UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1999 Or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number: 0-26190 US Oncology, Inc. (Exact name of registrant as specified in its charter) Delaware 84-1213501 (State or other jurisdiction of incorporation or (I.R.S. Employer organization) Identification No.) 16825 Northchase Drive, Suite 1300 Houston, Texas 77060 (Address of principal executive offices) (Zip Code) (281) 873-2674 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- As of November 09, 1999, 85,879,035 shares of the Registrant's Common Stock were outstanding. In addition, as of November 09, 1999, the Registrant had agreed to deliver 14,915,492 shares of its Common Stock on certain future dates for no additional consideration. US ONCOLOGY, INC. FORM 10-Q SEPTEMBER 30, 1999 Table of Contents Page No. -------- PART I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements Condensed Consolidated Balance Sheet 3 Condensed Consolidated Statement of Operations and Comprehensive Income 4 Condensed Consolidated Statement of Cash Flows 5 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 Item 3. Quantitative and Qualitative Disclosures About Market Risks 14 PART II. OTHER INFORMATION Item 1. Legal Proceedings 15 Item 2. Changes in Securities 15 Item 6. Exhibits and Reports on Form 8-K 16 SIGNATURES 17 -2- PART I. FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS US ONCOLOGY, INC. CONDENSED CONSOLIDATED BALANCE SHEET (in thousands, except par value) September 30, December 31, 1999 1998 -------------------- ---------------------- ASSETS (unaudited) Current assets: Cash and equivalents.................................................... $ 2,070 $ 13,691 Accounts receivable..................................................... 302,624 243,390 Prepaids and other current assets....................................... 76,421 42,581 Due from affiliated physician groups.................................... 13,126 22,354 ---------- ----------- Total current assets............................................... 394,241 322,016 Property and equipment, net.............................................. 253,274 220,944 Management service agreements, net....................................... 526,357 467,214 Other assets............................................................. 25,269 23,354 ---------- ----------- $1,199,141 $1,033,528 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current maturities of long-term indebtedness.......................... $ 20,246 $ 22,426 Accounts payable...................................................... 73,253 80,729 Due to affiliated physician groups.................................... 13,933 6,606 Accrued compensation costs............................................ 7,009 10,118 Income taxes payable.................................................. 11,222 4,066 Other accrued liabilities............................................. 28,769 19,809 ---------- ---------- Total current liabilities............................................. 154,432 143,754 Deferred income taxes.................................................... 23,060 23,537 Long-term indebtedness................................................... 331,410 234,474 ---------- ---------- Total liabilities..................................................... 508,902 401,765 ---------- ---------- Minority interest........................................................ 2,307 1,965 Stockholders' equity: Preferred Stock, $.01 par value, 1,500 shares authorized, none issued and outstanding.............................................. Series A Preferred Stock, $.01 par value, 500 shares authorized and reserved, none issued and outstanding............................... Common Stock, $.01 par value, 250,000 shares authorized, 85,539 and 81,205 issued and 85,539 and 80,830 outstanding........................ 855 812 Additional paid-in capital.............................................. 414,379 404,749 Common Stock to be issued, approximately 14,978 and 16,947 shares....... 102,244 89,142 Treasury Stock, 0 and 375 shares....................................... (3,696) Accumulated other comprehensive income................................. 1,648 269 Retained earnings....................................................... 168,806 138,522 ---------- ---------- Total stockholders' equity............................................ 687,932 629,798 ---------- ---------- $1,199,141 $1,033,528 ========== ========== The accompanying notes are an integral part of this statement. -3- US ONCOLOGY, INC. CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS AND COMPREHENSIVE INCOME (in thousands, except per share data) (unaudited) Three Months Nine Months Ended September 30, Ended September 30, --------------------- --------------------- 1999 1998 1999 1998 --------- --------- --------- --------- Revenue...................................................... $277,789 $216,916 $793,415 $609,297 Operating expenses: Pharmaceuticals and supplies............................ 134,773 92,916 373,502 256,307 Practice compensation and benefits...................... 54,464 44,169 156,043 126,375 Other practice costs.................................... 33,435 28,172 95,787 80,524 General and administrative.............................. 10,062 10,303 27,867 28,769 Merger and integration costs............................ 2,747 27,238 Depreciation and amortization........................... 15,317 13,458 45,573 34,708 -------- -------- -------- -------- 250,798 189,018 726,010 526,683 -------- -------- -------- -------- Income from operations....................................... 26,991 27,898 67,405 82,614 Interest expense, net........................................ (6,016) (3,804) (15,949) (11,877) -------- -------- -------- -------- Income before income taxes................................... 20,975 24,094 51,456 70,737 Income taxes................................................. 5,992 9,049 21,172 26,599 -------- -------- -------- -------- Net income................................................... 14,983 15,045 30,284 44,138 -------- -------- -------- -------- Other comprehensive income (loss), net of tax................ 1,499 124 1,379 (134) -------- -------- -------- -------- Comprehensive income......................................... $ 16,482 $ 15,169 $ 31,663 $ 44,004 ======== ======== ======== ======== Net income per share - basic................................. $0.15 $0.15 $0.30 $0.45 ======== ======== ======== ======== Shares used in per share calculations - basic................ 