UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
- --------------------------------------------------------------------------------
Amendment No. 1 to
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 March 31, 2006
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number: 0-23511
- --------------------------------------------------------------------------------
Integrated Healthcare Holdings, Inc.
(Exact name of small business issuer as specified in its charter)
Nevada 87-0412182
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1301 N. Tustin Ave. 92705
Santa Ana, California (Zip Code)
(Address of principal executive offices)
(714) 953-3503
(Registrant's telephone number, including area code)
(Former name, former address and former fiscal year,
if changed since last report)
- --------------------------------------------------------------------------------
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 |_| No |X|
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
Large accelerated filer |_| Accelerated filer |_| Non-accelerated filer |X|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). |_| Yes |X| No
There were 84,351,189 shares outstanding of the issuer's Common Stock as of
August 8, 2006.
- --------------------------------------------------------------------------------
Explanatory Note
On October 30, 2006, the Company's Audit Committee, acting on a recommendation
from the Company's management determined that the Company's unaudited condensed
consolidated quarterly financial statements for the periods ended March 31, 2006
and June 30, 2006, should be restated due to an error in the overstatement of
net revenues and accounts receivable. More specifically, the Company determined
that the restatements with respect to its financial statements for these periods
were necessary to write off patient accounts receivable for services provided
under capitated contracts. Please refer to Note 12 to our unaudited condensed
consolidated quarterly financial statements included in this amendment on Form
10-Q/A for a further discussion of the restatement. Accordingly, the Company has
restated its financial statements for the quarterly periods ended March 31, 2006
and June 30, 2006 with the filing of amended quarterly reports on Form 10-Q/A
and is restating its financial statements for the quarterly period ended March
31, 2006 in this amended report.
This amendment to the Company's Quarterly Report on Form 10-Q is being filed for
the purpose of amending and restating Items 1, 2 and 4 of Part I and Item 6 of
Part II of the Form 10-Q originally filed solely to the extent necessary (i) to
reflect the restatement of the Company's unaudited condensed consolidated
financial statements as of and for the period ended March 31, 2006, as described
in Note 12 to the unaudited condensed consolidated financial statements and (ii)
to make revisions to "Management's Discussion and Analysis of Financial
Condition and Results of Operations" as warranted by the restatement, (iii) to
make revisions to Item 4 of Part I to reflect our evaluation of controls and
procedures as of the date of filing this amended Quarterly Report on Form
10-Q/A, (iv) to include the certifications required by the Sarbanes-Oxley Act of
2002 and (v) to update the exhibits. Except as previously discussed and included
in Note 12 to our unaudited condensed consolidated quarterly financial
statements included in this amendment on Form 10-Q/A, we have not modified or
updated disclosures presented in the original quarterly report on Form 10-Q,
except as required to reflect the effects of the restatement in this Form
10-Q/A. Accordingly, this Form 10-Q/A does not reflect events occurring after
the filing of our original Form 10-Q or modify or update those disclosures
affected by subsequent events. Information not affected by the restatement is
unchanged and reflects the disclosures made at the time of the original filing
of the Form 10-Q on August 11, 2006. This Form 10-Q/A should be read in
conjunction with our filings made with the Securities and Exchange Commission
subsequent to the filing of the original Form 10-Q, including any amendments to
those filings.
INTEGRATED HEALTHCARE HOLDINGS, INC.
FORM 10-Q
TABLE OF CONTENTS
Page
Number
PART I FINANCIAL INFORMATION
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as of March 31, 2006
(unaudited) and December 31, 2005 2
Condensed Consolidated Statements of Operations for the three
months ended March 31, 2006 and 2005 (unaudited) 3
Condensed Consolidated Statements of Cash Flows for the three
months ended March 31, 2006 and 2005 (unaudited) 4
Notes to Condensed Consolidated Financial Statements (unaudited) 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 24
Item 3. Quantitative and Qualitative Disclosures About Market Risk 33
Item 4. Controls and Procedures 34
PART II OTHER INFORMATION
Item 1. Legal Proceedings 34
Item 1A. Risk Factors 34
Item 6. Exhibits 34
SIGNATURES 35
- --------------------------------------------------------------------------------
1
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
INTEGRATED HEALTHCARE HOLDINGS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
MARCH 31, DECEMBER 31,
2006 2005
------------- -------------
(unaudited)
(as restated) (as restated)
ASSETS
Current assets:
Cash and cash equivalents $ 7,129,693 $ 16,005,943
Restricted cash 4,971,636 4,971,636
Accounts receivable, net of allowance for doubtful
accounts of $2,432,084 and $3,148,276, respectively 14,902,829 15,975,486
Security reserve funds 13,021,487 12,127,337
Deferred purchase price receivables 14,354,540 9,337,703
Inventories of supplies, at cost 5,786,274 5,719,717
Due from governmental payers 6,587,219 3,024,772
Prepaid expenses and other current assets 6,369,539 6,694,045
------------- -------------
73,123,217 73,856,639
------------- -------------
Property and equipment, net of accumulated depreciation
of $2,785,921 and $2,138,134, respectively 58,860,857 59,431,285
Debt issuance costs, net of accumulated amortization
of $1,033,361 and $791,735, respectively 899,639 1,141,265
------------- -------------
Total assets $ 132,883,713 $ 134,429,189
============= =============
LIABILITIES AND STOCKHOLDERS' DEFICIENCY
Current liabilities:
Short term debt $ 70,330,734 $ -
Accounts payable 28,999,871 26,835,606
Accrued compensation and benefits 11,561,638 12,533,499
Warrant liabilities, current 23,546,650 10,700,000
Due to governmental payers 1,045,126 -
Other current liabilities 17,815,951 15,725,489
------------- -------------
Total current liabilities 153,299,970 65,794,594
------------- -------------
Long term debt - 70,330,734
Capital lease obligations, net of current portion
of $87,880 and $85,296, respectively 4,938,295 4,961,257
Warrant liability - 21,064,669
Minority interest in variable interest entity 3,041,453 3,341,549
Commitments and contingencies
Stockholders' deficiency:
Common stock, $0.001 par value; 250,000,000 shares
authorized; 84,351,189 and 83,932,316 shares
issued and outstanding, respectively 84,351 83,932
Additional paid in capital 16,257,683 16,125,970
Accumulated deficit (44,738,039) (47,273,516)
------------- -------------
Total stockholders' deficiency (28,396,005) (31,063,614)
------------- -------------
Total liabilities and stockholders' deficiency $ 132,883,713 $ 134,429,189
============= =============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS.
2
INTEGRATED HEALTHCARE HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
THREE MONTHS ENDED MARCH 31,
------------------------------
2006 2005
------------- -------------
(as restated)
Net operating revenues $ 86,163,974 $ 21,747,029
------------- -------------
Operating expenses:
Salaries and benefits 48,708,705 12,450,604
Supplies 12,031,608 3,033,815
Provision for doubtful accounts 8,298,928 3,141,406
Other operating expenses 16,757,363 3,900,220
Loss on sale of accounts receivable 2,807,805 -
Depreciation and amortization 647,789 262,212
------------- -------------
89,252,198 22,788,257
------------- -------------
Operating loss (3,088,224) (1,041,228)
Other income (expense):
Interest expense, net (2,694,414) (665,296)
Common stock warrant expense - (17,215,000)
Change in fair value of derivative 8,218,019 -
------------- -------------
5,523,605 (17,880,296)
------------- -------------
Income (loss) before minority interest
and provision for income taxes 2,435,381 (18,921,524)
Income tax benefit (provision) - (944,000)
Minority interest in variable interest entity 100,096 8,905
------------- -------------
Net income (loss) $ 2,535,477 $ (19,856,619)
============= =============
Per Share Data:
Earnings (loss) per common share-Basic $0.03 ($0.22)
Earnings (loss) per common share-Fully Diluted $0.02 ($0.22)
Weighted average shares outstanding-Basic 84,281,377 88,493,611
Weighted average shares-Fully Diluted 127,227,606 Note 10
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS.
3
INTEGRATED HEALTHCARE HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Three months ended March 31,
----------------------------
2006 2005
------------ ------------
(as restated)
Cash flows from operating activities:
Net income (loss) $ 2,535,477 $(19,856,619)
Adjustments to reconcile net loss to cash
used in operating activities:
Depreciation and amortization of property and equipment 647,789 249,363
Amortization of debt issuance costs and intangible assets 241,626 75,203
Common stock warrant expense - 17,215,000
Change in fair value of derivative (8,218,019) -
Minority interest in net loss of variable interest entity (100,096) (8,905)
Changes in operating assets and liabilities:
Accounts receivable, net 1,072,657 (16,968,328)
Security reserve funds (894,150) -
Deferred purchase price receivables (5,016,837) -
Inventories of supplies (66,557) 71,868
Due from governmental payers (3,562,447) -
Prepaids and other current assets 324,506 (1,375,081)
Accounts payable 2,164,265 5,933,254
Accrued compensation and benefits (971,861) 7,073,364
Due to governmental payers 1,045,126 -
Other current liabilities 2,090,462 1,439,151
------------ ------------
Net cash used in operating activities (8,708,059) (6,151,730)
------------ ------------
Cash flows from investing activities:
Acquisition of hospital assets - (63,171,676)
Additions to property and equipment, net (77,361) -
------------ ------------
Net cash used in investing activities (77,361) (63,171,676)
------------ ------------
Cash flows from financing activities:
Proceeds from long term debt - 50,000,000
Long term debt issuance costs - (1,933,000)
Proceeds from minority investment in PCHI - 5,000,000
LLC distribution (200,000) -
Drawdown on line of credit - 13,200,000
Issuance of common stock 132,132 10,699,501
Repayments of debt - (1,264,013)
Payments on capital lease obligations (22,962) (34,414)
------------ ------------
Net cash (used in) provided by financing activities (90,830) 75,668,074
------------ ------------
Net increase (decrease) in cash and cash equivalents (8,876,250) 6,344,668
Cash and cash equivalents, beginning of period 16,005,943 69,454
------------ ------------
Cash and cash equivalents, end of period $ 7,129,693 $ 6,414,122
============ ============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS.
4
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
NOTE 1 - DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles in the
United States of America ("U.S. GAAP") for interim consolidated financial
information and with the instructions for Form 10-Q and Article 10 of Regulation
S-X.
In the opinion of management, the accompanying unaudited consolidated
financial statements for Integrated Healthcare Holdings, Inc. and its
subsidiaries (the "Company") contain all adjustments, consisting only of normal
recurring adjustments, necessary to present fairly the Company's financial
position as of March 31, 2006, and the Company's results of operations and cash
flows for the three months ended March 31, 2006 and 2005. The consolidated
balance sheet as of December 31, 2005 is derived from the December 31, 2005
audited consolidated financial statements.
The results of operations for the three months ended March 31, 2006 are not
necessarily indicative of the results to be expected for the full year. The
information included in this Quarterly Report on Form 10-Q should be read in
conjunction with the audited consolidated financial statements for the year
ended December 31, 2005 and notes thereto included in the Company's Form 10-K
filed with the Securities and Exchange Commission (the "SEC") on July 28, 2006.
The accompanying unaudited consolidated financial statements have been
prepared in accordance with U.S. GAAP and prevailing practices for
investor-owned entities within the healthcare industry. The preparation of
financial statements in conformity with U.S. GAAP requires management to make
estimates and assumptions that affect the amounts reported in the consolidated
financial statements and accompanying notes. Management regularly evaluates the
accounting policies and estimates that are used. In general, management bases
the estimates on historical experience and on assumptions that it believes to be
reasonable given the particular circumstances in which its hospitals operate.
Although management believes that adjustments considered necessary for fair
presentation have been included, actual results may vary from those estimates.
DESCRIPTION OF BUSINESS - The Company was organized under the laws of the
State of Utah on July 31, 1984 under the name of Aquachlor Marketing. Aquachlor
Marketing never engaged in business activities and was suspended for failure to
file annual reports and tax returns. In December 1988, all required reports and
tax returns were filed and Aquachlor Marketing was reinstated by the State of
Utah. In December 1988, Aquachlor Marketing merged with Aquachlor, Inc., a
Nevada corporation incorporated on December 20, 1988. The Nevada corporation
became the surviving entity and changed its name to Deltavision, Inc. In March
1997, Deltavision, Inc. received a Certificate of Revival from the State of
Nevada using the name First Deltavision, Inc. In March 2004, First Deltavision,
Inc. changed its name to Integrated Healthcare Holdings, Inc.
On March 8, 2005, the Company completed its acquisition (the "Acquisition")
of four Orange County, California hospitals and associated real estate,
including: (i) 282-bed Western Medical Center--Santa Ana, CA; (ii) 188-bed
Western Medical Center--Anaheim, CA; (iii) 178-bed Coastal Communities Hospital
in Santa Ana, CA; and (iv) 114-bed Chapman Medical Center in Orange, CA
(collectively, the "Hospitals") from Tenet Healthcare Corporation ("Tenet"). The
Hospitals were assigned to four wholly-owned subsidiaries of the Company formed
for the purpose of completing the Acquisition. The Company also acquired the
following real estate, leases and assets associated with the Hospitals: (i) a
fee interest in the Western Medical Center at 1001 North Tustin Avenue, Santa
Ana, CA, a fee interest in the administration building at 1301 North Tustin
Avenue, Santa Ana, CA, certain rights to acquire condominium suites located in
the medical office building at 999 North Tustin Avenue, Santa Ana, CA, and the
business known as the West Coast Breast Cancer Center; (ii) a fee interest in
the Western Medical Center at 1025 South Anaheim Blvd., Anaheim, CA; (iii) a fee
interest in the Coastal Communities Hospital at 2701 South Bristol Street, Santa
Ana, CA, and a fee interest in the medical office building at 1901 North College
Avenue, Santa Ana, CA; (iv) a lease for the Chapman Medical Center at 2601 East
Chapman Avenue, Orange, CA, and a fee interest in the medical office building at
2617 East Chapman Avenue, Orange, CA; and (v) equipment and contract rights
associated with the Hospitals.
The results of operations of the acquired assets are included in the
Company's consolidated statements of operations from the date of Acquisition
(March 8, 2005).
5
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
BASIS OF PRESENTATION - The accompanying unaudited consolidated financial
statements have been prepared on a going concern basis, which contemplates the
realization of assets and settlement of obligations in the normal course of
business. The Company generated income of $2,535,477 (primarily attributable to
a gain from change in fair value of derivative of $8,218,019) during the three
months ended March 31, 2006 and has a working capital deficit of $80,176,753 at
March 31, 2006. For the three months ended March 31, 2006, cash used in
operations was $8,708,059.
On or around May 9, 2005, the Company received notice that it was in
default of a credit agreement comprised of a $50 million acquisition loan (the
"Acquisition Loan") and a $30 million working capital line of credit (the "Line
of Credit"). Outstanding borrowings under the line of credit were $25,330,734 as
of March 31, 2006 and December 31, 2005. On December 12, 2005, the Company
entered into an additional credit agreement for $10,700,000, due December 12,
2006, which included an amendment that (i) declared cured the aforementioned
default, (ii) required the Company to pay $5,000,000 against its Acquisition
Loan, (iii) required the Company to obtain $10,700,000 in additional new capital
contributions to pay in full and retire all amounts due and owing under the
additional credit agreement and (iv) included certain indemnities and releases
in favor of the lender.
