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HANGER, INC. - Quarter Report: 2012 March (Form 10-Q)

Table of Contents

 

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 


 

FORM 10-Q

 

(Mark One)

 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

For the quarterly period ended March 31, 2012

 

 

OR

 

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from           to           

 

Commission file number 1-10670

 

HANGER ORTHOPEDIC GROUP, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

84-0904275

(State or other jurisdiction of

 

(IRS Employer Identification No.)

incorporation or organization)

 

 

 

10910 Domain Drive, Suite 300, Austin, TX

 

78758

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code: (512) 777-3800

 

 

Former name, former address and former fiscal year, if changed since last report.

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.) Yes x No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one).

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. Yes o No x

 

As of April 27, 2012 34,117,244 shares of common stock, $.01 par value per share, were outstanding.

 

 

 



Table of Contents

 

HANGER ORTHOPEDIC GROUP, INC.

 

INDEX

 

 

 

 

Page No.

 

 

 

 

Part I.

 

FINANCIAL INFORMATION

 

 

 

 

 

Item 1.

 

Consolidated Financial Statements (unaudited)

 

 

 

 

 

 

 

Consolidated Balance Sheets — March 31, 2012 and December 31, 2011

1

 

 

 

 

 

 

Consolidated Statements of Income and Comprehensive Income for the Three Months ended March 31, 2012 and 2011

3

 

 

 

 

 

 

Consolidated Statements of Cash Flows for the Three Months ended March 31, 2012 and 2011

4

 

 

 

 

 

 

Notes to Consolidated Financial Statements

5

 

 

 

 

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

17

 

 

 

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

29

 

 

 

 

Item 4.

 

Controls and Procedures

30

 

 

 

 

Part II.

 

OTHER INFORMATION

 

 

 

 

 

Item 1A.

 

Risk Factors

31

 

 

 

 

Item 6.

 

Exhibits

33

 

 

 

 

SIGNATURES

34

 



Table of Contents

 

HANGER ORTHOPEDIC GROUP, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

(Unaudited)

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

CURRENT ASSETS

 

 

 

 

 

Cash and cash equivalents

 

$

32,248

 

$

42,896

 

Restricted cash

 

3,120

 

 

Accounts receivable, less allowance for doubtful accounts of $22,022 and $22,028 in 2012 and 2011, respectively

 

133,308

 

138,826

 

Inventories

 

120,485

 

114,086

 

Prepaid expenses, other assets, and income taxes receivable

 

20,106

 

17,015

 

Deferred income taxes

 

20,652

 

20,648

 

Total current assets

 

329,919

 

333,471

 

 

 

 

 

 

 

PROPERTY, PLANT AND EQUIPMENT

 

 

 

 

 

Land

 

794

 

794

 

Buildings

 

7,294

 

4,400

 

Furniture and fixtures

 

17,464

 

17,281

 

Machinery and equipment

 

57,314

 

56,137

 

Equipment leased to third parties under operating leases

 

34,186

 

33,830

 

Leasehold improvements

 

66,410

 

65,245

 

Computer and software

 

84,216

 

81,775

 

Total property, plant and equipment, gross

 

267,678

 

259,462

 

Less accumulated depreciation

 

161,538

 

154,690

 

Total property, plant and equipment, net

 

106,140

 

104,772

 

 

 

 

 

 

 

INTANGIBLE ASSETS

 

 

 

 

 

Goodwill

 

611,147

 

609,484

 

Patents and other intangible assets, net

 

53,958

 

54,894

 

Total intangible assets, net

 

665,105

 

664,378

 

 

 

 

 

 

 

OTHER ASSETS

 

 

 

 

 

Debt issuance costs, net

 

16,622

 

17,485

 

Other assets

 

8,661

 

8,394

 

Total other assets

 

25,283

 

25,879

 

 

 

 

 

 

 

TOTAL ASSETS

 

$

1,126,447

 

$

1,128,500

 

 

The accompanying notes are an integral part of the consolidated financial statements.

