UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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
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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)
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes |_| No |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 87,557,430 shares outstanding of the issuer's Common Stock as of
November 6, 2006
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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 September 30, 2006
(unaudited) and December 31, 2005 2
Condensed Consolidated Statements of Operations for the three
and nine months ended September 30, 2006 and 2005 (unaudited) 3
Condensed Consolidated Statements of Cash Flows for the
nine months ended September 30, 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 25
Item 3. Quantitative and Qualitative Disclosures About Market Risk 36
Item 4. Controls and Procedures 36
PART II OTHER INFORMATION
Item 1. Legal Proceedings 37
Item 6. Exhibits 37
SIGNATURES
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PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
INTEGRATED HEALTHCARE HOLDINGS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31,
2006 2005
------------- -------------
(unaudited) (as restated)
(Note 1)
ASSETS
Current assets:
Cash and cash equivalents $ 4,591,502 $ 16,005,943
Restricted cash 4,971,636 4,971,636
Accounts receivable, net of allowance for doubtful
accounts of $2,404,369 and $3,148,276, respectively 16,602,035 15,975,486
Security reserve funds 6,178,087 12,127,337
Deferred purchase price receivables 19,049,690 9,337,703
Inventories of supplies, at cost 5,636,836 5,719,717
Due from governmental payers 7,855,951 3,024,772
Prepaid expenses and other current assets 5,231,171 6,694,045
------------- -------------
70,116,908 73,856,639
Property and equipment, net of accumulated depreciation
of $4,110,766 and $2,138,134, respectively 57,700,236 59,431,285
Debt issuance costs, net of accumulated amortization
of $1,516,613 and $791,735, respectively 416,387 1,141,265
------------- -------------
Total assets $ 128,233,531 $ 134,429,189
============= =============
LIABILITIES AND STOCKHOLDERS' DEFICIENCY
Current liabilities:
Short term debt $ 72,330,734 $ --
Accounts payable 32,085,004 26,835,606
Accrued compensation and benefits 12,029,372 12,533,499
Warrant liabilities, current 18,442,594 10,700,000
Due to governmental payers 2,222,193 --
Other current liabilities 16,339,611 15,725,489
------------- -------------
Total current liabilities 153,449,508 65,794,594
Long term debt -- 70,330,734
Capital lease obligations, net of current portion
of $93,287 and $85,296, respectively 4,890,186 4,961,257
Warrant liability -- 21,064,669
Minority interest in variable interest entity 2,452,332 3,341,549
Commitments and contingencies
Stockholders' deficiency:
Common stock, $0.001 par value; 250,000,000 shares
authorized; 87,557,430 and 83,932,316 shares
issued and outstanding, respectively 87,557 83,932
Additional paid in capital 16,254,477 16,125,970
Accumulated deficit (48,900,529) (47,273,516)
------------- -------------
Total stockholders' deficiency (32,558,495) (31,063,614)
------------- -------------
Total liabilities and stockholders' deficiency $ 128,233,531 $ 134,429,189
============= =============
The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements.
2
INTEGRATED HEALTHCARE HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------- -------------------------------
2006 2005 2006 2005
------------- ------------- ------------- -------------
Net operating revenues $ 87,034,755 $ 91,620,003 $ 263,075,762 $ 196,557,569
Operating expenses:
Salaries and benefits 48,466,841 47,465,507 144,135,644 107,484,432
Supplies 12,324,891 11,771,288 36,384,451 26,313,499
Provision for doubtful accounts 9,372,758 15,587,741 27,344,251 30,060,501
Other operating expenses 16,634,384 18,103,472 51,746,615 38,905,484
Loss on sale of accounts receivable 2,630,364 2,570,646 7,777,657 6,154,056
Depreciation and amortization 654,930 707,015 1,973,175 1,872,072
------------- ------------- ------------- -------------
90,084,168 96,205,669 269,361,793 210,790,044
------------- ------------- ------------- -------------
Operating loss (3,049,413) (4,585,666) (6,286,031) (14,232,475)
Other income (expense):
Interest expense, net (3,406,343) (3,063,087) (9,092,274) (6,458,303)
Common stock warrant expense -- -- -- (17,215,000)
Change in fair value of derivative 778,584 -- 13,322,075 --
------------- ------------- ------------- -------------
(2,627,759) (3,063,087) 4,229,801 (23,673,303)
------------- ------------- ------------- -------------
Loss before minority interest
and income tax provision (5,677,172) (7,648,753) (2,056,230) (37,905,778)
Income tax benefit (provision) -- -- -- --
Minority interest in variable interest entity 186,831 1,151,113 429,217 1,355,535
------------- ------------- ------------- -------------
Net loss $ (5,490,341) $ (6,497,640) $ (1,627,013) $ (36,550,243)
============= ============= ============= =============
Per Share Data:
Loss per common share - Basic ($0.06) ($0.09) ($0.02) ($0.39)
Loss per common share - Diluted ($0.06) ($0.09) ($0.02) ($0.39)
Weighted average shares outstanding - Basic 85,013,347 69,853,444 84,554,388 94,310,167
Weighted average shares - Diluted Note 10 Note 10 Note 10 Note 10
The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements.