These factors, among others, indicate a need for the Company to take action
to resolve its financing issues and operate its business as a going concern. In
our Annual Report for the year ended December 31, 2005, our independent
accountants expressed a substantial doubt about the Company's ability to
continue as a going concern. Management is working on improvements in several
areas that the Company believes will help to mitigate its financing issues,
including (i) improved contracted reimbursements and governmental subsidies for
indigent care, (ii) reduction in operating expenses, and (iii) reduction in the
costs of borrowed capital.
We believe that we can reduce our costs of borrowed capital by replacing
debt with new equity. We are seeking new equity investments in the Company;
however we have not yet secured alternative sources of capital or re-negotiated
our commitments with our lenders. There can be no assurance that we will be able
to raise additional funds on terms acceptable to us or at all. Such additional
equity, if available, is likely to substantially dilute the interest of our
current shareholders in the Company. In addition, changes in the level of
investment are subject to the approval of the Company's Board of Directors,
which is currently comprised of three representatives of the lead investor, two
outside directors, and one officer of the Company and, accordingly, may not be
assured.
CONSOLIDATION - The consolidated financial statements include the accounts
of the Company and its wholly owned subsidiaries, the Hospitals and Mogel
Management Group, Inc. ("MMG").
As discussed further in Note 8, the Company's management has determined
that Pacific Coast Holdings Investment, LLC ("PCHI"), is a variable interest
entity as defined in Financial Accounting Standards Board ("FASB")
Interpretation Number 46R ("FIN 46R") "Consolidation of Variable Interest
Entities (revised December 2003)--an interpretation of ARB No. 51" and,
accordingly, the financial statements of PCHI are included in the accompanying
consolidated financial statements.
All significant intercompany accounts and transactions have been eliminated
in consolidation.
NET OPERATING REVENUES - Net operating revenues are recognized in the
period in which services are performed and are recorded based on established
billing rates (gross charges) less estimated discounts for contractual
allowances, principally for patients covered by Medicare, Medicaid, managed care
and other health plans. Gross charges are retail charges. They are not the same
as actual pricing, and they generally do not reflect what a hospital is
ultimately paid and therefore are not displayed in the consolidated statements
of operations. Hospitals are typically paid amounts that are negotiated with
insurance companies or are set by the government. Gross charges are used to
calculate Medicare outlier payments and to determine certain elements of payment
under managed care contracts (such as stop-loss payments). Because Medicare
requires that a hospital's gross charges be the same for all patients
(regardless of payer category), gross charges are also what hospitals charge all
other patients prior to the application of discounts and allowances.
6
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
Revenues under the traditional fee-for-service Medicare and Medicaid
programs are based primarily on prospective payment systems. Discounts for
retrospectively cost based revenues and certain other payments, which are based
on the Hospitals' cost reports, are estimated using historical trends and
current factors. Cost report settlements for retrospectively cost-based revenues
under these programs are subject to audit and administrative and judicial
review, which can take several years until final settlement of such matters are
determined and completely resolved. Since the laws, regulations, instructions
and rule interpretations governing Medicare and Medicaid reimbursement are
complex and change frequently, the estimates recorded by the Hospitals could
change by material amounts. The Company has established a settlement receivable
as of March 31, 2006 and December 31, 2005 of $1,845,511 and $2,273,248,
respectively.
Outlier payments, which were established by Congress as part of the
diagnosis-related groups (DRG) prospective payment system, are additional
payments made to hospitals for treating Medicare patients who are costlier to
treat than the average patient in the same DRG. To qualify as a cost outlier, a
hospital's billed (or gross) charges, adjusted to cost, must exceed the payment
rate for the DRG by a fixed threshold established annually by the Centers for
Medicare and Medicaid Services of the United State Department of Health and
Human Services (CMS). Under Sections 1886(d) and 1886(g) of the Social Security
Act, CMS must project aggregate annual outlier payments to all prospective
payment system hospitals to be not less than 5% or more than 6% of total DRG
payments (Outlier Percentage). The Outlier Percentage is determined by dividing
total outlier payments by the sum of DRG and outlier payments. CMS annually
adjusts the fixed threshold to bring expected outlier payments within the
mandated limit. A change to the fixed threshold affects total outlier payments
by changing (1) the number of cases that qualify for outlier payments, and (2)
the dollar amount hospitals receive for those cases that still qualify. The most
recent change to the cost outlier threshold that became effective on October 1,
2005 was a decrease from $25,800 to $23,600, which CMS projects will result in
an Outlier Percentage of 5.1%. The Medicare fiscal intermediary calculates the
cost of a claim by multiplying the billed charges by the cost-to-charge ratio
from the hospital's most recent filed cost report.
The Hospitals received new provider numbers in 2005 and, because there was
no specific history, the Hospitals were reimbursed for outliers based on
published statewide averages. If the computed cost exceeds the sum of the DRG
payment plus the fixed threshold, the hospital receives 80% of the difference as
an outlier payment. Medicare has reserved the option of adjusting outlier
payments, through the cost report, to the hospital's actual cost-to-charge
ratio. Upon receipt of the current payment cost-to-charge ratios from the fiscal
intermediary, any variance between current payments and the estimated final
outlier settlement will be reported. As of March 31, 2006 and December 31, 2005,
the Company recorded reserves for excess outlier payments due to the difference
between the Hospitals actual cost to charge rates and the statewide average in
the amount of $2,890,637 and $2,196,626, respectively. These reserves offset
against the third party settlement receivables and are included as a net payable
of $1,045,126 in due to governmental payers as of March 31, 2006, and as a net
receivable of $103,626 in due from governmental payers as of December 31, 2005.
The Hospitals receive supplemental payments from the State of California to
support indigent care (MediCal Disproportionate Share Hospital payments or
"DSH"). During the three months ended March 31, 2006, the Hospitals received
payments of $575,000. The Company estimates an additional $6,587,219 is
receivable based on State correspondence, which is included in due from
governmental payers in the consolidated balance sheet as of March 31, 2006
($2,921,150 at December 31, 2005). In April 2006, $3,811,305 of the $6,587,219
was received.
Revenues under managed care plans are based primarily on payment terms
involving predetermined rates per diagnosis, per-diem rates, discounted
fee-for-service rates and/or other similar contractual arrangements. These
revenues are also subject to review and possible audit by the payers. The payers
are billed for patient services on an individual patient basis. An individual
patient's bill is subject to adjustment on a patient-by-patient basis in the
ordinary course of business by the payers following their review and
adjudication of each particular bill. The Hospitals estimate the discounts for
contractual allowances utilizing billing data on an individual patient basis. At
the end of each month, the Hospitals estimate expected reimbursement for patient
of managed care plans based on the applicable contract terms. These estimates
are continuously reviewed for accuracy by taking into consideration known
contract terms as well as payment history. Although the Hospitals do not
7
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
separately accumulate and disclose the aggregate amount of adjustments to the
estimated reimbursements for every patient bill, management believes the
estimation and review process allows for timely identification of instances
where such estimates need to be revised. Management does not believe there were
any adjustments to estimates of individual patient bills that were material to
its net operating revenues.
Management is not aware of any material claims, disputes, or unsettled
matters with any payers that would affect revenues that have not been adequately
provided for in the accompanying consolidated financial statements.
The Hospitals provide charity care to patients whose income level is below
200% of the Federal Poverty Level with only a co-payment charged to the patient.
The Hospitals' policy is to not pursue collection of amounts determined to
qualify as charity care; and accordingly, the Hospitals do not report the
amounts in net operating revenues or in the provision for doubtful accounts.
Patients whose income level is between 200% and 300% of the Federal Poverty
Level may also be considered under a catastrophic provision of the charity care
policy. Patients without insurance who do not meet the Federal Poverty Level
guidelines are offered assistance in applying for Medicaid and other programs
they may be eligible for, such as state disability, Victims of Crime, or county
indigent programs. Patient advocates from the Hospitals' Medical Eligibility
Program (MEP) screen patients in the hospital and determine potential linkage to
financial assistance programs. They also expedite the process of applying for
these government programs. Based on average revenue for comparable services from
all other payers, revenues foregone under the charity policy, including indigent
care accounts, for the three months ended March 31, 2006 were approximately $1.6
million.
Receivables from patients who are potentially eligible for Medicaid are
classified as Medicaid pending under the MEP, with appropriate contractual
allowances recorded. If the patient does not quality for Medicaid, the
receivables are reclassified to charity care and written off, or they are
reclassified to self-pay and adjusted to their net realizable value through the
provision for doubtful accounts. Reclassifications of Medicaid pending accounts
to self-pay do not typically have a material impact on the results of operations
as the estimated Medicaid contractual allowances initially recorded are not
materially different than the estimated provision for doubtful accounts recorded
when the accounts are reclassified. All accounts classified as pending Medicaid
are fully reserved when they reach 180 days old.
PROVISION FOR DOUBTFUL ACCOUNTS - The Company sells substantially all of
its billed accounts receivable to a financing company (see Note 3). The Company
provides for accounts receivable that could become uncollectible by establishing
an allowance to reduce the carrying value of such receivables to their estimated
net realizable value. The allowance for doubtful accounts for accounts not sold
as of March 31, 2006 and December 31, 2005 was $2,432,084 and $3,148,276,
respectively. The Hospitals estimate this allowance based on the aging of their
accounts receivable, historical collections experience for each type of payer
and other relevant factors. There are various factors that can impact the
collection trends, such as changes in the economy, which in turn have an impact
on unemployment rates and the number of uninsured and underinsured patients,
volume of patients through the emergency department, the increased burden of
co-payments to be made by patients with insurance and business practices related
to collection efforts. These factors continuously change and can have an impact
on collection trends and the estimation process.
The Company's policy is to attempt to collect amounts due from patients,
including co-payments and deductibles due from patients with insurance, at the
time of service while complying with all federal and state laws and regulations,
including, but not limited to, the Emergency Medical Treatment and Labor Act
(EMTALA). Generally, as required by EMTALA, patients may not be denied emergency
treatment due to inability to pay. Therefore, until the legally required medical
screening examination is complete and stabilization of the patient has begun,
services are performed prior to the verification of the patient's insurance, if
any. In non-emergency circumstances or for elective procedures and services, it
is the Hospitals' policy, when appropriate, to verify insurance prior to a
patient being treated. During the three months ended March 31, 2006 and 2005,
the Company recorded provisions for doubtful accounts of $8,298,928 and
$3,141,406, respectively.
CASH AND CASH EQUIVALENTS - The Company considers all highly liquid debt
investments purchased with a maturity of three months or less to be cash
equivalents.
8
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
RESTRICTED CASH - Restricted cash consists of amounts deposited in short
term time deposits with a commercial bank to collateralize the Company's
obligations pursuant to certain agreements. A certificate of deposit for
$4,419,636 is pledged to a commercial bank that issued a standby letter of
credit for $4,200,000 in favor of an insurance company that is the administrator
of the Company's self-insured workers compensation plan. A certificate of
deposit for $552,000 is pledged as a reserve under the Company's capitation
agreement with CalOptima.
PROPERTY AND EQUIPMENT - Property and equipment are stated at cost, less
accumulated depreciation and any impairment write-downs related to assets held
and used. Additions and improvements to property and equipment are capitalized
at cost. Expenditures for maintenance and repairs are charged to expense as
incurred. Capital leases are recorded at the beginning of the lease term as
assets and liabilities. The value recorded is the lower of either the present
value of the minimum lease payments or the fair value of the asset. Such assets,
including improvements, are amortized over the shorter of either the lease term
or their estimated useful life.
The Company uses the straight-line method of depreciation for buildings and
improvements, and equipment over their estimated useful lives of 25 years and 3
to 15 years, respectively.
The Company evaluates its long-lived assets for possible impairment
whenever circumstances indicate that the carrying amount of the asset, or
related group of assets, may not be recoverable from estimated future cash
flows. However, there is an evaluation performed at least annually. Fair value
estimates are derived from independent appraisals, established market values of
comparable assets or internal calculations of estimated future net cash flows.
The estimates of future net cash flows are based on assumptions and projections
believed by management to be reasonable and supportable. These assumptions take
into account patient volumes, changes in payer mix, revenue, and expense growth
rates and changes in legislation and other payer payment patterns. The Company
believes there has been no impairment in the carrying value of its property and
equipment at March 31, 2006.
MEDICAL CLAIMS INCURRED BUT NOT REPORTED - The Company is contracted with
CalOptima, which is a county sponsored entity that operates similarly to an HMO,
to provide health care services to indigent patients at a fixed amount per
enrolled member per month. The Company receives payments from CalOptima based on
a fixed fee and the number of enrolled members at the Hospitals. The Company
recognizes these capitation fees as revenues on a monthly basis for providing
comprehensive health care services for the period.
In certain circumstances, members will receive health care services from
hospitals not owned by the Company. In these cases, the Company records
estimates of patient member claims incurred but not reported (IBNR) for services
provided by other health care institutions. Claims incurred but not reported are
estimated using historical claims patterns, current enrollment trends, hospital
pre-authorizations, member utilization patterns, timeliness of claims
submissions, and other factors. There can be no assurance that the ultimate
liability will not exceed our estimates. Adjustments to the estimated IBNR
reserves are recorded in our results of operations in the periods when such
amounts are determined. Per guidance under Statement of Financial Accounting
Standards ("SFAS") No. 5, "Accounting for Contingencies," the Company accrues
for IBNR reserves when it is probable that expected future health care costs and
maintenance costs under an existing contract have been incurred and the amount
can be reasonably estimable. The Company records these IBNR claim reserves
against its net operating revenues. During the three months ended March 31,
2006, the Company recorded net revenues from CalOptima capitation of
approximately $1,401,000, net of an increase in IBNR reserves of approximately
$547,000, resulting in IBNR reserves of $5,520,000. The Company's direct cost of
providing services to patient members in its facilities is recorded as an
operating expense.
STOCK-BASED COMPENSATION - SFAS No. 123, "Accounting for Stock-Based
Compensation," encourages, but does not require, companies to record
compensation cost for stock-based employee compensation plans at fair value. The
Company has adopted SFAS 123. As of March 31, 2006, the Company had not granted
any stock options to employees.
9
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
FAIR VALUE OF FINANCIAL INSTRUMENTS - The Company's financial instruments
recorded in the consolidated balance sheets include cash and cash equivalents,
restricted cash, receivables, accounts payable, and other liabilities including
warrant liability and long term debt. Management believes that the recorded
value of such financial instruments is a reasonable estimate of their fair
value. To finance the Acquisition, the Company entered into agreements that
contained warrants (see Notes 5 and 7), which are required to be accounted for
as derivative liabilities in accordance with SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities."
A derivative is an instrument whose value is derived from an underlying
instrument or index such as a future, forward, swap, or option contract, or
other financial instrument with similar characteristics, including certain
derivative instruments embedded in other contracts ("embedded derivatives") and
for hedging activities. As a matter of policy, the Company does not invest in
separable financial derivatives or engage in hedging transactions. However, the
Company may engage in complex transactions in the future that also may contain
embedded derivatives. Derivatives and embedded derivatives, if applicable, are
measured at fair value and marked to market through earnings.