 

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Table of Contents

 

HANGER ORTHOPEDIC GROUP, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

(Unaudited)

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

CURRENT LIABILITIES

 

 

 

 

 

Current portion of long-term debt

 

$

7,927

 

$

8,065

 

Accounts payable

 

26,105

 

26,561

 

Accrued expenses

 

19,325

 

18,247

 

Accrued interest payable

 

6,615

 

3,040

 

Accrued compensation related costs

 

19,031

 

35,829

 

Total current liabilities

 

79,003

 

91,742

 

 

 

 

 

 

 

LONG-TERM LIABILITIES

 

 

 

 

 

Long-term debt, less current portion

 

498,168

 

499,968

 

Deferred income taxes

 

74,257

 

74,309

 

Other liabilities

 

35,183

 

32,818

 

Total liabilities

 

686,611

 

698,837

 

 

 

 

 

 

 

COMMITMENTS AND CONTINGENCIES (Note H)

 

 

 

 

 

 

 

 

 

 

 

SHAREHOLDERS’ EQUITY

 

 

 

 

 

Common stock, $.01 par value; 60,000,000 shares authorized, 35,588,485 and 35,127,230 shares issued and outstanding at 2012 and 2011, respectively

 

356

 

351

 

Additional paid-in capital

 

271,149

 

268,535

 

Accumulated other comprehensive loss

 

(1,185

)

(1,185

)

Retained earnings

 

170,172

 

162,618

 

 

 

440,492

 

430,319

 

Treasury stock at cost (141,154 shares)

 

(656

)

(656

)

Total shareholders’ equity

 

439,836

 

429,663

 

 

 

 

 

 

 

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

 

$

1,126,447

 

$

1,128,500

 

 

The accompanying notes are an integral part of the consolidated financial statements.

 

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Table of Contents

 

HANGER ORTHOPEDIC GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME
AND COMPREHENSIVE INCOME

For the Three Months Ended March 31,

(Dollars in thousands, except share and per share amounts)

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Net sales

 

$

218,091

 

$

200,439

 

Cost of goods sold - materials

 

64,098

 

58,108

 

Personnel costs

 

83,619

 

78,889

 

Other operating expenses

 

42,133

 

37,390

 

Relocation expenses

 

 

376

 

Depreciation and amortization

 

8,285

 

7,292

 

Income from operations

 

19,956

 

18,384

 

 

 

 

 

 

 

Interest expense

 

7,777

 

8,379

 

Income before taxes

 

12,179

 

10,005

 

 

 

 

 

 

 

Provision for income taxes

 

4,624

 

3,792

 

Net income

 

$

7,555

 

$

6,213

 

 

 

 

 

 

 

Other comprehensive income

 

 

 

Comprehensive income

 

 

7,555

 

 

6,213

 

 

 

 

 

 

 

Basic Per Common Share Data

 

 

 

 

 

Net income

 

$

0.22

 

$

0.19

 

Shares used to compute basic per common share amounts

 

34,036,539

 

33,360,840

 

 

 

 

 

 

 

Diluted Per Common Share Data

 

 

 

 

 

Net income

 

$

0.22

 

$

0.18

 

Shares used to compute diluted per common share amounts

 

34,639,660

 

34,134,067

 

 

The accompanying notes are an integral part of the consolidated financial statements.

 

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HANGER ORTHOPEDIC GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Three Months Ended March 31,

(Dollars in thousands)

(Unaudited)

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

7,555

 

$

6,213

 

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

 

 

 

 

 

Loss on disposal of assets

 

 

5

 

Reduction of seller notes and earnouts

 

(177

)

(257

)

Provision for bad debts

 

4,723

 

4,078

 

Provision for deferred income taxes

 

 

(343

)

Depreciation and amortization

 

8,285

 

7,292

 

Amortization of debt issuance costs

 

863

 

748

 

Compensation expense on restricted stock

 

1,971

 

1,658

 

Excess tax benefit from stock-based compensation

 

(209

)

(816

)

Changes in operating assets and liabilities, net of effects of acquired companies:

 

 

 

 

 

Accounts receivable

 

851

 

5,483

 

Inventories

 

(6,087

)

(1,368

)

Prepaid expenses, other current assets, and income taxes

 

(2,234

)

(3,010

)

Accounts payable

 

(522

)

(6,339

)

Accrued expenses and accrued interest payable

 

3,594

 

