and quarterly thereafter on each December 1, March 1, June 1 and September 1, we are obligated to make equal payments of principal and interest calculated on a seven-year amortization of the unpaid principal balance of the Term Note as of June 1, 2011 at the then current WSJ Prime Rate or Floor Rate, and adjusted annually thereafter for any changes to the WSJ Prime Rate or Floor Rate as provided herein. The entire unpaid principal balance of the Term Note plus all accrued and unpaid interest thereon will be due and payable on May 21, 2014.
Furthermore, each advance or tranche of the Acquisition Line is repaid in quarterly payments of interest only for up to three years and thereafter, principal and interest payments based on a seven-year amortization until the balloon payment on the Tranche Note Maturity Date. We agreed to pay accrued and unpaid interest only at the WSJ Prime Rate or Floor Rate in quarterly payments on each advance or tranche of the Acquisition Line for the first three years of the term of the advance or tranche commencing three months after the first day of the month following the date of advance and on the first day of each third month thereafter. Commencing on the third anniversary of the first quarterly payment date, and each following anniversary thereof, the principal balance outstanding on an advance or tranche of the Acquisition Line, together with interest at the WSJ Prime Rate or Floor Rate on the most recent anniversary date of the date of advance, will be amortized in quarterly payments over a seven-year term beginning on the third anniversary of the date of advance, and recalculated each anniversary thereafter over the remaining portion of such seven-year period at the then applicable WSJ Prime Rate or Floor Rate. The entire unpaid principal balance of the Acquisition Line plus all accrued and unpaid interest thereon will be due and payable on the respective Tranche Note Maturity Date.
Use of Proceeds.All proceeds of the Term Loan were used solely for the funding of the acquisition and refinancing of the existing indebtedness and loans owed to Intrust Bank, the refinancing of the existing indebtedness owed to Arvest Bank; and other costs we incurred by Arvest Bank in connection with the preparation of the loan documents, subject to approval by Arvest Bank.
The proceeds of the Acquisition Line were to be used solely for the funding of up to 70% of either the purchase price of the acquisition of existing pharmacy business assets or sleep testing facilities or the startup costs of new sleep centers and other costs incurred by us or Arvest Bank in connection with the preparation of the Loan Agreement and related documents, subject to approval by Arvest Bank.
Collateral.Payment and performance of our obligations under the Arvest Credit Facility are secured by the personal guaranties of the Guarantors and in general our assets. If the Company sells any assets which are collateral for the Arvest Credit Facility, then subject to certain exceptions and without the consent of Arvest Bank, such sale proceeds must be used to reduce the amounts outstanding to Arvest Bank.
24
Table of Contents
Debt Service Coverage Ratio.Based on the latest four rolling quarters, we agreed to continuously maintain a “Debt Service Coverage Ratio” of not less than 1.25 to 1. Debt Service Coverage Ratio is, for any period, the ratio of:
• | the net income of Graymark Healthcare (i) increased (to the extent deducted in determining net income) by the sum, without duplication, of our interest expense, amortization, depreciation, and non-recurring expenses as approved by Arvest, and (ii) decreased (to the extent included in determining net income and without duplication) by the amount of minority interest share of net income and distributions to minority interests for taxes, if any, to |
• | the annual debt service including interest expense and current maturities of indebtedness as determined in accordance with generally accepted accounting principles. |
If we acquire another company or its business, the net income of the acquired company and the new debt service associated with acquiring the company may both be excluded from the Debt Service Coverage Ratio, at our option.