WARRANTS - In connection with its Acquisition of the Hospitals, the Company
entered into complex transactions that contained embedded derivatives in the
form of warrants (see Notes 5 and 7).
NET LOSS PER COMMON SHARE - Net loss per share is calculated in accordance
with SFAS No. 128, "Earnings per Share." Basic net loss per share is based upon
the weighted average number of common shares outstanding. Due to the loss from
operations incurred by the Company for the three months ended March 31, 2005,
the anti-dilutive effect of options and warrants has not been considered in the
calculations of loss per share for that period.
GOODWILL AND INTANGIBLE ASSETS - In accordance with SFAS No. 141, "Business
Combinations," and SFAS No. 142, "Goodwill and Intangible Assets," acquisitions
subsequent to June 30, 2001 must be accounted for using the purchase method of
accounting. The cost of intangible assets with indefinite lives and goodwill are
no longer amortized, but are subject to an annual impairment test based upon
fair value.
Goodwill and intangible assets principally result from business
acquisitions. The Company accounts for business acquisitions by assigning the
purchase price to tangible and intangible assets and liabilities. Assets
acquired and liabilities assumed are recorded at their fair values; the excess
of the purchase price over the net assets acquired is recorded as goodwill. As
of March 31, 2006 no goodwill had been recorded on acquisitions.
INCOME TAXES - The Company accounts for income taxes in accordance with
SFAS No. 109, "Accounting for Income Taxes," which requires the liability
approach for the effect of income taxes. Under SFAS 109, deferred income tax
assets and liabilities are determined based on the differences between the book
and tax basis of assets and liabilities and are measured using the currently
enacted tax rates and laws
The preparation of consolidated financial statements in conformity with
U.S. GAAP requires us to make estimates and assumptions that affect the reported
amount of tax-related assets and liabilities and income tax provisions. The
Company assesses the recoverability of the deferred tax assets on an ongoing
basis. In making this assessment the Company is required to consider all
available positive and negative evidence to determine whether, based on such
evidence, it is more likely than not that some portion or all of our net
deferred assets will be realized in future periods. This assessment requires
significant judgment. In addition, the Company has made significant estimates
involving current and deferred income taxes, tax attributes relating to the
interpretation of various tax laws, historical bases of tax attributes
associated with certain tangible and intangible assets and limitations
surrounding the realization of our deferred tax assets. As of March 31, 2006 and
December 31, 2005, the Company has established a 100% valuation allowance
against its deferred tax assets.
10
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
INSURANCE - The Company accrues for estimated general and professional
liability claims, to the extent not covered by insurance, when they are probable
and reasonably estimable. The Company has purchased as primary coverage a
claims-made form insurance policy for general and professional liability risks.
The policy limits are $1,000,000 per individual claim and $5,000,000 in the
aggregate. For the policy year ended March 8, 2006, retentions by the Company
were $500,000 per claim up to a maximum of $3,000,000 for claims covered during
that policy year. As of March 8, 2006, those retentions changed to $2,000,000
per claim up to a maximum of $8,000,000 for the policy year. Estimated losses
within general and professional liability retentions from claims incurred and
reported, along with incurred but not reported (IBNR) claims, are accrued based
upon actuarially determined projections and are discounted to their net present
value using a weighted average risk-free discount rate of 5%. To the extent that
subsequent claims information varies from our estimates, the liability is
adjusted in the period such information becomes available. As of March 31, 2006
and December 31, 2005, the Company had accrued approximately $2.9 and $2.3
million, respectively, comprised of approximately $0.6 and $0.6 million,
respectively, in incurred and reported claims, along with approximately $2.3 and
$1.7 million, respectively, in IBNR and an allowance for potential increases in
the costs of those claims incurred and reported.
The Company has purchased as primary coverage occurrence form insurance
policies to help fund its obligations under its workers' compensation program
for which the Company is responsible to reimburse the insurance carrier for
losses within a deductible of $500,000 per claim, to a maximum aggregate
deductible of $9,000,000. The company accrues for estimated workers'
compensation claims, to the extent not covered by insurance, when they are
probable and reasonably estimable. The ultimate costs related to this program
include expenses for deductible amounts associated with claims incurred and
reported in addition to an accrual for the estimated expenses incurred in
connection with IBNR claims. Claims are accrued based upon actuarially
determined projections and are discounted to their net present value using a
weighted average risk-free discount rate of 5%. To the extent that subsequent
claims information varies from our estimates, the liability is adjusted in the
period such information becomes available. As of March 31, 2006 and December 31,
2005, the Company had accrued approximately $1.7 and $1.3 million, respectively,
comprised of approximately $0.4 and $0.3 million, respectively, in incurred and
reported claims, along with $1.3 and $1.0 million, respectively, in IBNR.
The Company has also purchased all risk umbrella liability policies with
aggregate limits of $19,000,000. The umbrella policies provide coverage in
excess of the of the primary layer and applicable retentions for all of its
insured liability risks, including general and professional liability and the
workers' compensation program.
SEGMENT REPORTING - The Company operates in one line of business, the
provision of health care services through the operation of general hospitals and
related health care facilities. Our general hospitals generated substantially
all of our net operating revenues during the three months ended March 31, 2006
and 2005.
Our four general hospitals and our related health care facilities operate
in one geographic region in Orange County, California. This region is our
operating segment, as that term is defined by SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information." The regions' economic
characteristics, the nature of their operations, the regulatory environment in
which they operate, and the manner in which they are managed are all similar. In
addition, our general hospitals and related health care facilities share certain
resources and they benefit from many common clinical and management practices.
Accordingly, we aggregate the facilities into a single reportable operating
segment.
RECENTLY ENACTED ACCOUNTING STANDARDS - In February 2006, the FASB issued
SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an
amendment of FASB Statements No. 133 and 140." SFAS 155, among other things:
permits the fair value re-measurement of any hybrid financial instrument that
contains an embedded derivative that otherwise would require bifurcation and
establishes a requirement to evaluate interests in securitized financial assets
to identify interests that are freestanding derivatives or that are hybrid
financial instruments that contain an embedded derivative requiring bifurcation.
SFAS 155 is effective for all financial instruments acquired or issued in fiscal
years beginning after September 15, 2006. The Company is currently evaluating
the effect that adopting this statement will have on the Company's financial
position and results of operations.
11
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets - an amendment of FASB Statement No. 140," with respect to the
accounting for separately recognized servicing assets and servicing liabilities.
SFAS 156 permits the choice of the amortization method or the fair value
measurement method, with changes in fair value recorded in income, for the
subsequent measurement for each class of separately recognized servicing assets
and servicing liabilities. The statement is effective for years beginning after
September 15, 2006, with earlier adoption permitted. The Company is currently
evaluating the effect that adopting this statement will have on the Company's
financial position and results of operations.
RECLASSIFICATIONS - Certain reclassifications have been made to the 2005
consolidated financial statements to conform to the 2006 presentation.
NOTE 2 - ACQUISITION
The purchase price, after all purchase price adjustments, of the
Acquisition amounted to $66,246,821. The fair value of the assets acquired and
related costs consisted of the following:
Property and equipment $55,833,952
Inventories of supplies 6,018,995
Prepaid expenses and other current assets 2,460,874
-----------
64,313,821
Debt issuance costs 1,933,000
-----------
$66,246,821
===========
The Company financed the Acquisition and related financing costs (see Note
5) by obtaining a $50 million Acquisition Loan, drawing $3 million on a working
capital line of credit, selling shares of the Company's common stock for $10.1
Million, and receiving $5 million in proceeds from minority investments in PCHI.
The amount of $64,313,821 above includes the Company's initial direct
acquisition costs of $1,142,145, consisting primarily of legal fees, which were
incurred prior to 2005.
NOTE 3 - ACCOUNTS PURCHASE AGREEMENT
In March 2005, the Company entered into a two year Accounts Purchase
Agreement (the "APA") with Medical Provider Financial Corporation I, an
unrelated party (the "Buyer"). The Buyer is an affiliate of the Lender (see Note
5). The APA provides for the sale of 100% of the Company's eligible accounts
receivable, as defined, without recourse. After accounts receivable are sold,
the APA requires the Company to provide billing and collection services,
maintain the individual patient accounts, and resolve any disputes that arise
between the Company and the patient or other third party payer. The Company
accounts for its sale of accounts receivable in accordance with SFAS No. 140,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities - A Replacement of FASB Statement 125."
The accounts receivable are sold weekly based on billings for each
Hospital. The purchase price is comprised of two components, the advance rate
amount and the deferred portion amount. The advance rate amount is based on the
historical collection experience for accounts receivable similar to those
included in a respective purchase. At the time of sale, the Buyer advances 95%
of the advance rate amount (the "95% Advance"--note; increased from 85%
effective January 1, 2006) to the Company and holds the remaining 5% as security
reserve funds on sold accounts (the "Security Reserve Funds"), which is
non-interest bearing. Except in the case of a continuing default, the Security
Reserve Funds can not exceed 25% (the "25% Cap") of the aggregate advance rate
amount, as defined, of the open purchases. The Company is charged a "purchase
discount" (the "Transaction Fee") of 1.35% per month of the advance rate amount
of each purchase until closed, at which time the Buyer deducts the Transaction
Fee from the Security Reserve Funds. Collections are applied on a dollar value
basis, not by specific identification, to the respective Hospital's most aged
open purchase. The deferred portion amount represents amounts the Company
expects to collect, based on regulations, contracts, and historical collection
experience, in excess of the advance rate amount.
12
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
The following table reconciles accounts receivable as of March 31, 2006 and
December 31, 2005, as reported, to the pro forma accounts receivable, as if the
Company had deferred recognition of the sales.
March 31, 2006 December 31, 2005
---------------------------- ----------------------------
As reported Pro forma As reported Pro forma
------------ ------------ ------------ ------------
(as restated (as restated (as restated (as restated
- Note 12) - Note 12) - Note 12) - Note 12)
Accounts receivable:
Governmental $ 5,732,795 $ 19,362,292 $ 10,394,875 $ 23,771,977
Non-governmental 11,602,118 51,808,270 8,728,887 45,564,554
------------ ------------ ------------ ------------
17,334,913 71,170,562 19,123,762 69,336,531
Less allowance for doubtful accounts (2,432,084) (15,140,247) (3,148,276) (17,723,163)
------------ ------------ ------------ ------------
Net patient accounts receivable 14,902,829 56,030,315 15,975,486 51,613,368
------------ ------------ ------------ ------------
Security Reserve Funds 13,021,487 - 12,127,337 -
Deferred purchase price receivables 14,354,540 - 9,337,703 -
------------ ------------ ------------ ------------
Receivable from Buyer of accounts 27,376,027 - 21,465,040 -
------------ ------------ ------------ ------------
Advance rate amount, net - (9,028,239) - (10,843,197)
Transaction Fees deducted from
Security Reserve Funds - (4,723,220) - (3,329,645)
------------ ------------ ------------ ------------
$ 42,278,856 $ 42,278,856 $ 37,440,526 $ 37,440,526
============ ============ ============ ============
Although 100% of the Company's accounts receivable, as defined, is
purchased by the Buyer, certain payments (generally payments that cannot be
attributed to specific patient account, such as third party settlements,
capitation payments and MediCal Disproportionate Share Hospital ("DSH")
subsidies (collectively "Other Payments")) are retained by the Company and not
applied to the purchases processed by the Buyer. In the opinion of our
management, after consultation with the Buyer, DSH payments and CalOptima
capitation premium payments of $0.6 and $5.1 million, respectively, for the
three months ended March 31, 2006, are excludable from application to the
Security Reserve Funds. However, if cash collections on purchases are not
sufficient to recover the Buyer's advance rate amount and related transaction
fees, the Buyer could be entitled to funds the Company has received in Other
Payments or require transfer of substitute accounts to cover any such shortfall.
Based on collection history under the APA to date, the Company's management
believes the likelihood of the Buyer exercising this right is remote.
Any other term of the APA notwithstanding, the parties agreed as follows:
(a) all accounts derived from any government program payer including, without
limitation, the Medicare, Medi-Cal, or CHAMPUS programs, shall be handled as set
forth in a Deposit Account Security Agreement entered into by the parties, which
provides for the segregation and control of governmental payments by the
Company, (b) the parties agreed to take such further actions and execute such
further agreements as are reasonably necessary to effectuate the purpose of the
APA and to comply with the laws, rules, and regulations of the Medicare and
other government programs regarding the reassignment of claims and payment of
claims to parties other than the provider ("Reassignment Rules"), and (c) until
such time as accounts are delivered by the Company to the Buyer controlled
lockbox, the Company shall at all times have sole dominion and control over all
payments due from any government program payer. The Company's management (i)
believes that the foregoing method of segregating and controlling payments
received from governmental program payers complies with all applicable
Reassignment Rules, and (ii) the Company intends to request an opinion from the
Federal Center for Medicare and Medicaid Services ("CMS") that such method is
compliant with the Reassignment Rules in the view of CMS. As of March 31,2006
the Company has $13,629,497 in governmental accounts receivable that have been
reported as sold subject to the foregoing limitation.
The Company records estimated Transaction Fees and estimated servicing
costs related to the sold accounts receivable at the time of sale. For the three
months ended March 31, 2006, the Company incurred a loss on sale of accounts
receivable of $2,807,805, which is reflected in operating expenses in the
accompanying consolidated statement of operations, and is comprised of the
following.
13
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
Transaction Fees deducted from Security Reserve Funds - closed purchases $ 1,393,575
Increase in accrued Transaction Fees - open purchases 108,208
------------
Total Transaction Fees incurred 1,501,783
------------
Servicing costs for sold accounts receivable - closed purchases 1,230,578
Increase in accrued servicing costs for sold accounts receivable - open purchases 75,444
------------
Total servicing costs incurred 1,306,022
------------
Loss on sale of accounts receivable for the three months ended March 31, 2006 $ 2,807,805
============
No accounts receivable were sold as of March 31, 2005.
Effective March 31, 2006, an amendment to the APA reduced the required
Security Reserve Funds amount as a percentage of the total advance rate amount
outstanding from 25% to 15% (the "15% Cap"). At March 31, 2006, the Security
Reserve Funds balance of $13,021,487 was in excess of the 15% Cap. As a result,
$6,677,916 was released to the Company subsequent to March 31, 2006.
NOTE 4 - PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
March 31, December 31,
2006 2005
------------ ------------
Buildings $ 33,696,897 $ 33,696,897
Land and improvements 13,522,591 13,522,591
Equipment 9,318,403 9,241,044
Buildings under lease 5,108,887 5,108,887
------------ ------------
61,646,778 61,569,419
Less accumulated depreciation (2,785,921) (2,138,134)
------------ ------------
Property and equipment, net $ 58,860,857 $ 59,431,285
============ ============
The Hospitals are affected by State of California Senate Bill 1953 (SB
1953), which requires certain seismic safety building standards for acute care
hospital facilities. The Company is currently reviewing the SB 1953 compliance
requirements and developing multiple plans of action to achieve such compliance,
the estimated time frame for complying with such requirements, and the cost of
performing necessary remediation of certain of the properties. The Company
cannot currently estimate with reasonable accuracy the remediation costs that
will need to be incurred in order to make the Hospitals SB 1953-compliant, but
such remediation costs could be significant.