1,670

 

Accrued compensation related costs

 

(17,504

)

(25,531

)

Other

 

183

 

(1,794

)

Net cash provided by (used in) operating activities

 

1,292

 

(12,311

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchase of property, plant and equipment (net of acquisitions)

 

(4,777

)

(5,437

)

Purchase of equipment leased to third parties under operating leases

 

(539

)

 

Acquisitions and contingent purchase price (net of cash acquired)

 

(2,402

)

(4,941

)

Proceeds from sale of property, plant and equipment

 

 

3

 

Restricted cash

 

(3,120

)

 

Net cash used in investing activities

 

(10,838

)

(10,375

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Borrowings under revolving credit agreement

 

 

10,000

 

Repayment of term loan

 

(1,450

)

(750

)

Scheduled repayment of seller’s notes

 

(488

)

(406

)

Deferred financing costs

 

 

(4,189

)

Excess tax benefit from stock-based compensation

 

209

 

816

 

Proceeds from issuance of common stock

 

627

 

573

 

Net cash (used in) provided by financing activities

 

(1,102

)

6,044

 

 

 

 

 

 

 

Decrease in cash and cash equivalents

 

(10,648

)

(16,642

)

Cash and cash equivalents, at beginning of period

 

42,896

 

36,308

 

Cash and cash equivalents, at end of period

 

$

32,248

 

$

19,666

 

 

The accompanying notes are an integral part of the consolidated financial statements.

 

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HANGER ORTHOPEDIC GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE A — BASIS OF PRESENTATION

 

The unaudited interim consolidated financial statements as of and for the three months ended March 31, 2012 and 2011 have been prepared by Hanger Orthopedic Group, Inc. (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) considered necessary for a fair statement of the Company’s financial position, results of operations and cash flows for such periods. The year-end consolidated data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America (“GAAP”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. The results of operations for the three months ended March 31, 2012 are not necessarily indicative of the results to be expected for the full fiscal year.

 

These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company and notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2011, filed by the Company with the SEC.

 

NOTE B — SIGNIFICANT ACCOUNTING POLICIES

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated in the accompanying financial statements.

 

Revision of Previously Reported Statement of Cash Flow Information

 

During the second quarter of 2011, the Company identified a misclassification within the consolidated statements of cash flows, resulting in the overstatement of the net cash provided by operating activities in prior periods. The offsetting understatement was to net cash provided by financing activities. The misclassification had no impact on total reported decrease in cash and cash equivalents for any period, and therefore had no impact on operating or net income. The Company assessed the materiality of this item on previously reported periods and concluded the misclassification was not material. Accordingly, the three month period ended March 31, 2011 has been revised.

 

The impact of the reclassification on the statement of cash flows for the three month period ended March 31, 2011 is shown in the table below:

 

 

 

As Previously

 

 

 

 

 

(in thousands)

 

Reported

 

Adjustment

 

As Revised

 

Net cash used in operating activities

 

$

(11,495

)

(816

)

$

(12,311

)

Net cash (used in) provided by financing activities

 

$

5,228

 

816

 

$

6,044

 

 

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Table of Contents

 

NOTE B — SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Cash and Cash Equivalents

 

The Company considers all highly liquid investments with original maturities of three months or less at the date of purchase to be cash equivalents.  At various times throughout the year, the Company maintains cash balances in excess of Federal Deposit Insurance Corporation limits.

 

Restricted Cash

 

Restricted cash has statutory or contractual restrictions that prevent it from being used in the Company’s operations.  The Company agreed to restrict $3.1 million of cash to eliminate letters of credit obligations used as collateral under the revolving credit facility.

 

Inventories

 

Inventories, which consist principally of raw materials, work in process and finished goods, are stated at the lower of cost or market using the first-in, first-out method. For its Patient-Care Services segment, the Company calculates cost of goods sold—materials in accordance with the gross profit method for all reporting periods. The Company bases the estimates used in applying the gross profit method on the actual results of the most recently completed fiscal year and other factors, such as a change in the sales mix or changes in the trend of purchases. Cost of goods sold—materials during the interim periods are reconciled and adjusted when the annual physical inventory is taken. The Company treats these adjustments as changes in accounting estimates.