Compliance with Financial Covenants.As of March 31, 2011, our Debt Service Coverage Ratio is less than 1.25 to 1 and we do not meet the Minimum Net Worth requirement. Arvest Bank has waived the Debt Service Coverage Ratio and Minimum Net Worth requirements through June 30, 2011 assuming we make a $3 million principal payment by June 30, 2011. We made the $3 million principal payment on May 12, 2011 from the $4.5 million in total cash proceeds from the private placement offering of common stock and sale of Nocturna East, Inc. assets which were both completed in May 2011. If by June 30, 2011, we prepay Arvest Bank approximately $1.1 million, which represents all principal and interest payments due to Arvest Bank between July 1, 2011 and December 31, 2011, Arvest Bank will waive the Debt Service Coverage Ratio and Minimum Net Worth requirements through December 31, 2011. There is no assurance that Arvest Bank will waive Debt Service Coverage Ratio and Minimum Net Worth requirements beyond June 30, 2011 or December 31, 2011. Due to the non-compliance of these waivers and the associated contingent nature of achieving compliance before June 30, 2011, the associated debt has been classified as current on our consolidated balance sheet.
Default and Remedies.In addition to the general defaults of failure to perform our obligations and those of the Guarantors, collateral casualties, misrepresentation, bankruptcy, entry of a judgment of $50,000 or more, failure of first liens on collateral, default also includes our delisting by The Nasdaq Stock Market, Inc. In the event a default is not cured within 10 days or in some case five days following notice of the default by Arvest Bank (and in the case of failure to perform a payment obligation for three times with notice), Arvest Bank will have the right to declare the outstanding principal and accrued and unpaid interest immediately due and payable.
Deposit Account Control Agreement.Effective June 30, 2010, we entered into a Deposit Control Agreement (“Deposit Agreement”) with Arvest Bank and Valliance Bank covering the deposit accounts that we have at Valliance Bank. The Deposit Agreement requires Valliance Bank to comply with instructions originated by Arvest Bank directing the disposition of the funds held by us at Valliance Bank without our further consent. Without Arvest Bank’s consent, we cannot close any of our deposit accounts at Valliance Bank or open any additional accounts at Valliance Bank. Arvest Bank may exercise its rights to give instructions to Valliance Bank under the Deposit Agreement only in the event of an uncured default under the Loan Agreement, as amended.
Loan Agreement
On March 16, 2011, we entered into a Loan Agreement with Valiant Investments, LLC, an entity owned and controlled by Roy T. Oliver one of our controlling shareholders, of up to $1 million. We intend to use the loan to fund our working capital needs. The loan will be disbursed in amounts requested by the Company subject to the lender’s consent and compliance with other conditions contained in the Loan Agreement. The loan matures on August 1, 2011. Interest accrues at a rate of 6% and default interest accrues at a rate of 15%. We are also required to pay 1% of each advance on the loan as a loan fee. This loan is unsecured and subordinated to our Arvest Bank facility. The Loan Agreement also contains restrictions on our ability to take action without the consent of the lender, these include: (i) acquisitions of other businesses, (ii) the sale of all or substantially all of our assets, (iii) the issuance of common stock or convertible securities unless the proceeds are to be used to repay the loan in full.
25
Table of Contents
On March 11, 2011, we received the consent of Arvest to obtain this loan and requirements for payments of interest and principal on this loan and Arvest will waive the debt service coverage ratio and minimum net worth covenants through December 31, 2011 on the following conditions:
• | On or before June 30, 2011, Graymark will pay to Arvest the greater of $3 million or one-third of the proceeds of any public equity offering (we made a $3 million payment to Arvest on May 12, 2011); |
• | On or before June 30, 2011, Graymark will pay Arvest a fee equal to 0.25% of the outstanding loan balance as of June 30, 2011; |
• | If Graymark is not in compliance with the debt service coverage ratio and minimum net worth covenants on December 31, 2011, Graymark will pay Arvest a fee equal to 0.50% of the then outstanding balance of the loan (which does not cure any default in such covenants); |
• | On June 30, 2011, Graymark will prepay all interest and principal payments due to Arvest between July 1, 2011 and December 31, 2011; |
• | On June 30, 2011, if Graymark has received at least $15 million in proceeds from a public equity offering then Graymark will escrow with Arvest all principal and interest payments due to Arvest between January 1, 2012 and June 30, 2012; |
• | Graymark may not repay any amounts on the $1 million loan from Valiant Investments before August 1, 2011 except that Graymark may repay such loan in full if Graymark has received more than $10 million in proceeds from a public equity offering and if Graymark has received less than $10 million from a public equity offering then Graymark will be permitted to make interest payments only on such loan; and |