100,493 98,331 100,018 97,550 ======== ======== ======== ======== Net income per share - diluted............................... $ 0.15 $ 0.15 $ 0.30 $ 0.44 ======== ======== ======== ======== Shares used in per share calculations - diluted.............. 102,184 100,308 101,600 100,120 ======== ======== ======== ======== The accompanying notes are an integral part of this statement. -4- US ONCOLOGY, INC. CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (in thousands) (unaudited) Nine Months Ended September 30, 1999 1998 ------------------ ------------------ Cash flows from operating activities: Net income............................................................. $ 30,284 $ 44,138 Noncash adjustments: Depreciation and amortization......................................... 45,573 34,708 Deferred income taxes................................................. (477) 8,413 Non cash merger and integration costs................................. 2,300 Gain on contract termination.......................................... (3,152) Changes in operating assets and liabilities............................ (67,347) (37,969) -------- -------- Net cash provided by operating activities........................... 7,181 49,290 Cash flows from investing activities: Acquisition of property and equipment.................................. (60,978) (34,713) Net payments in medical practice transactions.......................... (36,182) (22,539) Other.................................................................. 342 (585) -------- -------- Net cash used in investing activities............................... (96,818) (57,837) Cash flows from financing activities: Net proceeds from credit facilities.................................... 83,000 39,000 Repayment of other indebtedness........................................ (9,621) (27,381) Purchase of Treasury Stock............................................. (9,562) Proceeds from exercise of options...................................... 4,637 3,350 -------- -------- Net cash provided by financing activities........................... 78,016 5,407 Decrease in cash and equivalents........................................ (11,621) (3,140) Cash and equivalents: Beginning of period.................................................... 13,691 7,772 -------- -------- End of period.......................................................... $ 2,070 $ 4,632 ======== ======== Noncash transactions: Value of Common Stock to be issued in medical practice transactions................................................ $ 21,834 $ 8,403 Debt issued in medical practice transactions........................... 20,642 14,696 Debt assumed in medical practice transactions.......................... 86 Tax benefit from exercise of non-qualified stock options............... 4,301 Debt issued to finance insurance premiums.............................. 649 The accompanying notes are an integral part of this statement. -5- US ONCOLOGY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) NOTE 1 - Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial reporting and in accordance with Form 10-Q and Rule 10.01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited condensed consolidated financial statements contained in this report reflect all adjustments that are normal and recurring in nature and considered necessary for a fair presentation of the financial position and the results of operations for the interim periods presented. The preparation of the Company's financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, as well as disclosures on contingent assets and liabilities. Because of inherent uncertainties in this process, actual future results could differ from those expected at the reporting date. These unaudited condensed consolidated financial statements, footnote disclosures and other information should be read in conjunction with the financial statements and the notes thereto included in US Oncology, Inc.'s Form 8-K/A-2 filed with the Securities and Exchange Commission on August 16, 1999. Operating segments During 1998, the Company adopted Financial Accounting Standards Board (FASB) Statement No. 131, "Disclosures About Segments of an Enterprise and Related Information" (FAS 131), which requires reporting of summarized financial results for the operating segments as well as establishes standards for related disclosures about products and services, geographic areas and major customers. The Company's sole business is providing comprehensive management services, facilities and equipment, administrative and technical support and ancillary services necessary for physicians to establish and maintain a fully integrated network of outpatient cancer care. The physicians affiliated with the Company provide all aspects of care related to the diagnosis and outpatient treatment of cancer, including comprehensive oncology services (including primarily medical, radiation, and gynecological services), diagnostic radiology services, retail pharmacy services and clinical research. For the first nine months of 1999 and 1998, oncology related services was the only product line that exceeded the reporting thresholds of FAS 131. The Company, therefore, has used the aggregation criteria of FAS 131 and reports a single segment. NOTE 2 - Business Combination On June 15, 1999, the Company, formerly American Oncology Resources, Inc. (AOR), consummated a merger transaction pursuant to which Physician Reliance Network, Inc. (PRN) became a wholly owned subsidiary of the Company and each outstanding share of PRN's common stock was converted into .94 shares of the Company's common stock (the Merger). At the time of the Merger, the Company changed its name to US Oncology, Inc. The transaction was accounted for as a pooling of interests and accordingly the financial statements presented herein have been restated to conform to the presentation and accounting standards of the two companies. The Company has recognized merger and integration costs for the nine months and three months ended September 30, 1999 of approximately $27.2 million and $2.7 million respectively. Merger and integration costs for the nine months ended September 30, 1999 are comprised of transaction costs of approximately $17.2 million for professional fees, costs of due diligence, severance costs and other out of pocket