 

Fair Value of Financial Instruments

 

The carrying value of the Company’s short-term financial instruments, such as receivables and payables, approximate their fair values based on the short-term maturities of these instruments. The carrying value of the Company’s long-term debt, excluding the Senior Notes, approximates fair value based on rates currently available to the Company for debt with similar terms and remaining maturities (level 2). The fair value of the Senior Notes, based on quoted market prices (level 1), as of March 31, 2012 was $210.5 million, as compared to the carrying value of $200.0 million as of that date.

 

Revenue Recognition

 

Revenues in the Company’s patient-care centers are derived from the sale of O&P devices and the maintenance and repair of existing devices and are recorded net of all contractual adjustments and discounts. The sale of O&P devices includes the design, fabrication, assembly, fitting and delivery of a wide range of braces, limbs and other devices. Revenues from the sale of these devices are recorded when (i) acceptance by and delivery to the patient has occurred; (ii) persuasive evidence of an arrangement exists and there are no further obligations to the patient; (iii) the sales price is fixed or determinable; and (iv) collectability is reasonably assured. Revenues from maintenance and repairs are recognized when the service is provided. Revenues on the sale of O&P devices to customers by the Distribution segment are

 

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Table of Contents

 

NOTE B — SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

 

recorded upon the shipment of products, in accordance with the terms of the invoice, net of merchandise returns received and the amount established for anticipated returns. Discounted sales are recorded at net realizable value. Revenues in the Therapeutic Solutions segment are primarily derived from leasing rehabilitation technology combined with clinical therapy programs and education and training. The revenue is recorded on a monthly basis according to terms of the contracts with our customers.

 

Certain accounts receivable may be uncollectible, even if properly pre-authorized and billed. Regardless of the balance, accounts receivable amounts are periodically evaluated to assess collectability. In addition to the actual bad debt expense recognized during collection activities, the Company estimates the amount of potential bad debt expense that may occur in the future. This estimate is based upon historical experience as well as a review of the receivable balances.

 

On a quarterly basis, the Company evaluates cash collections, accounts receivable balances and write-off activity to assess the adequacy of the allowance for doubtful accounts. Additionally, a company-wide evaluation of collectability of receivable balances older than 180 days is performed at least semi-annually, the results of which are used in the next allowance analysis. In these detailed reviews, the account’s net realizable value is estimated after considering the customer’s payment history, past efforts to collect on the balance and the outstanding balance, and a specific reserve is recorded if needed. From time to time, the Company may outsource the collection of such accounts to outsourced agencies after internal collection efforts are exhausted. In the cases when valid accounts receivable cannot be collected, the uncollectible account is written off to bad debt expense.

 

Income Taxes

 

The Company recognizes deferred income tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Deferred income tax liabilities and assets are determined based on the difference between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The Company recognizes a valuation allowance on the deferred tax assets if it is more likely than not that the assets will not be realized in future years. Significant accounting judgment is required in determining the provision for income taxes and related accruals, deferred tax assets and liabilities. The Company believes that its tax positions are consistent with applicable tax law, but certain positions may be challenged by taxing authorities. In the ordinary course of business, there are transactions and calculations where the ultimate tax outcome is uncertain. In addition, the Company is subject to periodic audits and examinations by the Internal Revenue Service and other state and local taxing authorities. Although the Company believes that its estimates are reasonable, actual results could differ from these estimates.

 

Segment Information

 

The Company applies a “management” approach to disclosure of segment information. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the basis of the Company’s reportable segments. The description of the Company’s reportable segments and the disclosure of segment information are presented in Note L.

 

New Accounting Guidance

 

In May 2011, the FASB issued Accounting Standards Update (“ASU”) 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs,” which amends ASC 820, “Fair Value Measurement.” The amended guidance changes the wording used to describe many requirements in U.S. GAAP for measuring fair value and for disclosing information about

 

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NOTE B — SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

 

fair value measurements. Additionally, the amendments clarify the FASB’s intent about the application of existing fair value measurement requirements. The guidance provided in ASU No. 2011-04 is effective for interim and annual periods beginning after December 15, 2011 and is applied prospectively. The Company adopted the amendments of this ASU effective January 1, 2012, and the initial adoption of the amendments in this ASU did not have a material impact on our condensed consolidated financial statements.