3
INTEGRATED HEALTHCARE HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Nine months ended September 30,
------------------------------
2006 2005
------------ ------------
Cash flows from operating activities:
Net loss $ (1,627,013) $(36,550,243)
Adjustments to reconcile net loss to cash used in operating activities:
Depreciation and amortization of property and equipment 1,973,175 1,872,072
Amortization of debt issuance costs and intangible assets 724,878 481,545
Common stock warrant expense -- 17,215,000
Change in fair value of derivative (13,322,075) --
Minority interest in net loss of variable interest entity (429,217) (1,355,535)
Changes in operating assets and liabilities:
Accounts receivable, net, including receivables from Buyer of accounts (4,389,286) (32,463,532)
Inventories of supplies 82,881 83,145
Due from governmental payers (4,831,179) (3,483,087)
Prepaids and other current assets 1,462,874 (3,881,134)
Accounts payable 5,249,398 20,333,327
Accrued compensation and benefits (504,127) 11,408,843
Due to governmental payers 2,222,193 --
Other current liabilities 614,122 10,024,602
------------ ------------
Net cash used in operating activities (12,773,376) (16,314,997)
------------ ------------
Cash flows from investing activities:
Acquisition of hospital assets -- (63,171,676)
Increase in restricted cash -- (4,971,636)
Additions to property and equipment, net (242,126) (479,187)
------------ ------------
Net cash used in investing activities (242,126) (68,622,499)
------------ ------------
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
Distribution to PCHI investors (460,000) --
Proceeds from line of credit 2,000,000 25,330,734
Issuance of common stock 132,132 10,954,645
Repayments of debt -- (1,264,013)
Payments on capital lease obligations (71,071) (150,265)
------------ ------------
Net cash provided by financing activities 1,601,061 87,938,101
------------ ------------
Net (decrease) increase in cash and cash equivalents (11,414,441) 3,000,605
Cash and cash equivalents, beginning of period 16,005,943 69,454
------------ ------------
Cash and cash equivalents, end of period $ 4,591,502 $ 3,070,059
============ ============
The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements.
4
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 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 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 condensed
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 September 30, 2006, its results of operations for the
three and nine months ended September 30, 2006 and 2005, and its cash flows for
the nine months ended September 30, 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 and nine months ended September
30, 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 generally accepted accounting principles in the
United States of America ("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 the Company operates.
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
SEPTEMBER 30, 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 incurred a net loss of $1,627,013 during
the nine months ended September 30, 2006 and has a working capital deficit of
$83,332,600 at September 30, 2006. For the nine months ended September 30, 2006,
cash used in operations was $12,773,376.
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 $27,330,734
and $25,330,734 as of September 30, 2006 and December 31, 2005, respectively. 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
SEPTEMBER 30, 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 settlement receivables
as of September 30, 2006 and December 31, 2005 of $1,447,152 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 September 30, 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 $3,669,344 and $2,169,626, respectively. These reserves
offset against the third party settlement receivables and are included as a net
payable of $2,222,193 in due to governmental payers as of September 30, 2006,
and as a net receivable of $103,622 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 September 30, 2006, the
Hospitals received payments of $3,500,000. During the nine months ended
September 30, 2006 and 2005, the Hospitals received payments of $11,289,902 and
$2,606,035, respectively. The Company estimates an additional $7,855,951 is
receivable based on State correspondence, which is included in due from
governmental payers in the consolidated balance sheet as of September 30, 2006
($2,921,150 at December 31, 2005).
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.
7
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
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 September 30, 2006 and 2005 were
approximately $2.0 million and $0.9 million, respectively, and for the nine
months ended September 30, 2006 and 2005 were approximately $6.0 million and
$1.8 million, respectively.
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 from date of service.
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 September 30, 2006 and December 31, 2005 was $2,404,369
and $3,148,276, respectively. The Company estimates this allowance based on the
aging of 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 Company's policy, when appropriate, to
verify insurance prior to a patient being treated. The Company recorded
provisions for doubtful accounts of $9,372,758 and $15,587,741 for the three
months ended September 30, 2006 and 2005, respectively, and $27,344,251 and
$30,060,501 for the nine months ended September 30, 2006 and 2005, 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
SEPTEMBER 30, 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 September 30, 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. The Company recorded a reduction in net
revenues from CalOptima capitation of $193,685 due to an increase in claim
experience during the three months ended September 30, 2006 and net revenues of
$910,000 for the three months ended September 30, 2005. The Company recorded net
revenues from CalOptima capitation of $1,883,315 and $2,410,000 for the nine
months ended September 30, 2006 and 2005, respectively. These amounts are net of
outsider medical expenses including IBNR reserves. As of September 30, 2006 and
December 31, 2005, the IBNR reserves were approximately $3,760,478 and
$4,973,000, respectively. 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 September 30, 2006, the Company had not
granted any stock options to employees.