expenses; restructuring costs of approximately $5.0 for leasehold and software abandonment; and, integration costs of approximately $5.0 million for integration consulting fees, communications, and Merger related Company meetings. Note 3 - Revenue Medical service revenue for services to patients by the physician groups affiliated with the Company is recorded when services are rendered based on established or negotiated charges reduced by contractual adjustments and allowances for doubtful accounts. Differences between estimated contractual adjustments and final settlements are reported in the period when final settlements are determined. Medical service revenue of the affiliated physician groups is reduced by amounts retained by the physician groups under the Company's management services agreements to arrive at the Company's management fee revenue. The following presents the amounts included in the determination of the Company's revenue (in thousands): Three Months Nine Months Ended September 30, Ended September 30, -------------------------------- --------------------------------- 1999 1998 1999 1998 --------------- -------------- --------------- --------------- Medical service revenue........................... $351,127 $275,952 $1,008,897 $780,456 Amounts retained by affiliated physician groups... 83,297 68,152 240,104 193,003 -------- -------- ---------- -------- Management fee revenue............................ 267,830 207,800 768,793 587,453 Other revenue..................................... 9,959 9,116 24,622 21,844 -------- -------- ---------- -------- Revenue........................................... $277,789 $216,916 $ 793,415 $609,297 ======== ======== ========== ======== The Company's most significant and only management service agreement to provide more than 10% of revenues to the Company is with Texas Oncology, P.A. (TOPA). TOPA accounted for approximately 29.5% and 25.2% for the nine months ended September 30, 1998 and 1999 of the Company's total revenue, and 28.9% and 24.8% for the three months ended September 30, 1998 and 1999. -6- US ONCOLOGY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS CONTINUED (unaudited) NOTE 4 - Credit Facility and Master Lease Credit Facility On June 15, 1999, in connection with the Merger, the Company executed a $275 million revolving credit facility (Credit Facility) with First Union National Bank (First Union), individually and as Administrative Agent for eight additional lenders ("Lenders"). The Credit Facility consists of a $175 million five-year revolving credit facility and a $100 million 364-day revolving credit facility. Initial proceeds under the Revolver were used to refinance existing debt and to pay certain transaction fees and expenses in connection with the Credit Facility and the Merger. Proceeds of loans under the Credit Facility may be used to finance medical practice transactions, to provide working capital and for other general corporate uses. As of September 30, 1999, the Company had an outstanding balance of $239 million under the Credit Facility. The Company has classified the Credit Facility as long-term indebtedness due to its ability and intent to maintain the borrowings beyond the next twelve months. Costs incurred in connection with the extinguishment of the Company's previous credit facilities were expensed in the second quarter as merger and integration costs. Borrowings under the Credit Facility are secured by all capital stock of the Company's subsidiaries, all of the Company's management services agreements and all accounts receivable of the Company. At the Company's option, funds may be borrowed at the Base interest rate or the London Interbank Offered Rate (LIBOR) up to LIBOR plus an amount determined under a defined formula. The Base rate is selected by First Union and is defined as their prime rate or Federal Funds Rate plus 1/2%. Interest on amounts outstanding under Base rate loans is due quarterly while interest on LIBOR related loans is due at the end of each applicable interest period or quarterly, if earlier. As of September 30, 1999, the weighted average interest rate on all outstanding draws under the Credit Facility was 6.7%. The Company is subject to restrictive covenants under the Credit Facility, including the maintenance of certain financial ratios. The agreement limits certain activities such as incurrence of additional indebtedness, sales of assets, investments, capital expenditures, mergers and consolidations and the payment of dividends. Under certain circumstances, additional medical practice transactions may require First Union's and the Lenders' consent. Master Lease On June 15, 1999, the Company amended its $75 million master lease agreement related to integrated cancer centers to extend the construction and acquisition period through December 2000. Under the agreement, the lessor purchases and has title to the properties, pays for the construction costs and thereafter leases the facilities to the Company. The initial term of the lease is for five years and can be renewed in one year increments if approved by the lessor. The lease provides for substantial residual value guarantees and includes purchase options at original cost on each option. Advances under the master lease agreement as of September 30, 1999 were $42 million. -7- US ONCOLOGY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS CONTINUED (unaudited) NOTE 5 - Earnings Per Share The Company computes earnings per share in accordance with the provisions of FASB Statement No. 128, "Earnings Per Share", which requires the Company to disclose "basic" and "diluted" earnings per share (EPS). The computation of basic EPS is based on a weighted average number of outstanding shares of Common Stock and Common Stock to be issued during the periods. The Company includes Common Stock to be issued in both basic and diluted EPS as there are no foreseeable circumstances that would relieve the Company of its obligation to issue these shares. The computation of the diluted EPS is based on a weighted average number of outstanding shares of Common Stock and Common Stock to be issued during the periods as well as all dilutive potential Common Stock calculated under the treasury stock method. The table summarizes the determination of shares used in per share calculations (in thousands): Three Months Nine Months Ended September 30, Ended September 30, --------------------------------- ------------------------------------ 1999 1998 1999 1998 ----------------- ------------- ----------------- ---------------- Outstanding at end of period: Common Stock................................... 