NOTE 5 - DEBT
The Company's debt consists of the following:
March 31, December 31,
2006 2005
------------ ------------
Short term debt:
----------------
Secured note payable $ 10,700,000 $ 10,700,000
Less derivative - warrant liability, current (see Note 7) (10,700,000) (10,700,000)
Secured acquisition loan 45,000,000 -
Secured line of credit, outstanding borrowings 25,330,734 -
------------ ------------
Short term debt $ 70,330,734 $ -
============ ============
Long term debt:
---------------
Secured acquisition loan $ - $ 45,000,000
Secured line of credit, outstanding borrowings - 25,330,734
------------ ------------
Long term debt $ - $ 70,330,734
============ ============
14
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
ACQUISITION LOAN AND LINE OF CREDIT - In connection with the Acquisition,
the Company obtained borrowings from affiliates of Medical Capital Corporation.
Effective March 3, 2005, the Company and its subsidiaries collectively entered
into a credit agreement (the "Credit Agreement") with Medical Provider Financial
Corporation II ("the Lender"), whereby the Company obtained initial financing in
the form of a loan with interest at the rate of 14% per annum in the amount of
$80,000,000 of which $30,000,000 is in the form of a non-revolving Line of
Credit and a $50,000,000 Acquisition Loan (less $5,000,000 repayment on December
12, 2005) in the form of a real estate loan (collectively, the "Obligations").
The Company used the proceeds from the $50 million Acquisition Loan and $3
million from the Line of Credit to complete the Acquisition (see Note 1). The
Line of Credit is to be used for the purpose of providing (a) working capital
financing for the Company and its subsidiaries, (b) funds for other general
corporate purposes of the Company and its subsidiaries, and (c) other permitted
purposes. Effective January 1, 2006, the Company and the Lender agreed to an
amendment to the Obligations that changed the interest rate from 14% to prime
plus 5.75%.
Interest payments are due on the Obligations on the first business day of
each calendar month while any Obligation is outstanding. The Obligations mature
at the first to occur of (i) the Commitment Termination Date for the Line of
Credit; (ii) March 2, 2007; or (iii) the occurrence or existence of a continuing
Event of Default under any of the Obligations. The Commitment Termination Date
means the earliest of (a) thirty calendar days prior to March 2, 2007; (b) the
date of termination of Lender's obligations to make Advances under the Line of
Credit or permit existing Obligations to remain outstanding, (c) the date of
prepayment in full by the Company and its subsidiaries of the Obligations and
the permanent reduction of all commitments to zero dollars; or (d) March 2,
2007. Per the Credit Agreement, all future capital contributions to the Company
by Orange County Physicians Investment Network, LLC ("OC-PIN") shall be used by
the Company as mandatory prepayments of the Line of Credit.
The Acquisition Loan and Line of Credit are secured by a lien on
substantially all of the assets of the Company and its subsidiaries, including
without limitation, a pledge of the capital stock by the Company in its wholly
owned Hospitals. In addition, (i) PCHI has agreed to guaranty the payment and
performance of the Obligations, (ii) West Coast and Ganesha have
each agreed to pledge their membership interests in PCHI as security for
repayment of the Obligations, (iii) the members of West Coast have agreed to
pledge their membership interests in PCHI as security for repayment of the
Obligations, and (iv) OC-PIN (see Note 8) has agreed to guaranty the payment and
performance of all the Obligations.
CREDIT AGREEMENT FEES - Concurrently with the execution and delivery of the
Credit Agreement and as a condition to the funding of the Acquisition Loan, the
Company and its subsidiaries agreed to pay to the Lender origination fees in
amounts equal to 2% of the Credit Line, or $600,000, and 2% of the Acquisition
Loan, or $1,000,000, Such fees were required to be paid out of the Company and
its subsidiaries own funds were deemed earned in full upon receipt by the
Lender. Upon the completion of the Acquisition on March 8, 2005, the Company
paid the Lender a total of $1,600,000 in origination fees and paid the Lender's
legal fees of approximately $333,000. The Company is amortizing the debt
issuance costs of $1,933,000 over the two year term of the Obligations. During
the three months ended March 31, 2006 and 2005, the Company recognized $241,626
and $62,355, respectively, of amortization expense and has unamortized debt
issuance costs of $899,639 and $1,141,265 as of March 31, 2006 and December 31,
2005, respectively.
DEFAULT NOTICE - On or about May 9, 2005, the Company received a notice of
default from the Lender in connection with the Credit Agreement. In addition,
each of OC-PIN, PCHI, Ganesha Realty, LLC, and West Coast Holdings, LLC, which
are parties to the Credit Agreement, received a notice of default.
The notice of default asserted that (i) the Company failed to provide
satisfactory evidence that the Company received capital contributions of not
less than $15,000,000, as required under the Credit Agreement, (ii) the Company
failed to prepay $5,000,000 by the Mandatory Prepay Date as required under the
Credit Agreement, and (iii) a Material Adverse Effect had occurred under the
Credit Agreement for reasons relating primarily to OC-PIN's failure to fully
fund its obligations under its Stock Purchase Agreement with the Company.
15
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
FORBEARANCE AGREEMENT - In connection with the First Amendment (see Note
6), the Company entered into an Agreement to Forbear as of June 1, 2005 by and
among the Company, OC-PIN, West Coast Holdings, LLC and the Lender (the
"Forbearance Agreement"). Without another default, the Lender agreed for 100
days to forbear from (i) recording Notices of Default, (ii) filing a judicial
foreclosure lawsuit against the Company, OC-PIN and West Coast Holdings, LLC,
and (iii) filing lawsuits against the Company, OC-PIN and West Coast Holdings,
LLC. The interest rate on the notes was increased to the Default Rate of 19%, as
defined in the Credit Agreement, and all Obligations (as defined in the Credit
Agreement) were due and payable, as long as the events of default remain
uncured. The Company's Line of Credit facility was suspended to additional
advances. During the forbearance period of 100 days, OC-PIN and other investors
agreed to invest not less than $15 million in new equity capital in the Company
(see Note 6).
SECURED SHORT TERM NOTE - On December 12, 2005, the Company entered into a
credit agreement (the "December Credit Agreement") with the Credit Parties and
the Lender. Under the December Credit Agreement, the Lender loaned $10,700,000
to the Company as evidenced by a promissory note (the "December Note"). Interest
is payable monthly at the rate of 12% per annum and the December Note is due on
December 12, 2006. The Company may not prepay the December Note in whole or in
part.
The December Note is secured by substantially all of the Company's assets.
In addition, the Company issued a common stock warrant (the "December Note
Warrant") to the Lender as collateral under the December Note. The December Note
Warrant is exercisable by the Lender only in the event that a default has
occurred and is continuing on the December Note. The December Note Warrant
entitles the Lender to purchase the number of shares of the Company's common
stock equal in value to the amount of the December Note not repaid at maturity,
plus accrued interest and lender fees for an aggregate exercise price of $1.00,
regardless of the number of shares acquired. The December Credit Agreement
provides that "upon payment in full of the obligations, surplus net proceeds, if
any, thereafter remaining shall be paid to the Borrower, subject to the rights
of any holder of a Lien on the Collateral of which the Lender or Holder has
actual notice." The December Note Warrant is exercisable from and after December
12, 2005 until the occurrence of either a termination of the December Credit
Agreement by the Lender or the Company's payment in full of all obligations
under the December Credit Agreement. The Company is obligated to register the
estimated number of shares of common stock issuable upon exercise of the
December Note Warrant by filing a registration statement under the Securities
Act of 1933, as amended (the "Securities Act"), no later than ninety days prior
to the maturity date of the December Note. If the Company proposes to file a
registration statement under the Securities Act on or before the expiration date
of the December Note Warrant, then the Company must offer to the holder of the
December Note Warrant the opportunity to include the number of shares of common
stock as the holder may request. In accordance with U.S. GAAP, the Company has
classified the December Note as current warrant liability in the accompanying
consolidated balance sheets as of March 31, 2006 and December 31, 2005 (see Note
7).
CURE OF DEFAULT - On December 12, 2005, the Company entered into Amendment
No. 1 to the December Credit Agreement (the "Amendment"), that amends the Credit
Agreement with PCHI, OC-PIN, Ganesha Realty, LLC, West Coast Holdings, LLC (the
"Credit Parties") and the Lender. The Amendment (i) declared cured those certain
events of default set forth in the notices of default received on or about May
9, 2005, from the Lender, (ii) required the Company to pay $5,000,000 to Lender
for mandatory prepayment required under the Credit Agreement, (iii) required the
Company to obtain $10,700,000 in additional new capital contributions to pay in
full and retire all amounts due and owing under the December Note evidenced by
the December Credit Agreement and (iv) includes certain indemnities and releases
in favor of the Lender.
WAIVER OF DEFAULT - The Company is currently in default of its obligation
under its loan and security agreements to timely file financial reports with the
Securities and Exchange Commission. The lender has been notified of the
condition of default and has conditionally waived its right to accelerate
repayment of the debt subject to filing of Form 10-K for the year ended December
31, 2005 (which was filed with the SEC on July 28, 2006) and filing of this Form
10-Q for the quarter ended March 31, 2006 no later than August 10, 2006.
16
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
NOTE 6 - COMMON STOCK
STOCK PURCHASE AGREEMENT - On January 28, 2005, the Company entered into a
Stock Purchase Agreement (the "Stock Purchase Agreement") with OC-PIN, a company
founded by Dr. Anil V. Shah, the Company's chairman, and owned by a number of
physicians practicing at the acquired Hospitals, pursuant to which OC-PIN
committed to invest $30,000,000 in the Company for an aggregate of 108,000,000
shares of the Company's common stock. In addition, a prior Purchase Option
Agreement, dated November 16, 2004, between the Company and Dr. Shah, was
terminated. In 2005, the Company issued a total of 61,973,316 shares of its
common stock in consideration of $14.4 million from OC-PIN under the Stock
Purchase Agreement. The Company used the proceeds from this stock sale as part
of the consideration paid to Tenet for the Acquisition.
Under the Stock Purchase Agreement, no later than nine calendar days before
the closing of the Acquisition, OC-PIN was to deliver to the Company additional
financing totaling $20,000,000. Upon receipt of the $20,000,000, the Company was
to issue an additional 5.4 million shares of its common stock to OC-PIN.
However, OC-PIN was unable to raise the additional financing in time for the
closing of the Acquisition and OC-PIN indicated that it disagreed with the
Company's interpretation of OC-PIN's obligations under the Stock Purchase
Agreement. In order to avoid litigation, the Company agreed to extend OC-PIN's
additional $20,000,000 financing commitment, and on June 16, 2005 the Company
entered into the following new agreements with OC-PIN:
First Amendment to the Stock Purchase Agreement, dated as of June 1,
2005 (the "First Amendment"); and
Escrow Agreement, dated as of June 1, 2005, by and among the Company,
OC-PIN and City National Bank (the "Escrow Agreement").
The following material terms were contained in the First Amendment and the
Escrow Agreement:
OC-PIN's total stock purchase commitment under the Stock Purchase
Agreement was reduced from $30 million to $25 million;
A total of 57,250,000 shares of the Company's common stock previously
issued to OC-PIN were placed in an escrow account with City National
Bank in July 2005. OC-PIN had until September 1, 2005 to make monthly
installments into the escrow account up to an aggregate of
approximately $15,000,000. Such portion of the escrowed shares which
were fully paid was to be returned to OC-PIN and the balance was to be
transferred back to the Company;
OC-PIN agreed to reimburse the Company for $707,868 of its additional
debt financing costs incurred since March 8, 2005. As of March 31,
2006, $340,000 of these costs had been recovered by the Company;
The Company would work to complete a new borrowing transaction; and
Upon receipt of at least $5,000,000 of new capital under the First
Amendment, the Company would call a shareholders meeting to re-elect
directors.
Under the First Amendment and the Escrow Agreement, OC-PIN deposited a
total of $12,500,000 into the escrow account. However, following receipt of such
funds, a disagreement arose between OC-PIN and the third party which provided
$11,000,000 of the $12,500,000 deposited into the escrow account. In order to
resolve this matter and to avoid potential litigation involving the Company, the
Company agreed to return $11,000,000 of these funds and provide OC-PIN with a
limited opportunity to provide alternative financing. Therefore, effective
October 31, 2005, the Company entered into a Second Amendment to the Stock
Purchase Agreement (the "Second Amendment"), pursuant to which the Company and
OC-PIN issued escrow instructions to release escrowed funds as of November 2,
2005, terminate the Escrow Agreement and distribute the assets in the escrow
account as follows:
1. $1,500,000 of the escrowed cash, plus a pro rata portion of the
accrued interest, was delivered to the Company for payment of stock.
2. $11,000,000 of the escrowed cash, plus a pro rata portion of the
accrued interest was delivered to OC-PIN.
3. $5,798,831 of the escrowed shares of the Company's common stock were
delivered to OC-PIN.
17
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
4. 40,626,684 of the escrowed shares of the Company's common stock were
delivered to the Company.
5. OC-PIN transferred $2,800,000 from another account to the Company for
which OC-PIN received 10,824,485 of the escrowed shares.
6. The Company agreed to issue to OC-PIN 5,400,000 shares of its common
stock multiplied by the percentage of OC-PIN's payment required to be
made under the Stock Purchase Agreement, as amended, which had been
made to date. As of March 31, 2006, 3,246,201 of these shares were not
issued pending the Company's recovery of $367,868 in additional debt
financing costs pursuant to the First Amendment. The Company resolved
this matter with OC-PIN on July 25, 2006.
7. The Company granted OC-PIN the right to purchase up to $6,700,000 of
common stock within 30 calendar days following the cure of the
Company's default relating to the Credit Agreement at a price of
$0.2586728 per share or a maximum of 25,901,447 shares of its common
stock, plus interest on the purchase price at 14% per annum from
September 12, 2005 through the date of closing on the funds from
OC-PIN. Upon one or more closings on funds received under this section
of the Second Amendment, the Company shall issue an additional portion
of the 5,400,000 shares mentioned in item (6) above. As of March 31,
2006, the Company had issued 418,873 of these shares to OC-PIN.
NOTE 7 - COMMON STOCK WARRANTS
The Company entered into a Rescission, Restructuring and Assignment
Agreement with Dr. Kali Chaudhuri and Mr. William Thomas on January 27, 2005
(the "Restructuring Agreement"). Previously, the Company had obtained financing
from Dr. Chaudhuri and Mr. Thomas and had issued to them a $500,000 secured
convertible promissory note that was convertible into approximately 88.8% of the
Company's issued and outstanding common stock on a fully-diluted basis, a $10
million secured promissory note, and a Real Estate Purchase Option agreement
originally dated September 28, 2004 to purchase 100% of substantially all of the
real property in the Acquisition for $5 million (the "Real Estate Option"), all
of which together with related accrued interest payable pursuant to the terms of
the notes were rescinded and cancelled. Pursuant to the Restructuring Agreement,
the Company released its initial deposit of $10 million plus accrued interest on
the Acquisition back to Dr. Chaudhuri and issued non-convertible secured
promissory notes totaling $1,264,014 and warrants to purchase up to 74,700,000
shares of the Company's common stock (the "Warrants") to Dr. Chaudhuri and Mr.