 

In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220),” which changes the presentation of comprehensive income. The amended guidance gives companies the option to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The guidance provided in ASU No. 2011-05 is effective for interim and annual periods beginning after December 15, 2011 and is applied prospectively. The Company adopted the amendments of this ASU effective January 1, 2012, and the initial adoption of the amendments in this ASU did not have a material impact on our condensed consolidated financial statements.

 

In July 2011, the FASB issued ASU No. 2011-07 “Presentation and Disclosures of Patient Service Revenue, Provision for Bad Debts and the Allowance for Doubtful Accounts for Certain Health Care Entities.”  The objective of this update is to provide financial statement users with greater transparency about a health care entity’s net patient service revenue and the related allowance for doubtful accounts. This update provides information to assist financial statement users in assessing an entity’s sources of net patient service revenue and related changes in its allowance for doubtful accounts. The amendments require health care entities that recognize significant amounts of patient service revenue at the time the services are rendered even though they do not assess the patient’s ability to pay to present the provision for bad debts related to patient service revenue as a deduction from patient service revenue (net of contractual allowances and discounts) on their statement of operations. The amendments in this update require certain health care entities to change the presentation of their statement of operations by reclassifying the provision for bad debts associated with patient service revenue from an operating expense to a deduction from patient service revenue (net of contractual allowances and discounts). Additionally, those health care entities are required to provide enhanced disclosure about their policies for recognizing revenue and assessing bad debts. The amendments also require disclosures of patient service revenue (net of contractual allowances and discounts) as well as qualitative and quantitative information about changes in the allowance for doubtful accounts. The guidance provided in ASU No. 2011-07 is effective for interim and annual periods beginning after December 15, 2011 and is applied prospectively. The Company has determined that ASU No. 2011-07 has no impact on its financial statements.

 

In September 2011, FASB issued ASU 2011-08, “Intangibles — Goodwill and Other (Topic 350):  Testing Goodwill for Impairment”, which provides entities the option to perform a qualitative assessment in order to determine whether additional quantitative impairment testing is necessary. This amendment is effective for reporting periods beginning after December 15, 2011. This amendment does not impact the quantitative testing methodology, should it be necessary. The Company adopted this standard on January 1, 2012 and the initial adoption of the amendments in this ASU did not have a material impact on our condensed consolidated financial statements.

 

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NOTE C - SUPPLEMENTAL CASH FLOW FINANCIAL INFORMATION

 

The supplemental disclosure requirements for the statements of cash flows are as follows:

 

 

 

Three Months Ended

 

 

 

March 31,

 

(In thousands)

 

2012

 

2011

 

 

 

(Unaudited)

 

(Unaudited)

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

3,278

 

$

3,789

 

Income taxes (net of refunds)

 

1,566

 

1,030

 

 

 

 

 

 

 

Non-cash financing and investing activities:

 

 

 

 

 

Non-cash property, plant and equipment purchases

 

1,028

 

2,628

 

Earnouts payable on acquisitions

 

 

321

 

Issuance of notes in connection with acquistions

 

 

693

 

Issuance of restricted shares of common stock

 

8,419

 

11,566

 

 

NOTE D - GOODWILL

 

The Company determined that it has three reporting units with goodwill to be evaluated, which are the same as its reportable segments: (i) Patient-Care Services; (ii) Distribution; and (iii) Therapeutic Solutions. The Company completes its annual goodwill impairment analysis in October of each year. The fair value of the Company’s reporting units is primarily determined based on the income approach and considers the market and cost approach.