85,539 79,812 85,539 79,812 Common Stock to be issued...................... 14,978 17,905 14,978 17,905 ------- ------- ------- ------- 100,517 97,717 100,517 97,717 Effect of weighting............................ (24) 614 (499) (167) ------- ------- ------- ------- Shares used in per share calculations-basic.. 100,493 98,331 100,018 97,550 Effect of weighting and assumed share equivalents for grants of stock options at less than the weighted average price and subordinated convertible promissory notes...... 1,691 1,977 1,582 2,570 ------- ------- ------- ------- Shares used in per share calculations-diluted.. 102,184 100,308 101,600 100,120 ======= ======= ======= ======= Anti-dilutive stock options not included above... 3,921 3,356 5,737 2,242 ======= ======= ======= ======= NOTE 6 - Recent Pronouncements In June 1998, FASB issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities," (FAS 133) which is effective for the Company's financial statements beginning with the first quarter of the year ending December 31, 2000. FAS 133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and to measure those instruments at fair value. Management does not expect such implementation to have a material effect on the Company's operations. -8- US ONCOLOGY, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Introduction US Oncology, Inc. (the "Company") is a cancer management company which provides comprehensive management services under long-term agreements to its affiliated oncology practices, including operational and clinical research services and data management, and furnishes personnel, facilities, supplies and equipment. These affiliated practices provide a broad range of medical services to cancer patients, integrating the specialties of medical and gynecological oncology, hematology, radiation oncology, diagnostic radiology and stem cell transplantation. Substantially all of the Company's revenue consists of management fees and includes all medical practice operating costs for which the Company is contractually responsible. The Company believes that the coordinated delivery of comprehensive cancer care in an outpatient setting offers high quality care that is more cost-effective than traditional approaches and is increasingly preferred by patients, payors and physicians. The Company believes that many oncology practices recognize the need for outside managerial, financial and business expertise to more efficiently manage the increasingly complex, burdensome and time-consuming nonmedical aspects of their practices and that practices will increasingly elect to enter into management relationships with entities such as the Company. FORWARD-LOOKING STATEMENTS AND RISK FACTORS The statements contained in this report, in addition to historical information, are forward-looking statements based on the Company's current expectations, and actual results may vary materially. Forward-looking statements often include words like "believe", "plan", "expect", "intend" or "estimate". The Company's business and financial results are subject to various risks and uncertainties, including the Company's continued ability to enter into affiliations with new physician practices and to successfully integrate such practices, the results of operations of groups currently affiliated with the Company including results of operations impacted by changes in cancer therapies or the manner in which cancer care is delivered, the ability to construct integrated cancer centers and to operate them profitably, competition, reductions in third-party reimbursement for services rendered by physician groups affiliated with the Company, drug utilization, health care regulation and other risks generally affecting the health care industry. Please refer to the Company's Annual Report on Form 10-K for the year ended December 31, 1998 and the joint proxy statement and prospectus distributed in connection with the Merger, each of which was filed with the Securities and Exchange Commission (SEC), and the Company's subsequent filings with the SEC for a more detailed discussion of such risks and uncertainties. Many of these risks and uncertainties are beyond the Company's ability to control or predict. These forward-looking statements are provided as a framework for the Company's results of operations. The Company does not intend to provide updated information other than as otherwise required by applicable law. RESULTS OF OPERATIONS Medical service revenue for services to patients by the physician groups affiliated with the Company is recorded when services are rendered based on established or negotiated charges reduced by contractual adjustments and allowances for doubtful accounts. Differences between estimated contractual adjustments and final settlements are reported in the period when final settlements are determined. Medical service revenue of the affiliated physician groups is reduced by amounts retained by the physician groups under the Company's management services agreements to arrive at the Company's management fee revenue. -9- US ONCOLOGY, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED The following presents the amounts included in the determination of the Company's revenue (in thousands): Three Months Nine Months Ended September 30, Ended September 30, -------------------------------- ---------------------------------- 1999 1998 1999 1998 --------------- -------------- --------------- ---------------- Medical service revenue......................... $351,127 $275,952 $1,008,897 $780,456 Amounts retained by affiliated physician groups........................................ 83,297 68,152 240,104 193,003 -------- -------- ---------- -------- Management fee revenue.......................... 267,830 207,800 768,793 587,453 Other revenue................................... 