• | The $1 million Valiant Investments loan is subordinated to Arvest’s credit facility in all respects. |
Financial Commitments
Our future commitments under contractual obligations by expected maturity date at March 31, 2011 are as follows:
< 1 year | 1-3 years | 3-5 years | > 5 years | Total | ||||||||||||||||
Short-term debt | $ | 734,683 | $ | — | $ | — | $ | — | $ | 734,683 | ||||||||||
Long-term debt (1) | 23,863,772 | 369,789 | 18,771 | — | 24,252,332 | |||||||||||||||
Operating leases | 1,241,424 | 2,019,384 | 993,689 | 2,324,102 | 6,578,599 | |||||||||||||||
Operating leases, discontinued operations | 270,911 | 380,508 | 41,572 | — | 692,991 | |||||||||||||||
$ | 26,110,790 | $ | 2,769,681 | $ | 1,054,032 | $ | 2,324,102 | $ | 32,258,605 | |||||||||||
(1) | Includes principal and interest obligations. |
Our uses of cash for the next twelve months will be principally for working capital needs and debt service as we do not have any material capital expenditures planned, however, we do have contractual commitments of approximately $26.1 million for payments on our indebtedness and for operating lease payments. Included in this amount is $23.5 million related to the classification of our Arvest credit facility as current for financial statement purposes. We anticipate funding our business activities for the next twelve months from the proceeds of the sale of Nocturna East, Inc ($2.5 million), the cash proceeds of the private placement offering ($2.0 million) and the funds available under our credit facility with Valiant Investments, LLC ($0.3 million). In addition, we expect t to raise approximately $13.3 million in a public stock offering during 2011.
In the event that we are unable to obtain additional debt or equity financing or we are unable to obtain such financing on terms and conditions acceptable to us, we may have to cease or severely curtail our operations. This uncertainty raises substantial doubt regarding our ability to continue as a going concern. Historically, we have been able to raise the capital necessary to fund our operations and growth. Our consolidated financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.
26
Table of Contents
CRITICAL ACCOUNTING POLICIES
The consolidated condensed financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and include amounts based on management’s prudent judgments and estimates. Actual results may differ from these estimates. Management believes that any reasonable deviation from those judgments and estimates would not have a material impact on our consolidated financial position or results of operations. To the extent that the estimates used differ from actual results, however, adjustments to the statement of earnings and corresponding balance sheet accounts would be necessary. These adjustments would be made in future statements. For a complete discussion of all our significant accounting policies please see our 2010 annual report on Form 10-K. Some of the more significant estimates include revenue recognition, allowance for contractual adjustments and doubtful accounts, and goodwill and intangible asset impairment. We use the following methods to determine our estimates:
Revenue recognition —Sleep center services and product sales are recognized in the period in which services and related products are provided to customers and are recorded at net realizable amounts estimated to be paid by customers and third-party payers. Insurance benefits are assigned to us and, accordingly, we bill on behalf of our customers. For our sleep diagnostic business, we estimate the net realizable amount based primarily on the contracted rates stated in the contracts we have with various payors. We have used this method to determine the net revenue for the business acquired from somniCare, Inc. and somniTech, Inc. (“Somni”) business since the date of the acquisition in 2009 and for our remaining sleep diagnostic business since the fourth quarter of 2010. We do not anticipate any future changes to this process. In our historic sleep therapy business, the business has been predominantly out-of-network and as a result, we have not had contract rates to use for determining net revenue for a majority of our payors. For this portion of the business, we perform a quarterly analysis of actual reimbursement from each third party payor for the most recent 12-months. In the analysis, we calculate the percentage actually paid by each third party payor of the amount billed to determine the applicable amount of net revenue for each payor. The key assumption in this process is that actual reimbursement history is a reasonable predictor of the future reimbursement for each payor at each facility. During the fourth quarter of 2010, we migrated much of our historic sleep diagnostic business to an in-network position. As a result, commencing with the fourth quarter of 2010, the revenue from our historic sleep diagnostic business was determined using the process utilized in the Somni business. We expect to transition our historic sleep therapy business to the same process currently used for our sleep diagnostic business by the end of 2011. This change in process and assumptions for our historic sleep therapy business is not expected to have a material impact on future operating results.