9
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 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 and nine months ended
September 30, 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 September 30, 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 tax 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 September 30, 2006
and December 31, 2005, the Company established a 100% valuation allowance
against its deferred tax assets.
10
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 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 September 30,
2006 and December 31, 2005, the Company had accrued approximately $4.7 and $2.3
million, respectively, comprised of approximately $0.9 and $0.6 million,
respectively, in incurred and reported claims, along with approximately $3.8 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 the policy year ended May 15, 2006, 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. As of May 15, 2006, the Company
changed to a "guaranteed cost" policy, under which the carrier pays all workers'
compensation claims, with no deductible or reimbursement required of the
COMPANY. 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 September 30, 2006 and December 31, 2005, the Company
had accrued approximately $1.3 million, comprised of approximately $0.3 million
in incurred and reported claims, along with $1.0 million 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 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 and nine months ended
September 30, 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
SEPTEMBER 30, 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.
In June 2006, the FASB issued FASB Interpretation No. 48, "Accounting
for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109".
FIN 48 clarifies the circumstances in which a tax benefit may be recorded with
respect to uncertain tax positions. The Interpretation provides guidance for
determining whether tax benefits may be recognized with respect to uncertain tax
positions and, if recognized, the amount of such tax benefits that may be
recorded. Under the provisions of FIN 48, tax benefits associated with a tax
position may be recorded only if it is more likely than not that the claimed tax
position will be sustained upon audit. The statement is effective for years
beginning after December 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 September 2006, the FASB issued FASB Statement No. 157, "Fair Value
Measurements". This Statement establishes a single authoritative definition of
fair value, sets out a framework for measuring fair value, and requires
additional disclosures about fair value measurements. FASB 157 applies only to
fair value measurements that are already required or permitted by other
accounting standards. The statement is effective for financial statements for
fiscal years beginning after November 15, 2007, 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.
In September, 2006, the Securities and Exchange Commission released
Staff Accounting Bulletin 108. SAB 108 provides interpretative guidance on how
the effects of the carryover or reversal of prior year misstatements should be
considered in quantifying a current year misstatement. SAB 108 is effective for
fiscal years ending after November 15, 2006. The Company adopted SAB 108 during
the interim quarterly period ended September 30, 2006. The effect of adopting
this statement was considered in evaluating the impact of certain errors that
were identified during October, 2006 in relation to the financial statements for
the quarters ended March 31, 2006 and June 30, 2006. The Company restated the
unaudited condensed consolidated quarterly financial statements for the periods
ended March 31, 2006 and June 30, 2006 by filing of amendments to the Company's
Quarterly Report on Form 10-Q on November 3, 2006 and November 7, 2006,
respectively. The Company determined that $616,791 of the 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. However, in
accordance with the dual approach outlined in SAB 108 management determined that
the impact of the $616,791 error was material to the 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 filing of the next annual report on Form 10-K.
The following table sets for the amounts as originally reported in the
condensed consolidated balance sheet as of December 31, 2005, 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)
RECLASSIFICATIONS - Certain reclassifications have been made to the
2005 consolidated financial statements to conform to the 2006 presentation.
12
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
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 15% (the "15% Cap"-as amended March 31, 2006) 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.
13
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
The following table reconciles accounts receivable as of September 30,
2006 and December 31, 2005, as reported, to the pro forma accounts receivable,
as if the Company had deferred recognition of the sales.
September 30, 2006 December 31, 2005
----------------------------- -----------------------------
As reported Pro forma As reported Pro forma
------------ ------------ ------------ ------------
Accounts receivable:
Governmental $ 7,898,468 $ 27,890,960 $ 10,394,875 $ 23,771,977
Non-governmental 11,107,936 44,276,979 8,728,887 45,564,554
------------ ------------ ------------ ------------
19,006,404 72,167,939 19,123,762 69,336,531
Less allowance for doubtful accounts (2,404,369) (17,321,208) (3,148,276) (17,723,163)
------------ ------------ ------------ ------------
Net patient accounts receivable 16,602,035 54,846,731 15,975,486 51,613,368
------------ ------------ ------------ ------------
Security Reserve Funds 6,178,087 -- 12,127,337 --
Deferred purchase price receivables 19,049,690 -- 9,337,703 --
------------ ------------ ------------ ------------
Receivable from Buyer of accounts 25,227,777 -- 21,465,040 --
------------ ------------ ------------ ------------
Advance rate amount, net -- (6,178,088) -- (10,843,197)
Transaction Fees deducted from Security Reserve Funds -- (6,838,831) -- (3,329,645)
------------ ------------ ------------ ------------
$ 41,829,812 $ 41,829,812 $ 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 accounts, 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 $21.3 and $13.8 million for the nine months ended
September 30, 2006 and 2005, respectively, 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 September 30,
2006 the Company had $19,992,492 in governmental accounts receivable that had
been reported as sold which are subject to the foregoing limitation.