Thomas (not to exceed 24.9% of the Company's fully diluted capital stock at the
time of exercise). In addition, the Company amended the Real Estate Option to
provide for Dr. Chaudhuri's purchase of 49% interest in PCHI for $2,450,000.
Concurrent with the close of the Acquisition, the Company repaid the
non-convertible secured promissory notes of $1,264,014 to Dr. Chaudhuri and Mr.
Thomas.
The Warrants are exercisable beginning January 27, 2007 and expire in 3.5
years from the date of issuance. The exercise price for the first 43 million
shares purchased under the Warrants is $0.003125 per share, and the exercise or
purchase price for the remaining 31.7 million shares is $0.078 per share if
exercised between January 27, 2007 and July 26, 2007, $0.11 per share if
exercised between July 27, 2007 and January 26, 2008, and $0.15 per share
thereafter.
As a result of the Company not being able to determine the maximum number
of shares that could be required to be issued under the December Note Warrant
issued on December 12, 2005 (see Note 5), the Company has determined that share
settlement of the Warrants issued on January 27, 2005 is no longer within its
control and reclassified the Warrants as a liability on December 12, 2005 in
accordance with EITF No. 00-19 "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company's Own Stock" and SFAS No. 133
"Accounting for Derivative Instruments and Hedging Activities."
18
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
Based upon a valuation obtained by the Company from an independent
valuation firm, the Company recorded an expense of $17,215,000 for the three
months ended March 31, 2005 related to the issuance of the Warrants. For the
three months ended March 31, 2006, the Company recognized a gain of $8,218,019
in change in fair value of derivative. The related warrant liability as of March
31, 2006 and December 31, 2005 is $12,846,650 and $21,064,669, respectively. The
Company computed the expense of the Warrants based on the fair value of the
underlying shares and the estimated maximum number of shares of 43,254,715 that
could be issued under the Warrants. As of December 12, 2005, there was a
substantial reduction in the shares outstanding to 83,932,316 shares as a result
of the Company's settlement with OC-PIN. However, the requirement to repay the
December Note for $10.7 million may obligate the Company to issue new shares of
its common stock prior to the expected exercise of the Warrants and the
estimated maximum number of shares exercisable of 43,254,715 accordingly remains
unchanged.
The Company computed the fair value of the Warrants based on the
Black-Scholes option pricing model with the following assumptions:
March 31, 2006 December 31, 2005
-------------- -----------------
Risk-free interest rate 4.8% 4.4%
Expected volatility 27.9% 28.6%
Dividend yield -- --
Expected life (years) 2.32 2.57
Fair value of Warrants $0.297 $0.487
Market value per share $0.30 $0.49
Management believes that the likelihood of the December Note Warrant being
exercised is reasonably possible and, in accordance with EITF No. 00-19 and SFAS
133, has included the December Note value of $10.7 million in warrant liability,
current, in the accompanying consolidated balance sheets as of March 31, 2006
and December 31, 2005. Under the terms of the December Credit Agreement, any
proceeds from the sale of stock received under the December Note Warrant that
are in excess of the December Note and related issuance costs are to be returned
to the Company. Accordingly, the fair value of the December Note Warrant would
contractually continue to be $10.7 million (plus any issuance and exercise
costs, which are considered immaterial).
The Company computed the fair value, and related number of shares, of the
December Note Warrant based on the Black-Scholes option pricing model with the
following assumptions:
March 31, 2006 December 31, 2005
-------------- -----------------
Risk-free interest rate 4.4% 4.4%
Expected volatility 23.8% 23.9%
Dividend yield -- --
Expected life (years) .70 .95
Fair value of Warrants $0.300 $0.490
Number of shares 35,666,667 21,836,735
Due to the fact that the Company emerged from the development stage in
2005, the Company computed the volatility of its stock based on an average of
the following public companies that own hospitals:
Amsurg Inc (AMSG)
Community Health Systems (CYH)
HCA Healthcare Company (HCA)
Health Management Associates Inc. (HMA)
Lifepoint Hospitals Inc. (LPNT)
Tenet Healthcare Corp. (THC)
Triad Hospitals Inc. (TRI)
Universal Health Services Inc., Class B (UHS)
Although management believes this is the most reasonable and accurate
methodology to determine the Company's volatility, the circumstances affecting
volatility of the comparable companies selected may not be an accurate predictor
of the Company's volatility.
19
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
NOTE 8 - VARIABLE INTEREST ENTITY
Concurrent with the close on the Acquisition, and pursuant to an agreement
dated September 28, 2004, as amended and restated on November 16, 2004, Dr.
Chaudhuri and Dr. Shah exercised their option to purchase all of the equity
interests in PCHI, which simultaneously acquired title to substantially all of
the real property acquired by the Company in the Acquisition. The Company
received $5 million and PCHI guaranteed the Company's Acquisition Loan.
The Company remains primarily liable under the Acquisition Loan note
notwithstanding its guarantee by PCHI, and this note is cross-collateralized by
substantially all of the Company's assets and all of the real property of the
Hospitals. All of the Company's operating activities are directly affected by
the real property that was sold to PCHI. Given these factors, the Company has
indirectly guaranteed the indebtedness of PCHI. The Company is standing ready to
perform on the Acquisition Loan should PCHI not be able to perform and has
undertaken a contingent obligation to make future payments if those triggering
events or conditions occur.
PCHI is a related party entity that is affiliated with the Company through
common ownership and control. It is owned 51% by West Coast Holdings, LLC (Dr.
Shah and investors) and 49% by Ganesha Realty, LLC (Dr. Chaudhuri and Mr.
Thomas). Under FIN 46R (see Note 1) a company is required to consolidate the
financial statements of any entity that cannot finance its activities without
additional subordinated financial support, and for which one company provides
the majority of that support through means other than ownership. Effective March
8, 2005, the Company determined that it provided the majority of financial
support to PCHI through various sources including lease payments, remaining
primarily liable under the Acquisition Loan, and cross-collateralization of the
Company's non-real estate assets to secure the Acquisition Loan. Accordingly,
the Company has included the net assets of PCHI, net of consolidation
adjustments, in its consolidated financial statements.
Consolidation adjustments to reflect the effects of the following matters
are included in the accompanying consolidated financial statements as of March
31, 2006 and December 31, 2005, and for the three months ended March 31, 2006
and 2005:
The Company's rental income and expense in the Hospitals has been
eliminated, consolidating PCHI's ownership of the land and buildings in the
accompanying financial statements. Additionally, a gain of $4,433,374 during the
year ended December 31, 2005, arising from the Company's sale of the real
property of the Hospitals to PCHI, has been eliminated to state the land and
buildings at the Company's cost.
PCHI's equity accounts have been classified as minority interest variable
interest entity.
The Company has a 25 year lease commitment to PCHI with rental payments
equal to the following components:
(1) Interest expense on the Acquisition Loan, or successor upon
refinancing, and
(2) Up to 2.5% spread if interest rate is below 12%, and
(3) Amortization of principal on successor loan.
Concurrent with the close of the Acquisition, the Company entered into a
sale-leaseback transaction with PCHI involving substantially all of the real
property acquired in the Acquisition, except for the fee interest in the medical
office building at 2617 East Chapman Avenue, for an initial term of 25 years and
option to renew for an additional 25 years. The rental payments are variable
based primarily on the terms of financing. Based on the existing arrangements,
aggregate payments are estimated to be approximately $226 million over the
remainder of the initial term.
Additionally, the tenant is responsible for seismic remediation (SB 1953)
under the terms of the lease agreement.
Subsequent to execution of the lease, the Company was required to pay down
$5 million on the Acquisition Loan. The Company is evaluating the impact this
has, if any, on the foregoing terms.
20
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
NOTE 9 - RELATED PARTY TRANSACTIONS
PCHI - The Company leases substantially all of the real property of the
acquired Tenet Hospitals from PCHI. PCHI is owned by two LLC's, which are owned
and co-managed by Dr. Shah, Dr. Chaudhuri, and Mr. Thomas. Dr. Shah is the
chairman of the Company and is also the co-manager and an investor in OC-PIN,
which is the majority shareholder of the Company. Dr. Chaudhuri and Mr. Thomas
are the holders of the Warrants to purchase up to 24.9% of the Company's fully
diluted capital stock (see Note 7). The Company has consolidated the financial
statements of PCHI in the accompanying financial statements in accordance with
FIN 46R (see Note 8). During the three months ended March 31, 2006 and 2005, the
Company incurred rent expense paid to PCHI of $1,545,156 and $523,000,
respectively, which was eliminated upon consolidation.
MANAGEMENT AGREEMENTS - In December 2004, February 2005, and March 2005,
the Company entered into seven employment agreements with its executive
officers. Four of these agreements were amended on August 5, 2006. Among other
terms, the three year, amended employment agreements provide for annual salaries
aggregating $2,790,000, total stock option grants to purchase 3,650,000 shares
of the Company's common stock at an exercise price equal to the mean average per
share for the ten days following the date of issuance with vesting at 33% per
year, and an annual bonus to be determined by the Board of Directors. As of
March 31, 2006, the Company has not issued any stock options pursuant to the
employment agreements.
NOTE 10 - EARNINGS (LOSS) PER SHARE
Earnings (loss) per share have been calculated under SFAS No. 128,
"Earnings per Share." SFAS 128 requires companies to compute earnings (loss) per
share under two different methods, basic and diluted. Basic earnings (loss) per
share is calculated by dividing the net earnings (loss) by the weighted average
shares of common stock outstanding during the period. Diluted earnings (loss)
per share is calculated by dividing the net earnings (loss) by the weighted
average shares of common stock outstanding during the period and dilutive
potential shares of common stock. Dilutive potential shares of common stock, as
determined under the treasury stock method, consist of shares of common stock
issuable upon exercise of stock warrants or options, net of shares of common
stock assumed to be repurchased by the Company from the exercise proceeds.
Since the Company incurred losses for the three months ended March 31,
2005, antidilutive potential shares of common stock, consisting of approximately
40 million shares, issuable under warrants, have been excluded from the
calculation of diluted loss per share for that period in the following table.
The following table sets forth the computation of basic and diluted earnings
(loss) per share:
Three months ended
March 31,
---------------------------
2006 2005
------------ ------------
(as restated)
Numerator:
Net income (loss) $ 2,535,477 $(19,856,619)
============ ============
Denominator:
Weighted average common shares 84,281,377 88,493,611
Warrants 42,946,229 -
------------ ------------
Denominator for diluted calculation 127,227,606 88,493,611
============ ============
Earnings (loss) per share - basic $ 0.03 $ (0.22)
Earnings (loss) per share - diluted $ 0.02 $ (0.22)
NOTE 11 - COMMITMENTS AND CONTINGENCIES
OPERATING LEASES - Concurrent with the closing of the Acquisition as of
March 8, 2005, the Company entered into a sale leaseback type agreement with a
related party entity, PCHI. The Company leases substantially all of the real
estate of the acquired Hospitals and medical office buildings from PCHI. The
term of the lease for the Hospital is approximately 25 years, commencing March
8, 2005 and terminating on February 28, 2030. The Company has the option to
extend the term of this triple net lease for an additional term of 25 years.
21
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
As noted in Note 8, PCHI is included in the Company's consolidated
financial statements. Accordingly, the Company's liability related to its lease
commitment with PCHI is eliminated in consolidation.
Additionally, in connection with the Hospital Acquisition, the Company also
assumed the leases for the Chapman facility, which include buildings, land, and
other equipment with terms that were extended concurrently with the assignment
of the leases to December 31, 2023.
The following is a schedule of the Company's future minimum operating lease
payments, excluding the triple net lease with PCHI, that have initial or
remaining non-cancelable lease terms in excess of one year as of December 31,
2005:
Year ending December 31,
------------------------
2006 $ 2,114,106
2007 1,761,247
2008 1,233,130
2009 909,600
2010 909,600
Thereafter 16,589,772
------------
$ 23,517,457
============
Total rental expense was $454,724 and $130,509 for the three months ended
March 31, 2006 and 2005, respectively.
CAPITAL LEASES - The Company has a long-term lease obligation for the
buildings at the Chapman facility. For financial reporting purposes, the lease
has been classified as a capital lease; accordingly, assets with a net book
value of $4,818,632 and $4,886,503 are included in property and equipment in the
accompanying consolidated balance sheets as of March 31, 2006 and December 31,
2005, respectively. The following is a schedule of future minimum lease payments
under the capitalized building lease together with the present value of the net
minimum lease payments as of December 31, 2005:
Year ending December 31,
------------------------
2006 $ 686,292
2007 686,292
2008 686,292
2009 686,292
2010 686,292
Thereafter 8,921,796
-----------
Total minimum lease payments 12,353,256
Less amount representing interest 7,306,703
-----------
Present value of net minimum lease payments 5,046,553
Less current portion 85,296
-----------
Long-term portion $ 4,961,257
===========
AGREEMENT FOR COMPENSATION - In connection with the close of the
Acquisition, the Company entered into an Agreement for Compensation Related to
the 999 Medical Office Building (the "Compensation Agreement") with PCHI, a
related party (see Note 9). In the amended Asset Sale Agreement with Tenet,
certain medical office condominium units (the "Condo Units") were excluded from
the Company's Hospital Acquisition due to the tenants of the Condo Units having
the right of first refusal to purchase such real property. As a result, the
Company's purchase price of the Hospitals from Tenet was reduced by $5 million.
Pursuant to the amended Asset Sale Agreement, upon the expiration of the
tenants' rights of first refusal, Tenet will transfer title to the Condo Units
to the Company in exchange for consideration of $5 million, pro rated if less
than all of the Condo Units are transferred.
22
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
Pursuant to the Compensation Agreement, the Company shall acquire title to
the Condo Units upon expiration of the tenants' rights of first refusal and then
transfer such title to the Condo Units to PCHI. In the event of the Company's
failure to obtain title to the Condo Units, the Company shall pay to PCHI a sum
to be agreed upon between the Company, PCHI, and the owners of PCHI, but not
less than the product of $2,500,000 multiplied by a fraction, the numerator of
which shall be the number of Condo Units not acquired by the Company and
transferred to PCHI, and the denominator equal to the total Condo Units of
twenty-two. The tenants are currently in litigation with Tenet related to the
purchase price of the Condo Units offered by Tenet to the tenants.
As the financial statements of the related party entity, PCHI, a variable
interest entity (see Note 8), are included in the Company's accompanying
consolidated financial statements, management has determined that any future
payment to PCHI under the Compensation Agreement would reduce the Company's gain
on sale of assets to PCHI (see Note 8).
CLAIMS AND LAWSUITS - The Company and the Hospitals are subject to various
legal proceedings, most of which relate to routine matters incidental to our
business. The results of these claims cannot be predicted, and it is possible
that the ultimate resolution of these matters, individually or in the aggregate,
may have a material adverse effect on the Company's business (both in the near
and long term), financial position, results of operations, or cash flows.