9,959 9,116 24,622 21,844 -------- -------- ---------- -------- Revenue......................................... $277,789 $216,916 $ 793,415 $609,297 ======== ======== ========== ======== The Company's most significant and only management service agreement to provide more than 10% of revenues to the Company is with Texas Oncology, P.A. (TOPA). TOPA accounted for approximately 29.5% and 25.2% for the nine months ended September 30, 1998 and 1999 of the Company's total revenue, and 28.9% and 24.8% for the three months ended September 30, 1998 and 1999. The following table sets forth the percentages of revenue represented by certain items reflected in the Company's Statement of Operations and Comprehensive Income. The information that follows should be read in conjunction with the Company's unaudited condensed consolidated financial statements and notes thereto included elsewhere herein. Three Months Nine Months Ended September 30, Ended September 30, ----------------------------- ---------------------------- 1999 1998 1999 1998 ------------- ------------- ------------- ------------ Revenue.............................................. 100.0% 100.0% 100.0% 100.0% Operating expenses: Pharmaceuticals and supplies........................ 48.5 42.8 47.1 42.1 Practice compensation and benefits.................. 19.6 20.4 19.7 20.8 Other practice costs................................ 12.0 13.0 12.1 13.2 General and administrative.......................... 3.6 4.7 3.5 4.7 Merger and integration costs........................ 1.0 3.4 Depreciation and amortization....................... 5.5 6.2 5.7 5.7 Net interest expense................................ 2.2 1.8 2.0 1.9 ----- ----- ----- ----- Income before income taxes........................... 7.6 11.1 6.5 11.6 ----- ----- ----- ----- Income taxes......................................... 2.2 4.2 2.7 4.4 ----- ----- ----- ----- Net income........................................... 5.4% 6.9% 3.8% 7.2% ===== ===== ===== ===== -10- US ONCOLOGY, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED 1999 COMPARED TO 1998 The Company entered into new affiliation agreements with fifteen oncology groups in the first nine months of 1999 and twelve oncology groups in the first nine months of 1998. The results of the new affiliated oncology practices are included in the Company's operating results from the dates of affiliation. Changes in results of operations for the first nine months of 1998 compared to the first nine months of 1999 were caused, in part, by affiliations with these oncology practices. Revenue. Revenue increased from $609.3 million in the first nine months of 1998 to $793.4 million in 1999, an increase of $184.1 million, or 30.2%, and from $216.9 million in the third quarter of 1998 to $277.8 million in the third quarter of 1999, an increase of $60.9 million or 28.1%. Revenue for markets under management in the first nine months of 1998 and 1999 increased $114.2 million or 18.7% over the same period from the prior year, and $50.5 million or 24.7% in the third quarter of 1999. This growth was the result of expansion of services, increases in patient volume, and recruitment of or affiliation with additional physicians. Pharmaceuticals and Supplies. Pharmaceuticals and supplies expense, which includes drugs, medications and other supplies used by the affiliated physician groups, increased from $256.3 million for the first nine months of 1998 to $373.5 million for the first nine months of 1999, an increase of $117.2 million, or 45.7%, and from $92.9 million in the third quarter of 1998 to $134.7 million in the third quarter of 1999, an increase of $41.2 million or 45.0%. As a percentage of revenue, pharmaceuticals and supplies increased from 42.1% for the first nine months of 1998 to 47.1% for the comparable period of 1999 and from 42.8% in the third quarter of 1998 to 48.5% in the third quarter of 1999. This increase was primarily due to a shift in the revenue mix to a higher percentage of revenue from drugs, the introduction of a number of new chemotherapy agents and a shift to lower margin drugs. Management expects that third-party payors will continue to negotiate the reimbursement rate for pharmaceuticals and supplies, with the goal of lowering reimbursement rates, and that such lower reimbursement rates as well as shifts in revenue mix may continue to adversely impact the Company's margins with respect to such items. Other Practice Costs. Other practice costs which consist of rent, utilities, repairs and maintenance, insurance and other direct practice costs, increased from $80.5 million for the first nine months of 1998 to $95.8 million for the first nine months of 1999, an increase of $15.3 million or 19.0%, and from $28.2 million in the third quarter of 1998 to $33.5 million in the third quarter of 1999, an increase of $5.3 million or 18.8%. The increase was principally attributable to the same factors that caused revenue to increase. As a percentage of revenue other practice costs decreased from 13.2% in the first nine months of 1998 to 12.1% in the first nine months of 1999 and from 13.0% in the third quarter of 1998 to 12.0% in the third quarter of 1999. The decrease was primarily attributable to economies of scale. Merger and Integration Costs. In the first nine months of 1999 the Company recognized merger and integration costs of approximately $27.2 million. Merger and integration costs are comprised of transaction costs of approximately $17.2 million for professional fees, costs of due diligence, severance costs and other out of pocket expenses; restructuring costs of approximately $5.0 million for leasehold and software abandonment; and integration costs of approximately $5.0 million for integration consulting fees, communications and Merger related Company meetings. Income Taxes. Income tax expense increased from the prior year. For the first nine months of 1999 the Company recognized a tax expense of $21.2 million resulting in an effective tax rate of 41.1% compared to 37.6% for the same prior year period. The increase in the effective tax rate is attributable to non-deductible merger and integration charges. Net Income. Net income decreased from $44.1 million in the first nine months of 1998 to $30.3 million in the first nine months of 1999, a decrease of $13.8 million or 31.3%. Net income remained at $15.0 million for the third quarter of 1998 and 1999. Excluding the merger costs, net income for the first nine months of 1999 was $49.2 million, which represents earnings per share of $.48, and for the third quarter of 1999 net income would have been $14.8 million, which represents earnings per share of $.15. Net income as a percentage of revenue decreased from 7.2% for the nine months ended September 30, 1998 to 6.2% for the nine months ended September 30, 1999 excluding merger and integration costs, and decreased from 6.9% for the third quarter of 1998 to 5.3% for the third quarter of 1999, excluding merger and integration