For certain sleep therapy and other equipment sales, reimbursement from third-party payers occur over a period of time, typically 10 to 13 months. We recognize revenue on these sales as payments are earned over the payment period stipulated by the third-party payor.
We have established an allowance to account for contractual adjustments that result from differences between the amount billed and the expected realizable amount. Actual adjustments that result from differences between the payment amount received and the expected realizable amount are recorded against the allowance for contractual adjustments and are typically identified and ultimately recorded at the point of cash application or when otherwise determined pursuant to our collection procedures. Revenues are reported net of such adjustments.
Due to the nature of the healthcare industry and the reimbursement environment in which we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time products or services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on our operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payers may result in adjustments to amounts originally recorded.
The patient and their third party insurance provider typically share in the payment for our products and services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the number of out-of-network patients, we are not certain of the full amount of patient responsibility at the time of service. Starting in 2010, we implemented a process to estimate amounts due from patients prior to service and increase collection of those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.
27
Table of Contents
Cost of Services and Sales— Cost of services includes technician labor required to perform sleep diagnostics, fees associated with interpreting the results of the sleep study and disposable supplies used in providing sleep diagnostics. Cost of sales includes the acquisition cost of sleep therapy products sold. Costs of services are recorded in the time period the related service is provided. Cost of sales is recorded in the same time period that the related revenue is recognized. If the sale is paid for over a specified period, the product cost associated with that sale is recognized over that same period. If the product is paid for in one period, the cost of sale is recorded in the period the product was sold.
Accounts Receivable— Accounts receivable are reported net of allowances for contractual adjustments and doubtful accounts. The majority of our accounts receivable is due from private insurance carriers, Medicare and Medicaid and other third-party payors, as well as from customers under co-insurance and deductible provisions.
Third-party reimbursement is a complicated process that involves submission of claims to multiple payers, each having its own claims requirements. Adding to this complexity, a significant portion of our business has historically been out-of-network with several payors, which means we do not have defined contracted reimbursement rates with these payors. For this reason, our systems reported revenue at a higher gross billed amount, which we adjusted to an expected net amount based on historic payments. This process continues in our historic sleep therapy business, but was changed in the fourth quarter of 2010 for our historic sleep diagnostic business. As a result, the reserve for contractual allowance has been reduced as our systems now report a larger portion of our business at estimated net contract rates. As we continue to move more of our business to in-network contracting, the level of reserve related to contractual allowances is expected to decrease. In some cases, the ultimate collection of accounts receivable subsequent to the service dates may not be known for several months. As these accounts age, the risk of collection increases and the resulting reserves for bad debt expense reflect this longer payment cycle. We have established an allowance to account for contractual adjustments that result from differences between the amounts billed to customers and third-party payers and the expected realizable amounts. The percentage and amounts used to record the allowance for doubtful accounts are supported by various methods including current and historical cash collections, contractual adjustments, and aging of accounts receivable.
We offer payment plans to patients for amounts due from them for the sales and services we provide. For patients with a balance of $500 or less, we allow a maximum of six months for the patient to pay the amount due. For patients with a balance over $500, we allow a maximum of 12 months to pay the full amount due. The minimum monthly payment amount for both plans is $50 per month.