Although the Company defends itself vigorously against claims and lawsuits and
cooperates with investigations, these matters (1) could require payment of
substantial damages or amounts in judgments or settlements, which individually
or in the aggregate could exceed amounts, if any, that may be recovered under
insurance policies where coverage applies and is available, (2) cause
substantial expenses to be incurred, (3) require significant time and attention
from the Company's management, and (4) could cause the Company to close or sell
the Hospitals or otherwise modify the way its business is conducted. The Company
accrues for claims and lawsuits when an unfavorable outcome is probable and the
amount is reasonably estimable.
NOTE 12 - RESTATEMENT OF CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
During October 2006, the Company's management determined that the Company's
unaudited condensed consolidated quarterly financial statements for the periods
ended March 31, 2006 and June 30, 2006, should be restated due to an error in
the overstatement of net revenues and accounts receivable. More specifically,
the Company determined that the restatements with respect to its financial
statements for these periods were necessary to write-off patient accounts
receivable for services provided under capitated Cal Optima managed care
contracts. The correction of errors resulted in a decrease in net operating
revenues, income before minority interest and provision for income taxes and net
income of $322,887 for the three months ended March 31, 2006 and a decrease in
accounts receivable and an increase in accumulated deficit and stockholders'
deficiency of $939,678 as of March 31, 2006.
The following table sets for the amounts as originally reported in the
Company's condensed consolidated balance sheet as of March 31, 2006, and the
condensed consolidated statements of operations for the three months ended March
31, 2006 and the effects of the correction of the error as described above:
As of March 31, 2006
----------------------------
As previously
reported As restated
------------ ------------
Balance Sheet:
Accounts receivable $ 15,842,507 $ 14,902,829
Total assets 133,823,391 132,883,713
Accumulated deficit (43,798,361) (44,738,039)
Total stockholders' deficiency (27,456,327) (28,396,005)
Three months ended
March 31, 2006
----------------------------
As previously
reported As restated
------------ ------------
Statement of Operations:
Net operating revenues $ 86,486,861 $ 86,163,974
Operating loss (2,765,337) (3,088,224)
Income (loss) before minority interest
and provision for income taxes 2,758,268 2,435,381
Net income (loss) 2,858,364 2,535,477
23
The Company has determined that $616,791 of the $939,678 overstatement of
accounts receivable and understatement of accumulated deficit and stockholders'
deficiency as of March 31, 2006 related to errors that existed as of December
31, 2005. The overstatement of accounts receivable, net operating revenues,
income before minority interest and provision for income taxes and net income
and understatement of accumulated deficit and stockholders' deficiency by
$616,791 was determined by management to be immaterial to the financial
statements as of and for the year ended December 31, 2005 in accordance with
Staff Accounting Bulletin No. 108 ("SAB 108"). However, in accordance with the
dual approach outlined in SAB 108 management has determined that the impact of
the $616,791 error is material to the unaudited condensed consolidated quarterly
financial statements financial statements as of and for the three months ended
March 31, 2006. Based on management's evaluation of the errors, SAB 108 requires
the Company to correct the 2005 financial statements for the immaterial error
and make such correction to the financial statements in the filing of the next
annual report on Form 10-K.
The following table sets forth the amounts as originally reported in the
condensed consolidated balance sheet as of December 31, 2005 filed as part of
Form 10-Q for the three months ended March 31, 2006, and the effects of the
correction of the error as described above:
As of December 31, 2005
----------------------------
As previously
reported As restated
------------ ------------
Balance Sheet:
Accounts receivable $ 16,592,277 $ 15,975,486
Total assets 135,045,980 134,429,189
Accumulated deficit (46,656,725) (47,273,516)
Total stockholders' deficiency (30,446,823) (31,063,614)
24
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
FORWARD-LOOKING INFORMATION
This Quarterly Report on Form 10-Q contains forward-looking statements, as
that term is defined in the Private Securities Litigation Reform Act of 1995.
These statements relate to future events or our future financial performance. In
some cases, you can identify forward-looking statements by terminology such as
"may," "will," "should," "expects," "plans," "anticipates," "believes,"
"estimates," "predicts," "potential" or "continue" or the negative of these
terms or other comparable terminology. These statements are only predictions and
involve known and unknown risks, uncertainties and other factors, including the
risks discussed under the caption "Risk Factors" in our Annual Report on Form
10-K filed on July 28, 2006 that may cause our Company's or our industry's
actual results, levels of activity, performance or achievements to be materially
different from those expressed or implied by these forward-looking statements.
Although we believe that the expectations reflected in the forward-looking
statements are reasonable, we cannot guarantee future results, levels of
activity, performance or achievements. Except as may be required by applicable
law, we do not intend to update any of the forward-looking statements to conform
these statements to actual results.
As used in this report, the terms "we," "us," "our," "the Company,"
"Integrated Healthcare Holdings" or "IHHI" mean Integrated Healthcare Holdings,
Inc., a Nevada corporation, unless otherwise indicated.
OVERVIEW
ACQUISITION - Prior to March 8, 2005, we were primarily a development stage
company with no material operations and no revenues from operations. On
September 29, 2004, the Company entered into a definitive agreement to acquire
four hospitals from subsidiaries of Tenet Healthcare Corporation ("Tenet"), and
completed the transaction on March 8, 2005 (the "Acquisition"). Effective March
8, 2005, we acquired and began operating the following four hospital facilities
in Orange County, California (referred to in this report as our "Hospitals"):
o 282-bed Western Medical Center in Santa Ana;
o 188-bed Western Medical Center in Anaheim;
o 178-bed Coastal Communities Hospital in Santa Ana; and
o 114-bed Chapman Medical Center in Orange.
We enter into agreements with third-party payers, including government
programs and managed care health plans, under which rates are based upon
established charges, the cost of providing services, predetermined rates per
diagnosis, fixed per diem rates or discounts from established charges. During
the 24 days ended March 31, 2005, substantially all of Tenet's negotiated rate
agreements were assigned to our Hospitals. Our own Medicare provider numbers
were received in April 2005. California State Medicaid Program provider numbers
were received in June 2005.
ACQUISITION DEBT - Effective March 3, 2005, in connection with the
Acquisition, the Company and its subsidiaries collectively entered into a credit
agreement (the "Credit Agreement") with Medical Provider Financial Corporation
II ("the Lender"), whereby the Company obtained initial financing in the form of
a loan with interest at the rate of 14% per annum in the amount of $80,000,000
of which $30,000,000 is in the form of a non-revolving Line of Credit and
$50,000,000 (less $5,000,000 repayment on December 12, 2005) is in the form of
an Acquisition Loan (collectively, the "Obligations"). The Company used the
proceeds from the $50 million Acquisition Loan and $3 million from the Line of
Credit to complete the Acquisition. The Acquisition Loan and Line of Credit are
secured by a lien on substantially all of the assets of the Company and its
subsidiaries, including without limitation, a pledge of the capital stock by the
Company in its wholly owned Hospitals.
LONG TERM LEASE COMMITMENT WITH VARIABLE INTEREST ENTITY - Concurrent with
the close on the Acquisition, the Company sold substantially all of the real
property acquired in the Acquisition to Pacific Coast Holdings Investment, LLC
("PCHI"). The Company sold $5 million in limited partnership interests to
finance the Acquisition and PCHI guaranteed the Company's Acquisition Loan. PCHI
is a related party entity that is affiliated with the Company through common
ownership and control. Upon such sale, the Company entered into a 25 year lease
agreement with PCHI involving substantially all of the real property acquired in
the Acquisition. In accordance with Financial Accounting Standards Board
Interpretation Number 46R, "Consolidation of Variable Interest Entities (revised
December 2003)--an interpretation of ARB No. 51," PCHI is a variable interest
entity and has been included in the accompanying consolidated financial
statements as of March 31, 2006 and December 31, 2005, and for the three months
ended March 31, 2006 and 2005.
25
The Company remains primarily liable under the Acquisition Loan note
notwithstanding its guarantee by PCHI, and this note is cross-collateralized by
substantially all of the Company's assets and all of the real property of the
Hospitals. All of the Company's operating activities are directly affected by
the real property that was sold to PCHI. Given these factors, the Company has
indirectly guaranteed the indebtedness of PCHI. The Company is standing ready to
perform on the Acquisition Loan should PCHI not be able to perform and has
undertaken a contingent obligation to make future payments if those triggering
events or conditions occur.
ACCOUNTS PURCHASE AGREEMENT - In March 2005, the Company entered into a two
year Accounts Purchase Agreement (the "APA") with Medical Provider Financial
Corporation I, an unrelated party (the "Buyer"). The Buyer is an affiliate of
the Lender (see Note 5). The APA provides for the sale of 100% of the Company's
eligible accounts receivable, as defined, without recourse. After accounts
receivable are sold, the APA requires the Company to provide billing and
collection services, maintain the individual patient accounts, and resolve any
disputes that arise between the Company and the patient or other third party
payer. The Company accounts for its sale of accounts receivable in accordance
with SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities - A Replacement of FASB Statement 125."
The accounts receivable are sold weekly based on billings for each
Hospital. The purchase price is comprised of two components, the advance rate
amount and the deferred portion amount. The advance rate amount is based on the
historical collection experience for accounts receivable similar to those
included in a respective purchase. At the time of sale, the Buyer advances 95%
of the advance rate amount (the "95% Advance"-note; increased from 85% effective
January 1, 2006) to the Company and holds the remaining 5% as security reserve
funds on sold accounts (the "Security Reserve Funds"), which is non-interest
bearing. Except in the case of a continuing default, the Security Reserve Funds
can not exceed 25% (the "25% Cap") of the aggregate advance rate amount, as
defined, of the open purchases. The Company is charged a "purchase discount"
(the "Transaction Fee") of 1.35% per month of the advance rate amount of each
purchase until closed, at which time the Buyer deducts the Transaction Fee from
the Security Reserve Funds. Collections are applied on a dollar value basis, not
by specific identification, to the respective Hospital's most aged open
purchase. The deferred portion amount represents amounts the Company expects to
collect, based on regulations, contracts, and historical collection experience,
in excess of the advance rate amount.
The following table reflects the components of accounts receivable and
receivable from Buyer of accounts as of March 31, 2006 and December 31, 2005.
March 31, December 31,
2006 2005
------------ ------------
(as restated) (as restated)
Accounts receivable:
Governmental $ 5,732,795 $10,394,875
Non-governmental 11,602,118 8,728,887
------------ ------------
17,334,913 19,123,762
Less allowance for doubtful accounts (2,432,084) (3,148,276)
------------ ------------
Net patient accounts receivable 14,902,829 15,975,486
------------ ------------
Security Reserve Funds 13,021,487 12,127,337
Deferred purchase price receivables 14,354,540 9,337,703
------------ -----------
Receivable from Buyer of accounts 27,376,027 21,465,040
------------ ------------
$ 42,278,856 $ 37,440,526
============ ============
Although 100% of the Company's accounts receivable, as defined, is
purchased by the Buyer, certain payments (generally payments that cannot be
attributed to specific patient account, such as third party settlements,
capitation payments and MediCal Disproportionate Share Hospital ("DSH")
subsidies (collectively "Other Payments") are retained by the Company and not
applied to the purchases processed by the Buyer. In the opinion of our
management, after consultation with the Buyer, DSH payments and CalOptima
capitation premium payments of $0.6 and $5.1 million, respectively, for the
three months ended March 31, 2006, are excludable from application to the
Security Reserve Funds. However, if cash collections on purchases are not
sufficient to recover the Buyer's advance rate amount and related transaction
fees, the Buyer could be entitled to funds the Company has received in Other
Payments or require transfer of substitute accounts to cover any such shortfall.
Based on collection history under the APA to date, the Company's management
believes the likelihood of the Buyer exercising this right is remote.
26
Any other term of the APA notwithstanding, the parties agreed as follows:
(a) all accounts derived from any government program payer including, without
limitation, the Medicare, Medi-Cal, or CHAMPUS programs, shall be handled as set
forth in a Deposit Account Security Agreement entered into by the parties, which
provides for the segregation and control of governmental payments by the
Company, (b) the parties agreed to take such further actions and execute such
further agreements as are reasonably necessary to effectuate the purpose of the
APA and to comply with the laws, rules, and regulations of the Medicare and
other government programs regarding the reassignment of claims and payment of
claims to parties other than the provider ("Reassignment Rules"), and (c) until
such time as accounts are delivered by the Company to the Buyer controlled
lockbox, the Company shall at all times have sole dominion and control over all
payments due from any government program payer. The Company's management (i)
believes that the foregoing method of segregating and controlling payments
received from governmental program payers complies with all applicable
Reassignment Rules, and (ii) the Company intends to request an opinion from the
Federal Center for Medicare and Medicaid Services ("CMS") that such method is
compliant with the Reassignment Rules in the view of CMS. As of March 31,2006
the Company has $13,629,497 in governmental accounts receivable that have been
reported as sold subject to the foregoing limitation.
The Company records estimated Transaction Fees and estimated servicing
costs related to the sold accounts receivable at the time of sale. For the three
months ended March 31, 2006, the Company incurred a loss on sale of accounts
receivable of $2,807,805. No accounts receivable were sold as of March 31, 2005.
Effective March 31, 2006, an amendment to the APA reduced the required
Security Reserve Funds amount as a percentage of the total advance rate amount
outstanding from 25% to 15% (the "15% Cap"). At March 31, 2006, the Security
Reserve Funds balance of $13,021,487 was in excess of the 15% Cap. As a result,
$6,677,916 was released to the Company subsequent to March 31, 2006.
COMMON STOCK WARRANTS - On January 27, 2005, the Company entered into a
Rescission, Restructuring and Assignment Agreement with Dr. Kali Chaudhuri and
Mr. William Thomas, both of whom have ownership interests in PCHI (the
"Restructuring Agreement"). Previously, the Company had obtained financing from
Dr. Chaudhuri and Mr. Thomas and had issued to them a $500,000 secured
convertible promissory note that was convertible into approximately 88.8% of the
Company's issued and outstanding common stock on a fully-diluted basis, a $10
million secured promissory note, and a Real Estate Purchase Option agreement
originally dated September 28, 2004 to purchase 100% of substantially all of the
real property in the Acquisition for $5 million (the "Real Estate Option"), all
of which together with related accrued interest payable pursuant to the terms of
the notes were rescinded and cancelled. Pursuant to the Restructuring Agreement,
the company released its initial deposit of $10 million plus accrued interest on
the Acquisition back to Dr. Chaudhuri and issued non-convertible secured
promissory notes totaling $1,264,014 and warrants to purchase up to 74,700,000
shares of the Company's common stock (the "Warrants") to Dr. Chaudhuri and Mr.
Thomas (not to exceed 24.9% of the Company's fully diluted capital stock at the
time of exercise). Concurrent with the close of the Acquisition, the Company
repaid the non-convertible secured promissory notes of $1,264,014 to Dr.
Chaudhuri and Mr. Thomas.
The Warrants are exercisable beginning January 27, 2007 and expire 3.5
years from the date of issuance. The exercise price for the first 43 million
shares purchased under the Warrants is $0.003125 per share, and the exercise or
purchase price for the remaining 31.7 million shares is $0.078 per share if
exercised between January 27, 2007 and July 26, 2007, $0.11 per share if
exercised between July 27, 2007 and January 26, 2008, and $0.15 per share
thereafter until expiration of the warrants.