costs. Such decreases are attributable to the shift in the revenue mix to a higher percentage of drug revenue as discussed above, an increase in the use of lower margin chemotherapy agents and, for the nine months ended only, to a change in amortization period for management services agreements from forty years to twenty-five years, effective July 1, 1998. -11- US ONCOLOGY, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED In response to this decline in margin relating to certain pharmaceutical agents, the Company has adopted several strategies. Most importantly, the Company has formed a number of preferred pharmaceutical relationships and continues to pursue others. In addition, the Company routinely considers and implements measures to control other operating costs to enable it to achieve greater economies of scale. Lastly, the Company seeks opportunities to expand its business in areas that are less affected by lower pharmaceutical margins, such as radiation oncology and diagnostic radiology. The Company believes that its results of operations and financial condition have benefited from each of these strategies. LIQUIDITY AND CAPITAL RESOURCES The Company requires capital primarily to enter into management services agreements with, and to purchase the nonmedical assets of, medical and radiation oncology practices. During the first nine months of 1999, the Company paid total consideration of $78.7 million in connection with affiliations with fifteen physician groups, including cash and transaction costs of $36.2 million. During the comparable period of the prior year, the Company paid total consideration of $45.6 million for affiliations with twelve physician groups, including cash and transaction costs of $22.5 million. To fund its growth and development, the Company has satisfied its transaction and working capital needs through borrowings under a $275 million syndicated revolving credit facility ("Credit Facility") with First Union National Bank ("First Union"), as agent for the various lenders. In addition, the Company has obtained a $75 million end-loaded leasing facility (Leasing Facility) for its integrated cancer centers. During the first nine months of 1999, the Company borrowed $83 million, net, under the Credit Facility to fund medical practice transactions, pay merger related expenses and the acquisition of property and equipment. Borrowings under the Credit Facility bear interest at a rate equal to a rate based on prime rate or the London Interbank Offered Rate, based on a defined formula. The Credit Facility and Leasing Facility contain affirmative and negative covenants, including the maintenance of certain financial ratios, restrictions on sales, leases or other dispositions of property, restrictions on other indebtedness and prohibitions on the payment of dividends. The Company's management services agreements, the capital stock of the Company's subsidiaries and the Company's accounts receivable are pledged as security under the Credit Facility and Leasing Facility. The Company is currently in compliance with the Credit Facility and Leasing Facility covenants, with additional capacity under the Credit Facility of $36 million and Leasing Facility of approximately $33 million at September 30, 1999. The Company has relied primarily on management fees received from its affiliated physician groups to fund its operations. Cash provided by operations was $7.2 million in the first nine months of 1999, a decrease of $42.1 million from the comparable period in 1998. The decrease was due primarily to Merger related expenditures of $21.5 million and the timing of certain working capital payments. Excluding merger related expenditures, cash provided from operations would have been $28.7 million. Cash used in investing activities was $96.8 million for the first nine months of 1999, an increase of $39.0 million from the same period of 1998. Such increase is due primarily to greater activity in medical practice transactions in 1999 as well as increased purchases of property and equipment. Cash provided by financing activities was $78.0 million for the first nine months of 1999, an increase of $72.6 million from the comparable prior year period. Such increase is due to borrowings to pay merger and integration costs as well as fund medical practice transaction costs. Incremental borrowings of $83 million under the Credit Facility were incurred in the first nine months of 1999. As of September 30, 1999, the Company had net working capital of $239.8 million and cash and cash equivalents of $2.1 million. The Company's also had $154.4 million of current liabilities, including approximately $20.2 million of current indebtedness maturing before September 30, 2000. The Company currently expects that its principal use of funds in the near future will be in connection with anticipated medical practice transactions, merger and integration expenses and purchases of medical equipment. -12- US ONCOLOGY, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED YEAR 2000 ISSUE The "Year 2000 problem" describes computer programs that use two rather than four digits to define the applicable year, and thus cannot distinguish between the year 1900 and the year 2000. The Company's computer hardware and software, building infrastructure components (e.g., alarm systems and HVAC systems) and medical equipment (e.g., linear accelerators, which are used to provide radiation therapy) that are date sensitive may contain programs with the Year 2000 problem. If uncorrected, the problem could result in computer system and program failure or equipment malfunctions that could disrupt business operations. Project. The Company has divided its Year 2000 Project into six phases: development, awareness, assessment, remediation, validation and implementation. In connection with its Year 2000 Project, the Company is assessing information technology software and hardware, medical equipment, third-party payors and third-party suppliers. The Company's strategy also includes development of contingency plans to address potential disruption of operations arising from the Year 2000 problems. Information Systems. The Company recognizes that investment in information systems and state-of-the-art medical equipment is integral to its operations. The majority of the Company's technology expenditures for 1998 and 1999 relate to the development and implementation of a clinical information system. This system provides an