14
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
The Company records estimated Transaction Fees and estimated servicing
costs related to the sold accounts receivable at the time of sale. The Company
incurred loss on sale of accounts receivable of $2,630,364 and $2,570,646 for
the three months ended September 30, 2006 and 2005, respectively, and $7,777,657
and $6,154,056 for the nine months ended September 30, 2006 and 2005,
respectively, comprised of the following:
Three months Nine months
ended September 30, ended September 30,
------------------------ ------------------------
2006 2005 2006 2005
---------- ---------- ---------- ----------
Transaction Fees deducted from Security Reserve Funds - closed purchases $ 900,168 $1,241,512 $3,509,186 $2,580,621
Increase (decrease) in accrued Transaction Fees - open purchases 285,305 56,420 342,312 411,493
---------- ---------- ---------- ----------
Total Transaction Fees incurred 1,185,473 1,297,932 3,851,498 2,992,114
---------- ---------- ---------- ----------
Servicing costs for sold accounts receivable - closed purchases 1,291,228 1,173,674 3,788,322 2,439,612
Increase (decrease) in accrued servicing costs - open purchases 153,663 99,040 137,837 722,330
---------- ---------- ---------- ----------
Total servicing costs incurred 1,444,891 1,272,714 3,926,159 3,161,942
---------- ---------- ---------- ----------
Loss on sale of accounts receivable $2,630,364 $2,570,646 $7,777,657 $6,154,056
========== ========== ========== ==========
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%. As a result of this change, $6,677,916 was released
to the Company in April 2006.
NOTE 4 - PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
September 30, December 31,
2006 2005
------------ ------------
Buildings $ 33,696,897 $ 33,696,897
Land and improvements 13,522,591 13,522,591
Equipment 9,482,627 9,241,044
Buildings under lease 5,108,887 5,108,887
------------ ------------
61,811,002 61,569,419
Less accumulated depreciation (4,110,766) (2,138,134)
------------ ------------
Property and equipment, net $ 57,700,236 $ 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:
September 30, 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 27,330,734 --
------------ ------------
Short term debt $ 72,330,734 $ --
============ ============
Long term debt:
Secured acquisition loan $ -- $ 45,000,000
Secured line of credit, outstanding borrowings -- 25,330,734
------------ ------------
Long term debt $ -- $ 70,330,734
============ ============
15
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 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. The
Company recognized amortization expense of $241,626 and $148,638 for the three
months ended September 30, 2006 and 2005, respectively, and $724,878 and
$481,545 for the nine months ended September 30, 2006 and 2005, respectively. As
of September 30, 2006 and December 31, 2005, unamortized debt issuance costs are
$416,387 and $1,141,265, 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.
16
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 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 September 30, 2006 and December 31, 2005 (see
Note 7). The Lender and the Company have drafted an amendment and forbearance
agreement revising the effective date for filing of the registration statement
until May 15, 2007, subject to execution by all parties to the December Note.
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 -During the period from April, 2006 through
mid-August, 2006 the Company was in default of its obligation under its loan and
security agreements to timely file financial reports with the Securities and
Exchange Commission. The lender was notified of the condition of default and
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 Form 10-Q for the quarter ended March
31, 2006 (which was filed with the SEC on August 11, 2006).
17
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 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
September 30, 2006, these costs had been recovered by the
Company; confirmed by the parties on July 25, 2006.
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.
4. 40,626,684 of the escrowed shares of the Company's common stock were
delivered to the Company.
18
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
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.
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 September
30, 2006, the Company had issued 3,625,114 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."
Based upon valuations obtained by the Company from an independent
valuation firm, the Company recognized a gain of $778,584 and $13,322,075
related to the change in fair value of derivative for the three and nine months
ended September 30, 2006, respectively. During the nine months ended September
30, 2005, the Company recognized a related warrant expense of $17,215,000. The
related warrant liability as of September 30, 2006 and December 31, 2005 is
$7,742,594 and $21,064,669, respectively. The warrant liability has been
classified as a current liability in the accompanying September 30, 2006 balance
sheet because the warrants will be exercisable within one year. 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.
19
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
The Company computed the fair value of the Warrants based on the
Black-Scholes option pricing model with the following assumptions:
September 30, 2006 December 31, 2005
------------------ -----------------
Risk-free interest rate 4.7% 4.4%
Expected volatility 22.2% 28.6%
Dividend yield -- --
Expected life (years) 1.82 2.57
Fair value of Warrants $0.179 $0.487
Market value per share $0.18 $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
liabilities, current, in the accompanying consolidated balance sheets as of
September 30, 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:
September 30, 2006 December 31, 2005
------------------ -----------------
Risk-free interest rate 4.9% 4.4%
Expected volatility 24.1% 23.9%
Dividend yield -- --
Expected life (years) .20 .95
Fair value of Warrants $0.182 $0.490
Number of shares 58,791,209 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)
Medcath Corp. (MDTH)
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.
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.
20
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
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
September 30, 2006 and December 31, 2005, and for the three and nine months
ended September 30, 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.
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 September 30, 2006 and 2005,
the Company incurred rent expense paid to PCHI of $1,548,465 and $2,632,329,
respectively, which was eliminated upon consolidation. During the nine months
ended September 30, 2006 and 2005, the Company incurred rent expense paid to
PCHI of $4,625,673 and $5,357,273, respectively, which was eliminated upon
consolidation.