Effective December 12, 2005, the Company entered into a credit agreement
(the "December Credit Agreement") with the Credit Parties and the Lender. Under
the December Credit Agreement, the Lender loaned $10,700,000 to the Company as
evidenced by a promissory note (the "December Note"), of which $5 million was
used to pay down the Acquisition Loan. Interest is payable monthly at the rate
of 12% per annum and the December Note is due on December 12, 2006.
The December Note is secured by substantially all of the Company's assets.
In addition, the Company issued a common stock warrant (the "December Note
Warrant") to the Lender as collateral under the December Note. The December Note
Warrant is exercisable by the Lender only in the event that a default has
occurred and is continuing on the December Note. The December Note Warrant
entitles the Lender to purchase the number of shares of the Company's common
stock equal in value to the amount of the December Note not repaid at maturity,
plus accrued interest and lender fees for an aggregate exercise price of $1.00,
regardless of the number of shares acquired. The December Note Warrant is
exercisable from and after December 12, 2005 until the occurrence of either a
27
termination of the December Credit Agreement by the Lender or the Company's
payment in full of all obligations under the December Credit Agreement. The
Company is obligated to register the estimated number of shares of common stock
issuable upon exercise of the December Note Warrant by filing a registration
statement under the Securities Act of 1933, as amended (the "Securities Act"),
no later than ninety days prior to the maturity date of the December Note. If
the Company proposes to file a registration statement under the Securities Act
on or before the expiration date of the December Note Warrant, then the Company
must offer to the holder of the December Note Warrant the opportunity to include
the number of shares of common stock as the holder may request.
Based upon a valuation obtained by the Company from an independent
valuation firm, the Company recorded a warrant expense of $17,215,000 for the
three months ended March 31, 2005 related to the issuance of the Warrants. The
Company computed the expense of the Warrants based on the fair value of the
underlying shares at the date of grant and the estimated maximum number of
shares of 43,254,715 that could be issued under the Warrants. The Company
recognized a gain of $8,218,019 in change in fair value of derivative in the
accompanying consolidated statement of operations for the three months ended
March 31, 2006.
As a result of the Company not being able to determine the maximum number
of shares that could be required to be issued under the December Note Warrant
issued on December 12, 2005, the Company has determined that share settlement of
the Warrants issued on January 27, 2005 is no longer within its control and
reclassified the Warrants as a liability on December 12, 2005 in accordance with
EITF No. 00-19 "Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company's Own Stock" and SFAS 133 "Accounting for
Derivative Instruments and Hedging Activities." As of December 12, 2005, there
was a substantial reduction in the shares outstanding to 83,932,316 shares as a
result of the Company's settlement with OC-PIN. However, the requirement to
repay the December Note for $10.7 million may obligate the Company to issue new
shares of its common stock prior to the expected exercise of the Warrants and
the estimated maximum number of shares exercisable of 43,254,715 accordingly
remains unchanged.
Management believes that the likelihood of the December Note Warrant being
exercised is reasonably possible and, in accordance with EITF No. 00-19 and SFAS
133, has included the December Note value of $10.7 million in warrant liability,
current, in its consolidated balance sheets as of March 31, 2006 and December
31, 2005. Under the terms of the December Credit Agreement, any proceeds from
the sale of stock received under the December Note Warrant that are in excess of
the December Note and related issuance costs are to be returned to the Company.
Accordingly, the fair value of the December Note Warrant would contractually
continue to be $10.7 million (plus any issuance and exercise costs, which are
considered immaterial).
The Company computed the fair value of the Warrants, and the fair value of
the December Note Warrant and related number of shares, based on the
Black-Scholes option pricing model. Due to the fact that the Company emerged
from the development stage during 2005, the Company computed the volatility of
its stock based on an average of public companies that own hospitals. Although
management believes this is the most reasonable and accurate methodology to
determine the Company's volatility, the circumstances affecting volatility of
the comparable companies selected may not be an accurate predictor of the
Company's volatility.
SIGNIFICANT CHALLENGES
COMPANY - Our acquisition of the Hospitals involves numerous potential
risks, including:
o potential loss of key employees and management of acquired companies;
o difficulties integrating acquired personnel and distinct cultures;
o difficulties integrating acquired companies into our proposed
operating, financial planning and financial reporting systems;
o diversion of management attention; and
o assumption of liabilities and potentially unforeseen liabilities,
including liabilities for past failure to comply with healthcare
regulations.
Our acquisition also involved significant cash expenditures, debt
incurrence and integration expenses that could seriously strain our financial
condition. If we are required to issue equity securities to raise additional
capital, existing stockholders will likely be substantially diluted, which could
affect the market price of our stock.
28
INDUSTRY - Our Hospitals receive a substantial portion of their revenues
from Medicare and Medicaid. The healthcare industry is experiencing a strong
trend toward cost containment, as the government seeks to impose lower
reimbursement and resource utilization group rates, limit the scope of covered
services and negotiate reduced payment schedules with providers. These cost
containment measures generally have resulted in a reduced rate of growth in the
reimbursement for the services that we provide relative to the increase in our
cost to provide such services.
Changes to Medicare and Medicaid reimbursement programs have limited, and
are expected to continue to limit, payment increases under these programs. Also,
the timing of payments made under the Medicare and Medicaid programs is subject
to regulatory action and governmental budgetary constraints resulting in a risk
that the time period between submission of claims and payment could increase.
Further, within the statutory framework of the Medicare and Medicaid programs, a
substantial number of areas are subject to administrative rulings and
interpretations which may further affect payments.
Our business is subject to extensive federal, state and, in some cases,
local regulation with respect to, among other things, participation in the
Medicare and Medicaid programs, licensure and certification of facilities, and
reimbursement. These regulations relate, among other things, to the adequacy of
physical property and equipment, qualifications of personnel, standards of care,
government reimbursement and operational requirements. Compliance with these
regulatory requirements, as interpreted and amended from time to time, can
increase operating costs and thereby adversely affect the financial viability of
our business. Because these regulations are amended from time to time and are
subject to interpretation, we cannot predict when and to what extent liability
may arise. Failure to comply with current or future regulatory requirements
could also result in the imposition of various remedies including (with respect
to inpatient care) fines, restrictions on admission, denial of payment for all
or new admissions, the revocation of licensure, decertification, imposition of
temporary management or the closure of a facility or site of service.
We are subject to periodic audits by the Medicare and Medicaid programs,
which have various rights and remedies against us if they assert that we have
overcharged the programs or failed to comply with program requirements. Rights
and remedies available to these programs include repayment of any amounts
alleged to be overpayments or in violation of program requirements, or making
deductions from future amounts due to us. These programs may also impose fines,
criminal penalties or program exclusions. Other third-party payer sources also
reserve rights to conduct audits and make monetary adjustments in connection
with or exclusive of audit activities.
The healthcare industry is highly competitive. We compete with a variety of
other organizations in providing medical services, many of which have greater
financial and other resources and may be more established in their respective
communities than we are. Competing companies may offer newer or different
centers or services than we do and may thereby attract patients or customers who
are presently patients, customers or are otherwise receiving our services.
An increasing trend in malpractice litigation claims, rising costs of
malpractice litigation, losses associated with these malpractice lawsuits and a
constriction of insurers have caused many insurance carriers to raise the cost
of insurance premiums or refuse to write insurance policies for hospital
facilities. Also, a tightening of the reinsurance market has affected property,
auto and excess liability insurance carriers. Accordingly, the costs of all
insurance premiums have increased.
We receive all of our inpatient services revenue from operations in Orange
County, California. The economic condition of this market could affect the
ability of our patients and third-party payers to reimburse us for our services,
through its effect on disposable household income and the tax base used to
generate state funding for Medicaid programs. An economic downturn, or changes
in the laws affecting our business in our market and in surrounding markets,
could have a material adverse effect on our financial position, results of
operations and cash flows.
LIQUIDITY AND CAPITAL RESOURCES
The Company's consolidated financial statements have been prepared on a
going concern basis, which contemplates the realization of assets and settlement
of obligations in the normal course of business. The Company generated income of
$2,535,477 (primarily attributable to a gain from change in fair value of
derivative of $8,218,019) during the three months ended March 31, 2006 and has a
working capital deficit of $80,176,753 at March 31, 2006. For the three months
ended March 31, 2006, cash used in operations was $8,708,059.
29
On or around May 9, 2005, the Company received notice that it was in
default of its Acquisition Loan and Line of Credit. Effective December 12, 2005,
the Company entered into a one year credit agreement for $10,700,000, which
included an amendment that (i) declared cured the aforementioned default, (ii)
required the Company to pay $5,000,000 against its Acquisition Loan, (iii)
required the Company to obtain $10,700,000 in additional new capital
contributions to pay in full and retire all amounts due and owing under the one
year credit agreement and (iv) included certain indemnities and releases in
favor of the Lender. Accordingly, on December 12, 2005, the Company paid
$5,000,000 against the Acquisition Loan reducing its outstanding balance to $45
million. As of March 31, 2006, the Company had outstanding short term debt
aggregating $81,030,734, of which $10,700,000 (included within Warrant Liability
- - Current) was classified as warrant liability, current. See "Overview - Common
Stock Warrants" above in this Item 2.
Effective January 1, 2006, the Company and the Lender agreed to an
amendment to the Acquisition Loan and Line of Credit that changed the interest
rate from 14% to prime plus 5.75%. As a result, future increases in the prime
rate would increase the Company's interest expense.
Our working capital deficit as of March 31, 2006 was $80.2 million and, for
the three months then ended, cash used by operations was $8.7 million.
Management is working on improvements in several areas that the Company believes
will mitigate these deficits:
1. Net operating revenues: The Hospitals serve a disproportionate number
of indigent patients and receive governmental revenues and subsidies
in support of care for these patients. We have received increases in
Medicaid, Medicaid DSH, and Orange County, CA (CalOptima) payments.
Increased reimbursement and support in these areas represent $0.7
million per month in committed improvement and an additional $0.1 to
$0.2 million per month still under discussion. Commercial managed care
rate improvements are approximately $0.2 million per month in 2006 vs.
2005. Adjusting for calendar days, revenues for the three months ended
March 31, 2006 were $4.6 million higher than for the same period in
the preceding year.
2. Operating expenses: Management is working aggressively to reduce cost
without reduction in service levels. These efforts have in large part
been offset by inflationary pressures. However, a net improvement of
$0.2 to $0.3 million per month is a reasonable expectation for 2006.
Adjusting for calendar days, operating expenses for the three months
ended March 31, 2006 were $5.0 million higher than for the same period
in the preceding year.
3. Financing costs: The Company completed the Acquisition of the
Hospitals with a high level of debt financing. Additionally, the
Company entered into an Accounts Purchase Agreement, and is incurring
significant discounts on the sale of accounts receivable. As described
in the notes to the consolidated financial statements, the largest
investor was unable to meet all the commitments under the stock
purchase agreement. As a result, the Company incurred additional
interest costs from default rates and higher than planned borrowings.
We are seeking new equity investments in the Company; however we have
not yet secured alternative sources of capital or re-negotiated our
commitments with our lenders. The Company intends to work with
interested parties to place an additional $20 million in equity, of
which $10.7 million will be applied toward the payment of the December
Note and the remainder will reduce the level required when the term
notes are refinanced. Management believes the reduction in leverage
and refinancing, if successful, will yield reductions in the discount
on sales of accounts receivable. The combined impact of these changes
is expected to yield from $0.4 to $0.5 million in reduced capital
costs per month. There can be no assurance that we will be able raise
additional funds on terms acceptable to us or at all. Such additional
equity, if available, is likely to substantially dilute the interest
of our current shareholders in the Company. These steps are also
subject to the approval of the Company's Board of Directors which
currently is comprised of three representatives of the lead investor,
two outside directors, and one officer of the Company and,
accordingly, may not be assured.
The foregoing analysis presumes that capital expenditures to replace
equipment can be kept to an immaterial amount in the short term. It is the
intent of management to fund future capital expenditures from operations.
30
As of March 31, 2006, the Company had approximately $4.7 million available
under its $30 million Line of Credit. The Line of Credit is to be used for the
purpose of providing (a) working capital financing for the Company and its
subsidiaries, (b) funds for other general corporate purposes of the Company and
its subsidiaries, and (c) other permitted purposes.
Effective March 31, 2006, an amendment to the APA will accelerate the
Company's cash receipts in connection with its sales of accounts receivable. The
amendment reduced the required accumulated Security Reserve Funds amount as a
percentage of the total advance rate amount outstanding from 25% to 15%. At
March 31, 2006, the Security Reserve Funds balance of $13,021,487 was in excess
of the 15% Cap. As result, $6,677,916 was released to the Company subsequent to
March 31, 2006.
RESULTS OF OPERATIONS
The following table sets forth, for the three months ended March 31, 2006
and 2005, our consolidated statements of operations expressed as a percentage of
net operating revenues. The three months ended March 31, 2005 reflects only 24
days of operations from the Acquisition date.
Three months ended
March 31,
---------------------
2006 2005
-------- --------
Net operating revenues 100.0% 100.0%
Operating expenses 103.6 104.8
-------- --------
Operating loss (3.6) (4.8)
-------- --------
Other income (expense):
Interest expense, net (3.1) (3.0)
Common stock warrant expense - (79.2)
Change in fair value of derivative 9.5 -
-------- --------
Other income (expense), net 6.4 (82.2)
-------- --------
Income (loss) before provision for income taxes
and minority interest 2.8 (87.0)
Provision for income taxes - (4.3)
Minority interest in variable interest entity 0.1 -
-------- --------
Net income (loss) 2.9% (91.3)%
======== ========
CONSOLIDATED RESULTS OF OPERATIONS--THREE MONTHS ENDED MARCH 31, 2006 AND MARCH
31, 2005
NET OPERATING REVENUES
Our consolidated net operating revenues, on a calendar day basis (using 24
days for the three months ended March 31, 2005- "Acquisition" days), increased
5.7% as a result of contract rate increases. Average daily census remained
unchanged.
OPERATING EXPENSES
Operating expenses decreased as a percent of revenues by 1.2% which equates
to inflationary increases (net of efficiencies) of 6.6%.
The provision for doubtful accounts as a percentage of revenue decreased to
9.6% for the three months ended March 31, 2006 from 14.4% in the comparable
period in 2005, more than offsetting the $2.8 loss on sale of accounts
receivable incurred during the three months ended March 31, 2006.
Salaries and benefits (adjusted for Acquisition days) increased $2.0
million or 4.3%, slightly under the average wage increase which ranged from
5-6%.
Supplies increased $0.6 million or 5.8% due to inflationary pressures.
Remaining operating expenses (adjusted for Acquisition days) increased
approximately $1.8 million. The most significant of these were medical fees for
emergency coverage, data processing fees for system conversions and medical
equipment repairs.
31
OPERATING LOSS
Loss from operations as a percent of revenue improved by 1.2% due to rate
improvements in excess of cost increases.