interactive electronic format for capturing the spectrum of patient care and creates an electronic medical record. This system is believed to be Year 2000 compliant. The costs of the clinical information system are expected to be capitalized and amortized over the life of the asset. In 1994, the Company began a project to replace the existing practice management systems (billing and collection systems) with a common system to improve efficiency and consistency among its affiliated practices of this common practice management system. The common practice management system being implemented is believed to be Year 2000 compliant. Any remaining practice management systems not replaced by the new system have been modified with vendor-supplied upgrades to make them Year 2000 compliant. Costs to upgrade the practice management systems that are not converted to the common system would be expensed; however, such costs are not expected to be material. In 1996, the Company's management incorporated a business strategy to accommodate the rapid growth of its operations. One component of this strategy was the investment in developing an integrated financial system throughout its network of affiliated physicians. This financial system is believed to be Year 2000 compliant and has been implemented in several locations. The Company intends to complete the implementation of this financial system by the first quarter of 2000. The costs incurred in developing this financial system have been capitalized through the initial implementation date. Any legacy financial systems not replaced before the end of 1999 are believed to be Year 2000 compliant. Medical Equipment. The Company has reviewed the Year 2000 readiness of the linear accelerators and associated equipment used in the affiliated radiation oncology practices. The suppliers of the radiation oncology equipment have certified that, with minor upgrades, these systems will be Year 2000 compliant by the end of the fourth quarter. The Company has determined that all other medical equipment is Year 2000 compliant. Costs incurred to upgrade medical equipment have been expensed. Third-Party Payors. The Company bills and collects for medical services from numerous third party payors in operating its business. These third parties include fiscal intermediaries on behalf of the Medicare program, as well as insurance companies, HMOs and other private payors. As part of the Company's Year 2000 strategy, a comprehensive survey has been sent to all significant payors to assess their timeline for Year 2000 compliance and the impact to the Company. The response rate for compliance is over 90% and non-respondants are being contacted directly. All major payors who have responded to the Company's requests have declared that they are or will be Year 2000 compliant by December 31, 1999. -13- US ONCOLOGY, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Third-Party Suppliers. The Company is currently evaluating third party vendors of medical supplies and pharmaceuticals in order to determine whether their services and products will be interrupted or malfunction due to the Year 2000 problem. The Company's pharmaceutical ordering system is a proprietary system developed by a third party vendor and is utilized under the Company's purchasing contract with such vendor. This relationship has been identified and prioritized as the most critical in the vendor evaluation process. The third party vendor has upgraded its pharmaceuticals purchase ordering system at no cost to the Company. The upgraded system has been certified as Year 2000 compliant by the vendor and is scheduled for implementation by the fourth quarter of 1999. Risks. The failure to correct a material Year 2000 problem could result in an interruption in, or failure of, certain normal business activities or operations. Such failures could materially and adversely affect the Company's results of operations, liquidity and financial condition. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from the uncertainty of the Year 2000 readiness of third-party payors and third-party suppliers, the Company is unable to determine at this time whether the consequences of Year 2000 failures will have a material impact on the Company's results of operations, liquidity or financial condition. The Company has received compliance certification from all major payors and its key third party supplier of pharmaceutical agents which reduces the Company's level of uncertainly considerably. The Company has also developed contingency plans to use alternative business practices in the event of unexpected Year 2000 related failures of third-party systems. However, there can be no assurance that unexpected Year 2000 related failures will not occur or that such contingency plans will be sufficient in the event of such failures. Any such failure affecting the Company or any third party could have a material adverse effect on the Company's results of operations, liquidity and financial condition. Costs. The Company estimates that total costs to be incurred in the execution of its Year 2000 Project are approximately $10.7 million, including approximately $600,000 relating to laboratory and medical equipment upgrades and replacements. The Company estimates that approximately $8.2 million of the costs will be capitalized and amortized over the useful life of the assets as they represent new applications and expanded capabilities. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS. In the normal course of business, the financial position of the Company is routinely subjected to a variety of risks. Among these risks is the market risk associated with interest rate movements on outstanding debt. The Company regularly assesses these risks and has established policies and business practices to protect against the adverse effects of these and other potential exposures. The Company's borrowings under the Credit Facility and subordinated notes due to affiliated physicians contain an element of market risk from changes in interest rates. The Company manages this risk, in part, through the use of interest rate swaps. The Company does not enter into interest rate swaps or hold other derivative financial instruments for speculative purposes. The Company is not obligated under any interest rate swap agreements at September 30, 1999. For purposes of specific risk analysis, the Company uses sensitivity analysis to determine the impact that market risk exposures