21
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
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 wherein the
officers agreed to waive commitments for stock options in their employment
agreements. 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 September 30, 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 and nine months ended September
30, 2006 and 2005, antidilutive potential shares of common stock, consisting of
approximately 40 million shares issuable under warrants, have been excluded from
the calculations of diluted loss per share for those periods in the following
table. The following table sets forth the computation of basic and diluted
earnings (loss) per share:
Three months ended Nine months ended
September 30, September 30,
----------------------------- -----------------------------
2006 2005 2006 2005
------------ ------------ ------------ ------------
Numerator:
Net loss $ (5,490,341) $ (6,497,640) $ (1,627,013) $(36,550,243)
============ ============ ============ ============
Denominator:
Weighted average common shares 85,013,347 69,853,444 84,554,388 94,310,167
Warrants -- -- -- --
------------ ------------ ------------ ------------
Denominator for diluted calculation 85,013,347 69,853,444 84,554,388 94,310,167
============ ============ ============ ============
Loss per share - basic $ (0.06) $ (0.09) $ (0.02) $ (0.39)
Loss per share - diluted $ (0.06) $ (0.09) $ (0.02) $ (0.39)
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.
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.
22
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
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
--------------
$ 23,517,455
==============
Total rental expense was $441,675 and $629,874 for the three months
ended September 30, 2006 and 2005, respectively, and $1,352,506 and $1,265,683
for the nine months ended September 30, 2006 and 2005, respectively.
The State of California has imposed new hospital seismic safety
requirements. The Company operates four hospitals located in an area near active
earthquake faults. Under these new requirements, the Company must meet stringent
seismic safety criteria in the future, and, must complete one set of seismic
upgrades to the facilities by January 1, 2013. This first set of upgrades is
expected to require the Company to incur substantial seismic retrofit costs.
There are additional requirements that must be complied with by 2030. The costs
of meeting these requirements have not yet been determined by management and
could have a material adverse effect on the Company.
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 $4,682,896 and $4,886,503 are included in property and equipment in the
accompanying consolidated balance sheets as of September 30, 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.
23
INTEGRATED HEALTHCARE HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 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.
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 September 30, 2006 and December 31, 2005, and for the three and
nine months ended September 30, 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 September 30, 2006 and December 31,
2005.
September 30, December 31,
2006 2005
------------ ------------
Accounts receivable:
Governmental $ 7,898,468 $ 10,394,875
Non-governmental 11,107,936 8,728,887
------------ ------------
19,006,404 19,123,762
Less allowance for doubtful accounts (2,404,369) (3,148,276)
------------ ------------
Net patient accounts receivable 16,602,035 15,975,486
------------ ------------
Security Reserve Funds 6,178,087 12,127,337
Deferred purchase price receivables 19,049,690 9,337,703
------------ ------------
Receivable from Buyer of accounts 25,227,777 21,465,040
------------ ------------
$ 41,829,812 $ 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 $21.3 and $13.8 million for the nine months ended
September 30, 2006 and 2005, respectively, 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 September 30,
2006 the Company had $19,992,492 in governmental accounts receivable that had
been reported as sold which are 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. The Company
incurred a loss on sale of accounts receivable of $2,630,364 and $2,570,646, for
the three months ended September 30, 2006 and 2005, respectively, and $7,777,657
and $6,154,056 for the nine months ended September 30, 2006 and 2005,
respectively.
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%. As a result of this change, $6,677,916 was released
to the Company in April 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.
27
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
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. The Lender and
the Company have prepared a draft amendment and forbearance agreement which
would revise the effective date for filing of the registration statement until
May 15, 2007, subject to execution by all parties to the December Note.
Based upon valuations obtained by the Company from an independent
valuation firm, the Company recognized gains of $778,584 and $13,322,075 related
to the change in fair value of derivative for the three and nine months ended
September 30, 2006, respectively. During the three and nine months ended
September 30, 2005, the Company recognized a related warrant expense of
$17,215,000. The related warrant liability as of September 30, 2006 and December
31, 2005 is $7,742,594 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 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
liabilities, current, in the accompanying consolidated balance sheets as of
September 30, 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.
28
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.
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 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
incurred a net loss of $1,627,013 (which includes a gain from change in fair
value of derivative of $13,322,075) during the nine months ended September 30,
2006 and has a working capital deficit of $83,332,600 at September 30, 2006. For
the nine months ended September 30, 2006, cash used in operations was
$12,773,376.
29
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 $27,330,734
and $25,340,734 as of September 30, 2006 and December 31, 2005, respectively. 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. Accordingly,
on December 12, 2005, the Company paid $5,000,000 against the Acquisition Loan
reducing its outstanding balance to $45 million. As of September 30, 2006, the
Company had outstanding short term debt aggregating $83,030,734, of which
$10,700,000 is included in warrant liabilities, 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 September 30, 2006 was $83.3 million
and, for the nine months then ended, cash used by operations was $12.8 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. Net operating revenues for the three months ended September 30,
2006 were $4.6 million lower than for the same period in the preceding
year. Adjusting for calendar days from date of Acquisition (March 8,
2005), net operating revenues for the nine months ended September 30
2006 were $3.8 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.