OTHER INCOME (EXPENSE), NET
Other income (expense), net, changed primarily as a result of the changes
in fair value of warrants. The initial valuation of warrants issued in the first
quarter of 2005 (as described in Form 10-Q/A for the three months ended March 31
2005) was $17,215,000. As described more fully in our Annual Report on Form 10-K
for the year ended December 31, 2005, this was revalued to $17,604,292 on
December 12, 2005 and subsequently increased to $21,064,669 as of December 31,
2005. As of March 31, 2006, the fair value of these warrants had decreased to
$12,846,650, resulting in a gain of $8,218,019.
Interest costs were relatively consistent between the periods as a
percentage of revenue.
PROVISION FOR INCOME TAXES
The estimated provision for income taxes for the first quarter of 2005 was
reversed in the subsequent quarter as a result of the impact of the
implementation of the Accounts Purchase Agreement.
CRITICAL ACCOUNTING ESTIMATES
REVENUE RECOGNITION - Net operating revenues are recognized in the period
in which services are performed and are recorded based on established billing
rates (gross charges) less estimated discounts for contractual allowances,
principally for patients covered by Medicare, Medicaid, managed care and other
health plans. Gross charges are retail charges. They are not the same as actual
pricing, and they generally do not reflect what a hospital is ultimately paid
and therefore are not displayed in the consolidated statements of operations.
Hospitals are typically paid amounts that are negotiated with insurance
companies or are set by the government. Gross charges are used to calculate
Medicare outlier payments and to determine certain elements of payment under
managed care contracts (such as stop-loss payments). Because Medicare requires
that a hospital's gross charges be the same for all patients (regardless of
payer category), gross charges are also what hospitals charge all other patients
prior to the application of discounts and allowances.
Revenues under the traditional fee-for-service Medicare and Medicaid
programs are based primarily on prospective payment systems. Discounts for
retrospectively cost-based revenues and certain other payments, which are based
on the Hospitals' cost reports, are estimated using historical trends and
current factors. Cost report settlements for retrospectively cost-based revenues
under these programs are subject to audit and administrative and judicial
review, which can take several years until final settlement of such matters are
determined and completely resolved. Since the laws, regulations, instructions
and rule interpretations governing Medicare and Medicaid reimbursement are
complex and change frequently, the estimates recorded by the Hospitals could
change by material amounts. The Company has established settlement receivables
as of March 31, 2006 and December 31, 2005 of $1,845,511 and $2,273,248,
respectively.
Outlier payments, which were established by Congress as part of the
diagnosis-related groups (DRG) prospective payment system, are additional
payments made to hospitals for treating Medicare patients who are costlier to
treat than the average patient in the same DRG. To qualify as a cost outlier, a
hospital's billed (or gross) charges, adjusted to cost, must exceed the payment
rate for the DRG by a fixed threshold established annually by the Centers for
Medicare and Medicaid Services of the United State Department of Health and
Human Services (CMS). Under Sections 1886(d) and 1886(g) of the Social Security
Act, CMS must project aggregate annual outlier payments to all prospective
payment system hospitals to be not less than 5% or more than 6% of total DRG
payments (Outlier Percentage). The Outlier Percentage is determined by dividing
total outlier payments by the sum of DRG and outlier payments. CMS annually
adjusts the fixed threshold to bring expected outlier payments within the
mandated limit. A change to the fixed threshold affects total outlier payments
by changing (1) the number of cases that qualify for outlier payments, and (2)
the dollar amount hospitals receive for those cases that still qualify. The most
recent change to the cost outlier threshold that became effective on October 1,
2005 was a decrease from $25,800 to $23,600, which CMS projects will result in
an Outlier Percentage of 5.1%. The Medicare fiscal intermediary calculates the
cost of a claim by multiplying the billed charges by the cost-to-charge ratio
from the hospital's most recent filed cost report.
32
The Hospitals received new provider numbers during the year ended December
31, 2005 and, because there was no specific history, the Hospitals were
reimbursed for outliers based on published statewide averages. If the computed
cost exceeds the sum of the DRG payment plus the fixed threshold, the hospital
receives 80% of the difference as an outlier payment. Medicare has reserved the
option of adjusting outlier payments, through the cost report, to the hospital's
actual cost-to-charge ratio. Upon receipt of the current payment cost-to-charge
ratios from the fiscal intermediary, any variance between current payments and
the estimated final outlier settlement will be reported. As of March 31, 2006,
the Company has recorded reserves for excess outlier payments due to the
difference between the Hospitals' actual cost to charge rates and the statewide
average in the amount of $2,890,637. These reserves offset against the third
party settlement receivables and are included as a net payable of $1,045,126 in
due to governmental payers in the Company's consolidated balance sheet as of
March 31, 2006.
The Hospitals receive supplemental payments from the State of California to
support indigent care (MediCal Disproportionate Share Hospital payments or
"DSH"). During the three months ended March 31, 2006, the Hospitals received
payments of $575,000. The Company estimates an additional $6,587,219 is
receivable based on State correspondence, which is included in due from
governmental payers in the consolidated balance sheet as of March 31, 2006. In
April 2006, $3,811,305 of the $6,587,219 was received.
Revenues under managed care plans are based primarily on payment terms
involving predetermined rates per diagnosis, per-diem rates, discounted
fee-for-service rates and/or other similar contractual arrangements. These=
revenues are also subject to review and possible audit by the payers. The payers
are billed for patient services on an individual patient basis. An individual
patient's bill is subject to adjustment on a patient-by-patient basis in the
ordinary course of business by the payers following their review and
adjudication of each particular bill. The Hospitals estimate the discounts for
contractual allowances utilizing billing data on an individual patient basis. At
the end of each month, the Hospitals estimate expected reimbursement for patient
of managed care plans based on the applicable contract terms. These estimates
are continuously reviewed for accuracy by taking into consideration known
contract terms as well as payment history. Although the Hospitals do not
separately accumulate and disclose the aggregate amount of adjustments to the
estimated reimbursements for every patient bill, management believes the
estimation and review process allows for timely identification of instances
where such estimates need to be revised. Management does not believe there were
any adjustments to estimates of individual patient bills that were material to
its net operating revenues.
Management is not aware of any material claims, disputes, or unsettled
matters with any payers that would affect revenues that have not been adequately
provided for in the Company's consolidated financial statements as of and for
the three months ended March 31, 2006.
The Hospitals provide charity care to patients whose income level is below
200% of the Federal Poverty Level with only a co-payment charged to the patient.
The Hospitals' policy is to not pursue collection of amounts determined to
qualify as charity care; and accordingly, the Hospitals do not report the
amounts in net operating revenues or in the provision for doubtful accounts.
Patients whose income level is between 200% and 300% of the Federal Poverty
Level may also be considered under a catastrophic provision of the charity care
policy. Patients without insurance who do not meet the Federal Poverty Level
guidelines are offered assistance in applying for Medicaid and other programs
they may be eligible for, such as state disability, Victims of Crime, or county
indigent programs. Patient advocates from the Hospitals' Medical Eligibility
Program (MEP) screen patients in the hospital and determine potential linkage to
financial assistance programs. They also expedite the process of applying for
these government programs. Based on average revenue for comparable services from
all other payers, revenues foregone under the charity policy, including indigent
care accounts, for the three months ended March 31, 2006 were approximately $1.6
million.
Receivables from patients who are potentially eligible for Medicaid are
classified as Medicaid pending under the MEP, with appropriate contractual
allowances recorded. If the patient does not quality for Medicaid, the
receivables are reclassified to charity care and written off, or they are
reclassified to self-pay and adjusted to their net realizable value through the
provision for doubtful accounts. Reclassifications of Medicaid pending accounts
to self-pay do not typically have a material impact on the results of operations
as the estimated Medicaid contractual allowances initially recorded are not
materially different than the estimated provision for doubtful accounts recorded
when the accounts are reclassified. All accounts classified as pending Medicaid
are fully reserved when they reach 180 days old.
33
SALE OF ACCOUNTS RECEIVABLE - During the three months ended March 31, 2006,
the Company incurred $2,807,805 in loss on sale of accounts receivable. See
"Overview - Accounts Purchase Agreement" above in this Item 2.
PROVISION FOR DOUBTFUL ACCOUNTS - The Company provides for accounts
receivable that could become uncollectible by establishing an allowance to
reduce the carrying value of such receivables to their estimated net realizable
value. The Hospitals estimate this allowance based on the aging of their
accounts receivable, historical collections experience for each type of payer
and other relevant factors. There are various factors that can impact the
collection trends, such as changes in the economy, which in turn have an impact
on unemployment rates and the number of uninsured and underinsured patients,
volume of patients through the emergency department, the increased burden of
co-payments to be made by patients with insurance and business practices related
to collection efforts. These factors continuously change and can have an impact
on collection trends and the estimation process.
The Company's policy is to attempt to collect amounts due from patients,
including co-payments and deductibles due from patients with insurance, at the
time of service while complying with all federal and state laws and regulations,
including, but not limited to, the Emergency Medical Treatment and Labor Act
(EMTALA). Generally, as required by EMTALA, patients may not be denied emergency
treatment due to inability to pay. Therefore, until the legally required medical
screening examination is complete and stabilization of the patient has begun,
services are performed prior to the verification of the patient's insurance, if
any. In non-emergency circumstances or for elective procedures and services, it
is the Hospitals' policy, when appropriate, to verify insurance prior to a
patient being treated.
During the three months ended March 31, 2006, the Company recorded a
provision for doubtful accounts of $8,298,928.
COMMON STOCK WARRANTS - During the three months ended March 31, 2006 and
2005, the Company recorded a gain of $8,218,019 and a warrant expense of
$17,215,000, respectively, related to warrants. See "Overview - Common Stock
Warrants" above in this Item 2.
RECENT ACCOUNTING STANDARDS
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140."
SFAS 155, among other things: permits the fair value re-measurement of any
hybrid financial instrument that contains an embedded derivative that otherwise
would require bifurcation and establishes a requirement to evaluate interests in
securitized financial assets to identify interests that are freestanding
derivatives or that are hybrid financial instruments that contain an embedded
derivative requiring bifurcation. SFAS 155 is effective for all financial
instruments acquired or issued in fiscal years beginning after September 15,
2006. The Company is currently evaluating the effect that adopting this
statement will have on the Company's financial position and results of
operations.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets - an amendment of FASB Statement No. 140," with respect to the
accounting for separately recognized servicing assets and servicing liabilities.
SFAS 156 permits the choice of the amortization method or the fair value
measurement method, with changes in fair value recorded in income, for the
subsequent measurement for each class of separately recognized servicing assets
and servicing liabilities. The statement is effective for years beginning after
September 15, 2006, with earlier adoption permitted. The Company is currently
evaluating the effect that adopting this statement will have on the Company's
financial position and results of operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
At March 31, 2006, we did not have any investment in or outstanding
liabilities under market rate sensitive instruments. We do not enter into
hedging instrument arrangements. On December 12, 2005 we entered into a
derivative financial instrument solely for the purpose of securing a related
loan. This is discussed more fully in the notes 5 and 7 to the consolidated
financial statements. We have no off-balance sheet arrangements.
34
ITEM 4. CONTROLS AND PROCEDURES.
The Company maintains disclosure controls and procedures that are designed
to ensure that information required to be disclosed in the Company's Exchange
Act reports is recorded, processed, summarized and reported within the time
periods specified in the SEC's rules and forms, and that such information is
accumulated and communicated to the Company's management, including its Chief
Executive Officer and Chief Financial Officer, as appropriate, to allow timely
decisions regarding required disclosure based closely on the definition of
"disclosure controls and procedures" in Rule 15d-15(e). The Company's disclosure
controls and procedures are designed to provide a reasonable level of assurance
of reaching the Company's desired disclosure control objectives. In designing
and evaluating the disclosure controls and procedures, management recognized
that any controls and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired control objectives,
and management necessarily was required to apply its judgment in evaluating the
cost-benefit relationship of possible controls and procedures.
We previously conducted an evaluation under the supervision and with the
participation of our management, including our Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures as of March 31, 2006 and June 30, 2006 and
found them to be effective as of such dates. However, we have subsequently
conducted a re-evaluation of the effectiveness of our disclosure controls and
procedures as of March 31, 2006 and June 30, 2006 and identified certain
material weaknesses, discussed further below. With the participation of the
Company's Chief Executive Officer and Chief Financial Officer, management
re-evaluated the effectiveness of our system of internal control over financial
reporting as a result of the restatement of the financial statements for the
quarterly periods ended March 31, 2006 and June 30, 2006, based on the framework
in Internal Control-Integrated Framework published by the Committee of
Sponsoring Organizations of the Treadway Commission.
Based on these evaluations and re-evaluations, management determined that
the Company's system of disclosure controls and procedures was not effective as
of March 31, 2006 and June 30, 2006, and the Company's systems of internal
control over financial reporting was not effective as of March 31, 2006 and June
30, 2006, due to the presence of certain material weaknesses. These weaknesses
contributed to the need for restatements of our financial statements for the
quarterly periods ending March 31, 2006 and June 30, 2006 as follows.
As described in the notes to the accompanying restated financial
statements, the Company's management determined that the Company's unaudited
condensed consolidated quarterly financial statements for the periods ended
March 31, 2006 and June 30, 2006, should be restated due to the an error in the
overstatement of net revenues and accounts receivable. The Company determined
that the restatements were necessary to write-off patient accounts receivable
for services provided under capitated contracts. The correction of errors
resulted in a decrease in net operating revenues, income before minority
interest and provision for income taxes and net income of $322,887 for the three
months ended March 31, 2006 and a decrease in accounts receivable and an
increase in accumulated deficit and stockholders' deficiency of $939,678 as of
March 31, 2006.
Management has identified, as a material weakness contributing to these
restatements, that the Company's controls over the timely preparation and review
of account reconciliations was inadequate. Management has implemented new
procedures to monitor the timely preparation and review of account
reconciliations. In addition, management has implemented new procedures to
ensure that material errors are prevented or detected on a timely basis.
35
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We and our subsidiaries are involved in various legal proceedings most of
which relate to routine matters incidental to our business. We do not believe
that the outcome of these matters is likely to have a material adverse effect on
the Company.
ITEM 1A. RISK FACTORS
There are no material changes from the risk factors previously disclosed in
our Annual Report on Form 10-K for the fiscal year ended December 31, 2005.
ITEM 6. EXHIBITS.
Exhibits required to be filed are listed below and except where
incorporated by reference, immediately follow. References to the "Commission"
mean the U.S. Securities and Exchange Commission.
Exhibit Description
Number
- -----------------------------------------------------------------------
10.1 Employment Severance Agreement and General Release of Claims and
Waiver of the Right to Cancel or Revoke Employment Severance Agreement
and General Release of Claims (incorporated herein by reference from
Exhibit 99.1 to the Registrant's Current Report on Form 8-K filed with
the Commission on January 26, 2006). *
31.1 Certification of Chief Executive Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
* Previously filed.
36
SIGNATURE
In accordance with the requirements of the Securities Exchange Act of 1934,
the registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
INTEGRATED HEALTHCARE HOLDINGS, INC.
Dated: November 2, 2006 By: /s/ Steven R. Blake
-----------------------------------
Steven R. Blake
Chief Financial Officer
(Principal Financial Officer)
37