Accounts are written-off as bad debt using a specific identification method. For amounts due from patients, we utilize a collections process that includes distributing monthly account statements. For patients that are not on a payment plan, collection efforts including collection letters and collection calls begin at 90 days from the initial statement. If the patient is on a payment program, these efforts begin 30 days after the patient fails to make a planned payment. For our diagnostic patients, we submit patient receivables to an outside collection agency if the patient has failed to pay 120 days following service or, if the patient is on a payment plan, they have failed to make two consecutive payments. For our therapy patients, patient receivables are submitted to an outside collection agency if payment has not been received between 180 and 270 days following service depending on the service provided and circumstances of the receivable or, if the patient is on a payment plan, they have failed to make two consecutive payments. It is our policy to write-off as bad debt all patient receivables at the time they are submitted to an outside collection agency. If funds are recovered by our collection agency, the amounts previously written-off are reversed as a recovery of bad debt. For amounts due from third party payors, it is our policy to write-off an account receivable to bad debt based on the specific circumstances related to that claim resulting in a determination that there is no further recourse for collection of a denied claim from the denying payor.
Included in accounts receivable are earned but unbilled receivables. Unbilled accounts receivable represent charges for services delivered to customers for which invoices have not yet been generated by the billing system. Prior to the delivery of services or equipment and supplies to customers, we perform certain certification and approval procedures to ensure collection is reasonably assured and that unbilled accounts receivable is recorded at net amounts expected to be paid by customers and third-party payers. Billing delays, ranging from several weeks to several months, can occur due to delays in obtaining certain required payer-specific documentation from internal and external sources, interim transactions occurring between cycle billing dates established for each customer within the billing system and new sleep centers awaiting assignment of new provider enrollment identification numbers. In the event that a third-party payer does not accept the claim for payment, the customer is ultimately responsible.
28
Table of Contents
A summary of the Days Sales Outstanding (“DSO”) and management’s expectations follows:
March 31, 2011 | December 31, 2010 | |||||||||||||||
Actual | Expected | Actual | Expected | |||||||||||||
Sleep diagnostic business | 47.06 | 45 to 50 | 48.62 | 50 to 55 | ||||||||||||
Sleep therapy business | 64.26 | 55 to 60 | 51.30 | 55 to 60 |
We decreased our expected DSO for sleep diagnostic business from 50 to 55 days at December 31, 2010 to 45 to 50 days at March 31, 2011 as a result of continued improvement in our collection process related to amounts due from patients. We anticipate that the expected DSO for our sleep diagnostic business will continue to decrease in the future. The DSO for our sleep therapy business was inflated at March 31, 2011 as a result of increased revenue in March 2011 compared with the first two months of 2011 which resulted in higher accounts receivable at March 31, 2011. We experienced a similar issue in the first quarter of 2010 when the DSO for our sleep therapy business was 65.06.
Goodwill and Intangible Assets— Goodwill is the excess of the purchase price paid over the fair value of the net assets of the acquired business. Goodwill and other indefinitely-lived intangible assets are not amortized, but are subject to annual impairment reviews, or more frequent reviews if events or circumstances indicate there may be an impairment of goodwill.
Intangible assets other than goodwill which include customer relationships, customer files, covenants not to compete, trademarks and payor contracts are amortized over their estimated useful lives using the straight line method. The remaining lives range from three to fifteen years. We evaluate the recoverability of identifiable intangible assets whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.
Recently Adopted and Recently Issued Accounting Guidance
Adopted Guidance
On January 1, 2011, we adopted changes issued by the Financial Accounting Standards Board (FASB) to revenue recognition for multiple-deliverable arrangements. These changes require separation of consideration received in such arrangements by establishing a selling price hierarchy (not the same as fair value) for determining the selling price of a deliverable, which will be based on available information in the following order: vendor-specific objective evidence, third-party evidence, or estimated selling price; eliminate the residual method of allocation and require that the consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method, which allocates any discount in the arrangement to each deliverable on the basis of each deliverable’s selling price; require that a vendor determine its best estimate of selling price in a manner that is consistent with that used to determine the price to sell the deliverable on a standalone basis; and expand the disclosures related to multiple-deliverable revenue arrangements. The adoption of these changes had no impact on our consolidated financial statements, as we do not currently have any such arrangements with its customers.
On January 1, 2011, we adopted changes issued by the FASB to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose, in the reconciliation of fair value measurements using significant unobservable inputs (Level 3), separate information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). The adoption of these changes had no impact on our consolidated financial statements.