Operating expenses for the three months ended September 30, 2006 were
$6.1 million lower than for the same period in the preceding year.
Adjusting for calendar days from date of Acquisition (March 8, 2005),
operating expenses for the nine months ended September 30 2006 were
$8.6 million lower 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.
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.
Additionally, management believes the reduction in leverage and
refinancing will yield reductions in the discount on sales of accounts
receivable or replacement with less costly financing. The combined
impact of these changes is expected to yield from $0.4 to $0.5 million
in reduced capital costs per month. These steps are 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.
As of September 30, 2006, the Company had approximately $2.7 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.
30
Effective March 31, 2006, an amendment to the APA accelerated the
Company's cash receipts in connection with its sales of accounts receivable. The
amendment reduced the required Security Reserve Funds amount as a percentage of
the total advance rate amount outstanding from 25% to 15%. As a result of this
change, $6,677,916 was released to the Company in April 2006.
Disproportionate Share Hospital (DSH) funds are received unevenly from
the State of California throughout the year. The estimated amounts of DSH funds
receivable has increased from December 31, 2005 to September 30, 2006 by $4.8
million to $7.9 million Of which $3.6 million was received on October 11, 2006.
RESULTS OF OPERATIONS
The following table sets forth, for the three and nine months ended
September 30, 2006 and 2005, our consolidated statements of operations expressed
as a percentage of net operating revenues. The nine months ended September 30,
2005 reflects operations from the Acquisition date of March 8, 2005.
Three months ended September 30, Nine months ended September 30,
---------------------------------- ------------------------------------
2006 2005 2006 2005
--------------- --------------- ---------------- ----------------
Net operating revenues 100.0% 100.0% 100.0% 100.0%
Operating expenses 103.5% 105.0% 102.4% 107.2%
--------------- --------------- ---------------- ----------------
Operating loss (3.5%) (5.0%) (2.4%) (7.2%)
--------------- --------------- ---------------- ----------------
Other income (expense):
Interest expense, net (3.9%) (3.3%) (3.5%) (3.3%)
Common stock warrant expense 0.0% 0.0% 0.0% (8.8%)
Change in fair value of derivative 0.9% 0.0% 5.1% 0.0%
--------------- --------------- ---------------- ----------------
Other income (expense), net (3.0%) (3.3%) 1.6% (12.1%)
--------------- --------------- ---------------- ----------------
Loss before minority interest and income
tax provision (6.5%) (8.3%) (0.8%) (19.3%)
Income tax benefit (provision) 0.0% 0.0% 0.0% 0.0%
Minority interest in variable interest entity 0.2% 1.2% 0.2% 0.7%
--------------- --------------- ---------------- ----------------
Net loss (6.3%) (7.1%) (0.6%) (18.6%)
=============== =============== ================ ================
CONSOLIDATED RESULTS OF OPERATIONS--THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER
30, 2006 AND SEPTEMBER 30, 2005
NET OPERATING REVENUES
Net operating revenues for the three months ended September 30, 2006
decreased to $87.0 million from $91.6 million, a decrease of $4.6 million or
5.0%, as compared to the same period in 2005. Admissions for the three months
ended September 30, 2006 increased by 1.0% as compared to the same period in
2005. Rates improved by 5.5% during the three months ended September 30, 2006
due to the impact of new contracts and governmental payments. The underlying mix
of patients remained fairly constant during the three months ended September 30,
2006 and 2005. Net operating revenues for the nine months ended September 30,
2006 increased to $263.1 million from $196.6 million, an increase of $66.5
million or 33.8%, as compared to the same period in 2005. The nine months ended
September 30, 2005 contained only 207 days of Hospital operations compared to
273 days for the nine months ended September 30, 2006. Adjusted for calendar
days, net operating revenues increased 1.5% on approximately the same level of
admissions. 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 September 30, 2006 and 2005 were
approximately $2.0 million and $0.9 million, respectively, and for the nine
months ended September 30, 2006 and 2005 were approximately $6.0 million and
$1.8 million, respectively. The increase in the recognition of charity and
corresponding reduction in revenues has also had a corresponding favorable
impact on the Provision for Doubtful Accounts (below)
OPERATING EXPENSES
Operating expenses for the three months ended September 30, 2006
decreased to $90.1 million from $96.2 million, a decrease of $6.1 million or
6.4%, as compared to the same period in 2005. The decrease in operating expenses
was primarily due to a decrease in provision for doubtful accounts of $6.2
million and other operating expenses of $1.5 million, offset in part by
increases in salaries and benefits of $1.0 million and supplies of $0.6 million.
Operating expenses for the nine months ended September 30, 2006 increased to
$269.4 million from $210.8 million, an increase of $58.6 million, The nine
months ended September 30, 2005 contained only 207 days of Hospital operations
compared to 273 days in 2006. Adjusted for calendar days, operating expenses
declined 3.1% for the nine months ended September 30, 2006 as compared to the
same period in 2005.