 

The activity related to goodwill for the three months ended March 31, 2012 and 2011 is as follows:

 

 

 

Patient-Care Services

 

Distribution

 

Therapeutic
Solutions

 

 

 

(In thousands)

 

Goodwill

 

Accumulated
Impairment Loss

 

Net

 

Goodwill

 

Goodwill

 

Total

 

Balance at December 31, 2011

 

$

519,974

 

$

(45,808

)

$

474,166

 

$

38,388

 

$

96,930

 

$

609,484

 

Additions due to acquisitions

 

1,536

 

 

1,536

 

 

 

1,536

 

Additions due to contingent considerations

 

127

 

 

127

 

 

 

127

 

Balance at March 31, 2012 (unaudited)

 

$

521,637

 

$

(45,808

)

$

475,829

 

$

38,388

 

$

96,930

 

$

611,147

 

 

 

 

Patient-Care Services

 

Distribution

 

Therapeutic
Solutions

 

 

 

(In thousands)

 

Goodwill

 

Accumulated
Impairment Loss

 

Net

 

Goodwill

 

Goodwill

 

Total

 

Balance at December 31, 2010

 

$

502,040

 

$

(45,808

)

$

456,232

 

$

38,388

 

$

96,079

 

$

590,699

 

Additions due to acquisitions

 

3,552

 

 

3,552

 

 

423

 

3,975

 

Additions due to contingent considerations

 

341

 

 

341

 

 

 

341

 

Balance at March 31, 2011 (unaudited)

 

$

505,933

 

$

(45,808

)

$

460,125

 

$

38,388

 

$

96,502

 

$

595,015

 

 

NOTE E INVENTORIES

 

Inventories, which are recorded at the lower of cost or market using the first-in, first-out method, were as follows:

 

 

 

March 31,

 

December 31,

 

(In thousands)

 

2012

 

2011

 

 

 

(Unaudited)

 

(Unaudited)

 

Raw materials

 

$

39,488

 

$

39,121

 

Work-in-process

 

52,970

 

45,735

 

Finished goods

 

28,027

 

29,230

 

 

 

$

120,485

 

$

114,086

 

 

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Table of Contents

 

NOTE F — ACQUISITIONS

 

During the three months ended March 31, 2012, the Company acquired one O&P company, operating a total of 2 patient-care centers. The aggregate purchase price for this O&P business was $2.0 million paid in cash. The Company recorded approximately $1.3 million of goodwill related to this acquisition, and the expenses incurred related to this acquisition were insignificant and are included in other operating expenses. During the three months ended March 31, 2011, the Company acquired one O&P company, operating a total of one patient care center. The aggregate purchase price for this O&P business was $5.8 million. Of this aggregate purchase price, $0.7 million consisted of promissory notes and $0.6 million is made up of contingent consideration payable within the next two years. Contingent consideration is reported as other liabilities on the Company’s consolidated balance sheet. The Company recorded approximately $3.6 million of goodwill related to this acquisition and the expenses incurred related to this acquisition were insignificant and are included in other operating expenses. The results of operations for these acquisitions are included in the Company’s results of operations from the date of acquisition. Pro forma results would not be materially different. The Company intends to make an election to treat this acquisition as an asset acquisition for tax purposes which will result in the goodwill being amortizable for tax purposes.

 

In connection with contingent consideration agreements with acquisitions completed prior to adoption of the revised authoritative guidance effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, the Company made payments of $0.1 million and $0.4 million during the three months ended March 31, 2012 and 2011, respectively. The Company has accounted for these amounts as additional purchase price, resulting in an increase in goodwill. In connection with contingent consideration agreements with acquisitions completed subsequent to adoption of revised authoritative guidance, the Company made payments of $0.4 million in the first three months of 2012 and $0.1 million in the same period 2011. The Company estimates that it may pay up to a total of $6.6 million related to contingent consideration provisions of acquisitions in future periods.

 

NOTE G — LONG TERM DEBT

 

Long-term debt consists of the following:

 

 

 

March 31,

 

December 31,

 

(In thousands)

 

2012

 

2011

 

 

 

(Unaudited)

 

(Unaudited)

 

Revolving Credit Facility

 

$

 

$

 

Term Loan

 

295,550

 

297,000

 

7 1/8% Senior Notes due 2018

 

200,000

 

200,000

 

Subordinated seller notes, non-collateralized, net of unamortized discount with principal and interest payable in either monthly, quarterly or annual installments at effective interest rates ranging from 3.00% to 7.00%, maturing through November 2016

 

10,545

 

11,033

 

 

 

506,095

 

508,033

 

Less current portion

 

(7,927

)

(8,065

)

 

 

$

498,168

 

$

499,968

 

 

Amendment to Credit Agreement

 

On March 11, 2011, the Company entered into an amendment to its Credit Agreement dated as of December 1, 2010 (as amended, the “Credit Agreement”). The amendment (i) reduced the interest rate margin applicable to the Term Loans under the Credit Agreement by 0.75% to 3.0% and (ii) reduced the LIBOR floor applicable to the Term Loans under the Credit Agreement from 1.5% to 1.0%. The

 

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Table of Contents

 

NOTE G — LONG TERM DEBT (CONTINUED)

 

Company incurred $4.1 million of fees related to this amendment, which will be amortized into interest expense over the remaining term of the debt.