may have on the Company. The financial instruments included in the sensitivity analysis consist of all of the Company's cash and equivalents, long-term and short-term debt and all derivative financial instruments To perform sensitivity analysis, the Company assesses the risk of loss in fair values from the impact of hypothetical changes in interest rates on market sensitive instruments. The market values for interest rate risk are computed based on the present value of future cash flows as impacted by the changes in the rates attributable to the market risk being measured. The discount rates used for the present value computations were selected based on market interest rates in effect at September 30, 1999. The market values that result from these computations are compared with the market values of these financial instruments at September 30, 1999. The differences in this comparison are the hypothetical gains or losses associated with each type of risk. A one percent increase or decrease in the levels of interest rates on variable rate debt with all other variables held constant would not result in a material change to the Company's results of operations or financial position or the fair value of its financial instruments. -14- US ONCOLOGY, INC. PART II. OTHER INFORMATION ITEM 1. Legal Proceedings A range of federal, civil and criminal laws target false claims and fraudulent activities. One of the most significant is the Federal False Claims Act, which prohibits the submission of a false claim or the making of a false record or statement in order to secure reimbursement. The Federal False Claims Act carries potential penalties of $5,000 to $10,000 for each false claim, as well as for treble damages, and exclusion from the Medicare and Medicaid system. Claims under these laws may be brought either by the government or by private individuals on behalf of the government, through a "whistleblower" or "qui tam" action. Because such actions are filed under seal and may remain secret for a significant period of time, the Company may not be aware of the existence of any such claim against it. Earlier this month, the Company was informed that one of the Company's subsidiaries and an affiliated physician group are the subject of allegations that their billing practices may violate the Federal False Claims Act. It is our understanding that the allegations are the result of two qui tam complaints filed under seal prior to the Merger. The Company has been informed that the Civil Division of the U.S. Department of Justice will be investigating the allegations in order to determine if the United States will intervene and pursue the claims on behalf of the plaintiffs. If the United States does not intervene, the plaintiffs may continue to pursue the claims individually. Because the complaints are under seal and very little information is available for the Company to review, and because the Company is awaiting further information from the Department of Justice (including its decision regarding intervention), the Company is unable to fully assess at this point in time the nature or magnitude of these allegations. If the plaintiffs and/or the United States were to prevail in these claims, the resulting judgment could have a material adverse effect on the Company. ITEM 2. Changes in Securities In connection with each affiliation transaction between the Company and a physician group, the Company purchases the nonmedical assets of, and enters into a long-term management services agreement with, that physician group. In consideration for that arrangement, the Company typically pays cash, issues subordinated promissory notes (in general, payable in equal installments on the third through seventh anniversaries of the closing date at an annual interest rate of seven percent) and unconditionally agrees to deliver shares of Common Stock at future specified dates (in general, on each of the third through fifth anniversaries of the closing date). The price per share is the lower of the average of the closing price per share for the five days preceding the date of the letter of intent or the closing date with respect to such affiliation transaction. For the first nine months of 1999 the Company affiliated with fifteen physician groups consisting of forty-one physicians. In conjunction with these transactions the Company agreed to issue 1,966,260 shares of Common Stock and issued $17.8 million of subordinated promissory notes. Each sale was a private placement made in connection with a physician transaction, as described in general in the preceding paragraph. The overwhelming majority of the affiliated physicians are accredited investors. No underwriter was involved in any such sale, and no commission or similar fee was paid with respect thereto. Each sale was not registered under the Securities Act of 1933 in reliance on Section 4(2) of such Act and Rule 506 enacted thereunder. -15- US ONCOLOGY, INC. OTHER INFORMATION - CONTINUED ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits Exhibit Number Description ------ ----------- 3.1 Amended and Restated Certificate of Incorporation (incorporated by reference from the Company's Form 8-K/A, filed June 17, 1999) 3.2 Amended and Restated By-Laws (incorporated by reference from the Company's Form 8-K/A filed June 17, 1999) 4.1 Rights Agreement between the Company and American Stock Transfer & Trust Company (incorporated by reference from Form 8-A filed June 2, 1997) 10.1 Fourth Amended and Restated Loan Agreement dated May 11, 1999 among First Union National Bank, various Lenders and the Company (incorporated by reference from the Form 10-Q for the Second Quarter of 1999) 10.2 Third Amendment to Certain Operative Agreements dated as of May 14, 1999 by and among the Company, various of its subsidiaries, First Security Bank, National Association as owner trustee, various Lenders and Holders (as defined herein) and First Union National Bank, as Agent (incorporated by reference from the Form 10-Q for the Second Quarter of 1999) 27 Financial Data Schedule (b) Reports on Form 8-K The Company did not file any current reports on Form 8-K during the Third Quarter of 1999. -16- US ONCOLOGY, INC. 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. Date: November 11, 1999 US ONCOLOGY, INC. By: /s/ L. FRED POUNDS ------------------------------------------- L. Fred Pounds, Chief Financial Officer and Treasurer (duly authorized signatory and Principal Financial Officer) -17-