31
The provision for doubtful accounts for the three months ended
September 30, 2006 decreased to $9.4 million from $15.6, a decrease of $6.2
million or 39.9%, as compared to the same period in 2005. The decrease in the
provision for doubtful accounts for the three months ended September 30, 2006 is
primarily due to improvements in collection efforts and more timely recognition
of charity accounts (see above), as compared to the same period in 2005. The
provision for doubtful accounts for the nine months ended September 30, 2006
decreased to $27.3 million from $30.1 million, a decrease of $2.8 million or
9.0%, as compared to the same period in 2005.
The loss on sale of accounts receivable for each of the three months
ended September 30, 2006 and 2005 was $2.6 million. The loss on sale of accounts
receivable for the nine months ended September 30, 2006 increased to $7.8
million from $6.2 million, an increase of $1.6 million or 26.4%, as compared to
the same period in 2005. The increase in the loss on sale of accounts receivable
for the nine months ended September 30, 2006 was primarily due to an increase in
the dollar amounts of accounts receivable sold during 2006 as compared to the
same period in 2005. The nine months ended September 30, 2005 contained only 207
days of Hospital operations compared to 273 days in 2006.
OPERATING LOSS
Operating loss for the three months ended September 30, 2006 decreased
to $3.0 million from $4.6 million, a decrease of $1.6 million or 33.5%, as
compared to the same period in 2005. Operating loss for the nine months ended
September 30, 2006 decreased to $6.3 million from $14.2 million, a decrease of
$7.9 million, as compared to the same period in 2005. The decrease in operating
loss in 2006 is primarily due to improvements in contracts and increased
governmental support along with continued emphasis on cost control by
management.
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 September 30, 2006, the fair value of these warrants
had decreased to $7,742,594, resulting in gains for the three and nine months
ended September 30, 2006 of $778,584 and $13,322,075, respectively.
Interest expense for the three months ended September 30, 2006
increased to $3.4 million from $3.1 million, an increase of $0.3 million or
11.2%, as compared to the same period in 2005. Interest expense for the nine
months ended September 30, 2006 increased to $9.1 million from $6.5 million, an
increase of $2.6 million, as compared to the same period in 2005. Interest
expense in 2006 increased as a result of borrowings from the acquisition
outstanding for the full nine months in 2006. In 2005, borrowings from the
acquisition were only outstanding from the date of the acquisition (March 8,
2005) through September 30, 2005. Interest costs were consistent between the
periods as a percentage of net operating revenues.
INCOME TAX BENEFIT (PROVISION)
During the each of the three and nine months ended September 30, 2006
and 2005, there was no provision for income taxes due to the loss incurred by
the Company during these periods.
NET LOSS
Net loss for the three months ended September 30, 2006 decreased to
$5.5 million from $6.5 million, a decrease of $1.0 million or 15.5%, as compared
to the same period in 2005. The decrease in net loss for the three months ended
September 30, 2006 was primarily due to decreases in provision for doubtful
accounts and other operating expenses. Net loss for the nine months ended
September 30, 2006 decreased to $1.6 million from $36.6 million, a decrease of
$35.0 million, as compared to the same period in 2005. The decrease in net loss
during the nine months ended September 30, 2006 was primarily due to a decrease
in operating expenses as a percentage of net operating revenues to 102.4% in
2006 from 107.2% in 2005 and a decrease in other expense of $27.9 million in
2006. The decrease in other expense was the result of a decrease in common stock
warrant expense of $17.2 and an increase in the change in fair value of
derivative of $13.3 million, offset by an increase in interest expense of $2.6
million.
32
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 established settlement receivables as of
September 30, 2006 and December 31, 2005 of $1,447,152 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 September 30, 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 $3,669,344 and $2,196,626, respectively. These reserves
offset against the third party settlement receivables and are included as a net
payable of $2,222,193 in due to governmental payers as of September 30, 2006,
and as a net receivable of $103,622 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 September 30, 2006 and 2005,
the Hospitals received payments of $3,500,000 and $0, respectively. During the
nine months ended September 30, 2006 and 2005, the Hospitals received payments
of $11,289,902 and $2,606,035, respectively. The Company estimates an additional
$7,855,951 is receivable based on State correspondence, which is included in due
from governmental payers in the consolidated balance sheet as of September 30,
2006 ($2,921,150 at December 31, 2005).
33
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 and nine months ended September 30, 2006 and 2005.
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 September 30, 2006 and 2005 were
approximately $2.0 million and $0.9 million, respectively, and for the nine
months ended September 30, 2006 and 2005 were approximately $6.0 million and
$1.8 million, respectively.
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.
SALE OF ACCOUNTS RECEIVABLE - The Company incurred loss on sale of
accounts receivable of $2,630,364 and $2,570,646, for the three months ended
September 30, 2006 and 2005, respectively, and $7,777,657 and $6,154,056 for the
nine months ended September 30, 2006 and 2005, respectively. 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.