29
Table of Contents
On January 1, 2011, we adopted changes issued by the FASB to the testing of goodwill for impairment. These changes require an entity to perform all steps in the test for a reporting unit whose carrying value is zero or negative if it is more likely than not (more than 50%) that a goodwill impairment exists based on qualitative factors. This will result in the elimination of an entity’s ability to assert that such a reporting unit’s goodwill is not impaired and additional testing is not necessary despite the existence of qualitative factors that indicate otherwise. Based on the most recent impairment review of our goodwill (2010 fourth quarter), the adoption of these changes had no impact on our consolidated financial statements.
On January 1, 2011, we adopted changes issued by the FASB to the disclosure of pro forma information for business combinations. These changes clarify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. Also, the existing supplemental pro forma disclosures were expanded to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The adoption of these changes had no impact on our consolidated financial statements.
Cautionary Statement Relating to Forward Looking Information
We have included some forward-looking statements in this section and other places in this report regarding our expectations. These forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, business plans or objectives, levels of activity, performance or achievements, or industry results, to be materially different from any future results, business plans or objectives, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Some of these forward-looking statements can be identified by the use of forward-looking terminology including “believes,” “expects,” “may,” “will,” “should” or “anticipates” or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategies that involve risks and uncertainties. You should read statements that contain these words carefully because they
• | discuss our future expectations; | ||
• | contain projections of our future operating results or of our future financial condition; or | ||
• | state other “forward-looking” information. |
We believe it is important to discuss our expectations; however, it must be recognized that events may occur in the future over which we have no control and which we are not accurately able to predict. Readers are cautioned to consider the specific business risk factors described in this report and our Annual Report on Form 10-K and not to place undue reliance on the forward-looking statements contained in this report or our Annual Report, which speak only as of the date of this report or the date of our Annual Report. We undertake no obligation to publicly revise forward-looking statements to reflect events or circumstances that may arise after the date of this report.
Item 3. | Quantitative and Qualitative Disclosures about Market Risk. |
We are a smaller reporting entity as defined in Rule 12b-2 of the Exchange Act and as such, are not required to provide the information required by Item 305 of Regulation S-K with respect to Quantitative and Qualitative Disclosures about Market Risk.
Item 4. | Controls and Procedures. |
Evaluation of Disclosure Controls and Procedures
Our management (with the participation of our Principal Executive Officer and Principal Financial Officer) evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of March 31, 2011. Disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported on a timely basis and that such information is accumulated and communicated to management, including the Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based on this evaluation, our Principal Executive Officer and Principal Financial Officer concluded that these disclosure controls and procedures are effective.
30
Table of Contents
Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Material Weakness
Internal Controls over Financial Reporting
During the fourth quarter of 2010 and as part of the sale of ApothecaryRx assets, we incurred significant charges related to the accounts receivable and inventory balances at ApothecaryRx. In addition, we noted additional control deficiencies that in aggregate with the material special charges incurred at ApothecaryRx caused us to conclude that we had a material weakness in our internal control over financial reporting.
A material weakness is a deficiency, or a combination of control deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. Although the accounts receivable trends and the inventory physical counts related to the ApothecaryRx throughout prior periods did not generate unusual results or cause us to question the validity of the accounts to receivable or inventory balances, we feel that the significant charges recorded as a result of adjusting the inventory and accounts receivable amounts to their net realizable value subsequent to the sale of the ApothecaryRx represented a material weakness in our internal controls over financial reporting.
Since the operations of ApothecaryRx were sold, no remediation efforts were needed related to those specific control deficiencies. However, due to the significance of the ApothecaryRx special charges, we began an evaluation of the circumstances and potential changes to our entity wide controls to address the other identified control deficiencies. The evaluation of entity wide controls is still in process. We have not identified any additional material weaknesses or significant deficiencies, but we have identified areas of improvement to eliminate identified control deficiencies, including enhancing the level of documentation and testing of our internal controls over financial reporting.