34
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.
The Company recorded provisions for doubtful accounts of $9,372,758 and
$15,587,741 for the three months ended September 30, 2006 and 2005,
respectively, and $27,344,251 and $30,060,501 for the nine months ended
September 30, 2006 and 2005, respectively.
COMMON STOCK WARRANTS - Based upon valuations obtained by the Company
from an independent valuation firm, the Company recognized a gain of $778,584
and $13,322,075 in change in fair value of derivative for the three and nine
months ended September 30, 2006, respectively. During the nine months ended
September 30, 2005, the Company recognized a related warrant expense of
$17,215,000. The related warrant liability as of September 30, 2006 and December
31, 2005 is $7,742,594 and $21,064,669, respectively. The warrant liability has
been classified as a current liability in the accompanying September 30, 2006
balance sheet because the warrants will be exercisable within one year. 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.
In June 2006, the FASB issued FASB Interpretation No. 48, "Accounting
for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109".
FIN 48 clarifies the circumstances in which a tax benefit may be recorded with
respect to uncertain tax positions. The Interpretation provides guidance for
determining whether tax benefits may be recognized with respect to uncertain tax
positions and, if recognized, the amount of such tax benefits that may be
recorded. Under the provisions of FIN 48, tax benefits associated with a tax
position may be recorded only if it is more likely than not that the claimed tax
position will be sustained upon audit. The statement is effective for years
beginning after December 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 September 2006, the FASB issued FASB Statement No. 157, "Fair Value
Measurements". This Statement establishes a single authoritative definition of
fair value, sets out a framework for measuring fair value, and requires
additional disclosures about fair value measurements. FASB 157 applies only to
fair value measurements that are already required or permitted by other
accounting standards. The statement is effective for financial statements for
fiscal years beginning after November 15, 2007, 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.
35
In September, 2006, the Securities and Exchange Commission released
Staff Accounting Bulletin 108 . SAB 108 provides interpretative guidance on how
the effects of the carryover or reversal of prior year misstatements should be
considered in quantifying a current year misstatement. SAB 108 is effective for
fiscal years ending after November 15, 2006. The Company adopted SAB 108 during
the interim quarterly period ended September 30, 2006. The effect of adopting
this statement was considered in evaluating the impact of the current year
restatements for the quarters ended March 31, 2006 and June 30, 2006. The
Company restated the unaudited condensed consolidated quarterly financial
statements for the periods ended March 31, 2006 and June 30, 2006 in filing of
an amendment to the Company's Quarterly Report on Form 10-Q on November 3, 2006
and November 7, 2006, respectively. The Company determined that $616,791 of the
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 SAB
108. However, in accordance with the dual approach outlined in SAB 108
management determined that the impact of the $616,791 error was material to the
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 filing of the next annual report on
Form 10-K.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
At September 30, 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.
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 restated our financial statements for the quarterly periods ended
March 31, 2006 and June 30, 2006. The restatements were necessary due to an
error overstating net revenues and patient accounts receivable. The correction
resulted in the write off of patient accounts receivable for services provided
under capitated contracts. In reviewing the circumstances underlying the
restatements, the Company's management determined that the error resulted from a
material weakness in the Company's internal controls over the timely preparation
and review of account reconciliations. In the fourth quarter of 2006, the
Company's management has implemented changes to controls and processes that
include: (i) new procedures to segregate certain responsibilities among staff;
(ii) new procedures regarding the manner in which patient accounts receivable
for services provided under capitated contracts should be recorded, (iii) new
procedures to monitor the timely, accurate preparation and review of accounts
reconciliations and (iv) new procedures to improve the education and
understanding by our staff in accounting for capitation agreements.
As of September 30, 2006, the Company carried out an evaluation, under
the supervision and with the participation of the Company's management,
including the Company's Chief Executive Officer and the Company's Chief
Financial Officer, of the effectiveness of the design and operation of the
Company's disclosure controls and procedures. As part of that evaluation the
Company's management considered deficiencies in its disclosure controls and
procedures described above and as reported in Amendment No. 1 to its Quarterly
Report on Form 10-Q for the period ended March 31, 2006 and Amendment No. 1 to
its Quarterly Report on Form 10-Q for the period ended June 30, 2006. Based upon
that evaluation and taking into account the deficiencies discussed above, the
Company's Chief Executive Officer and Chief Financial Officer concluded that as
of September 30, 2006, the Company's disclosure controls and procedures were not
effective at a reasonable level to ensure that the Company is able to collect,
process and disclose the information it is required to disclose in the reports
it files with the SEC within the required time periods and management has taken
the aforementioned steps to remediate.
36
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.
Exhibit Description
Number
- --------------------------------------------------------------------------------
10.1 Amendment to Employment Agreement dated August 5, 2006 by and among the
Company and each of Anil V. Shah, Hari S. Lal, Bruce Mogel and Larry B.
Anderson.
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.
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 13, 2006 By: /s/ Steven R. Blake
--------------------------------
Steven R. Blake
Chief Financial Officer
(Principal Financial Officer)
37