PART II. OTHER INFORMATION
Item 1. | Legal Proceedings. |
In the normal course of business, we may become involved in litigation or in legal proceedings. Except as described above, we are not aware of any such litigation or legal proceedings, that we believe will have, individually or in the aggregate, a material adverse effect on our business, financial condition and results of operations.
Item 1A. | Risk Factors. |
There have been no material changes from the risk factors previously disclosed in our 2010 Annual Report on Form 10-K.
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds. |
Unregistered Sales of Equity Securities
We do not have anything to report under this Item.
Repurchases of Equity Securities
We do not have anything to report under this Item.
31
Table of Contents
Item 3. | Defaults Upon Senior Securities. |
We do not have anything to report under this Item.
Item 4. | (Removed and Reserved). |
Item 5. | Other Information. |
We do not have anything to report under this Item.
Item 6. | Exhibits. |
(a) Exhibits:
Exhibit No. | Description | |||
10.1 | Loan Agreement dated March 16, 2011 by and between Valiant Investments LLC and Graymark Healthcare, Inc., is incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report with the U.S. Securities and Exchange Commission on Form 8-K filed on March 22, 2011. | |||
10.2 | Note dated March 16, 2011 issued by Graymark Healthcare, Inc., is incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report with the U.S. Securities and Exchange Commission on Form 8-K filed on March 22, 2011. | |||
10.3 | Subordination Agreement dated March 16, 2011 by and among Valiant Investments, L.L.C., ApothecaryRX, LLC, SDC Holdings LLC and Graymark Healthcare, Inc., in favor of Arvest Bank, is incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report with the U.S. Securities and Exchange Commission on Form 8-K filed on March 22, 2011. | |||
10.4 | Letter Agreement dated March 11, 2011 by and between Graymark Healthcare, Inc. and Arvest Bank, is incorporated by reference to Exhibit 99.1 to the Registrant’s Current Report with the U.S. Securities and Exchange Commission on Form 8-K filed on March 22, 2011. | |||
10.5 | Form of Subscription Agreement dated April 30, 2011 by and between each of Graymark Healthcare, Inc., and each of MTV Investments, LP, Black Oak II, LLC, TLW Securities, LLC and Valiant Investments, LLC, is incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report with the U.S. Securities and Exchange Commission on Form 8-K filed on May 5, 2011. | |||
10.6 | Form of Warrant Agreement dated May 4, 2011 issued to each of MTV Investments, LP, Black Oak II, LLC, TLW Securities, LLC and Valiant Investments, LLC, is incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report with the U.S. Securities and Exchange Commission on Form 8-K filed on May 5, 2011. | |||
31.1 | Certification of Stanton Nelson, Chief Executive Officer of Registrant (furnished herewith). | |||
31.2 | Certification of Edward M. Carriero, Jr., Chief Financial Officer of Registrant (furnished herewith). | |||
31.3 | Certification of Grant A. Christianson, Chief Accounting Officer of Registrant (furnished herewith). | |||
32.1 | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Stanton Nelson, Chief Executive Officer of Registrant (furnished herewith). | |||
32.2 | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Edward M. Carriero, Jr., Chief Financial Officer of Registrant (furnished herewith). | |||
32.3 | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Grant A. Christianson, Chief Accounting Officer of Registrant (furnished herewith). |
32
Table of Contents
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
GRAYMARK HEALTHCARE, INC. (Registrant) | ||||
By: | /S/ STANTON NELSON | |||
Stanton Nelson | ||||
Chief Executive Officer (Principal Executive Officer) | ||||
Date: May 16, 2011 | By: | /S/ EDWARD M. CARRIERO, JR. | ||
Edward M. Carriero, Jr. | ||||
Chief Financial Officer (Principal Financial Officer) | ||||
Date: May 16, 2011 | By: | /S/ GRANT A. CHRISTIANSON | ||
Grant A. Christianson | ||||
Chief Accounting Officer (Principal Accounting Officer) |
Date: May 16, 2011
33