 

Revolving Credit Facility

 

The $100.0 million Revolving Credit Facility matures on December 1, 2015 and bears interest at LIBOR plus 3.75%, or the applicable rate (as defined in the Credit Agreement). The Revolving Credit Facility requires compliance with various covenants including but not limited to (i) minimum consolidated interest coverage ratio of 3.25:1.00 from October 1, 2011 to September 30, 2012, and 3.50:1.00 thereafter until maturity; (ii) maximum total leverage ratio of 5.00:1.00 until December 31, 2011, 4.50:1.00 from January 1, 2012 to September 30, 2012, and 4.00:1.00 from October 1, 2012 thereafter until maturity; and (iii) maximum annual capital expenditures of 7.5% of consolidated net revenues of the preceding fiscal year with an additional maximum rollover of $15.0 million from the prior year’s allowance if not expended in the fiscal year for which it is permitted. As of March 31, 2012, the Company had $99.5 million available under the Revolving Credit Facility. Availability under the Revolving Credit Facility as of March 31, 2012 was net of standby letters of credit of approximately $0.5 million. As of March 31, 2012, the Company had no funds drawn on the Revolving Credit Facility. The obligations under the Revolving Credit Facility are senior obligations, are guaranteed by the Company’s subsidiaries, and are secured by a first priority perfected interest in the Company’s subsidiaries’ shares, all of the Company’s assets, and all the assets of the Company’s subsidiaries.

 

Term Loan

 

The $300.0 million Term Loan Facility matures on December 1, 2016 and requires quarterly principal payments which commenced March 31, 2011. From time to time, mandatory prepayments may be required as a result of excess free cash flow as defined in the Credit Agreement, certain additional debt incurrences,  certain asset sales, or other events as defined in the Credit Agreement. The Term Loan Facility bears interest at LIBOR plus 3.0%, or applicable rate (as defined in the Credit Agreement), and includes a 1.0% LIBOR floor. There were no mandatory prepayments required during the first three months of 2012 or 2011. As of March 31, 2012, the interest rate on the Term Loan Facility was 4.0%. The obligations under the Term Loan Facility are senior obligations, are guaranteed by the Company’s subsidiaries, and are secured by a first priority perfected interest in the Company’s subsidiaries’ shares, all of the Company’s assets, and all the assets of the Company’s subsidiaries.

 

71/8% Senior Notes

 

The 71/8% Senior Notes mature November 15, 2018 and are senior indebtness which is guaranteed on a senior unsecured basis by all of the Company’s current and future subsidiaries. Interest is payable semi-annually on May 15 and November 15 of each year, commencing May 15, 2011.

 

On or prior to November 15, 2013, the Company may redeem up to 35% of the aggregate principal amount of the notes at a redemption price of 107.125% of the principal amount thereof, plus accrued and unpaid interest and additional interest to the redemption date with the proceeds of a public offering of its equity securities. On or after November 15, 2014, the Company may redeem all or from time to time a part of the notes, upon not less than 30 days and not more than 60 days’ notice, for the twelve month period beginning on November 15, of the indicated years at (i) 103.563% during 2014; (ii) 101.781% during 2015; and (iii) 100.00% during 2016 and thereafter through November 15, 2018.

 

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Table of Contents

 

NOTE G — LONG TERM DEBT (CONTINUED)

 

Subsidiary Guarantees

 

The Revolving and Term Loan Facilities and the 71/8% Senior Notes are guaranteed by all of the Company’s subsidiaries. Separate condensed consolidating information is not included as the Company does not have independent assets or operations. The Guarantees are full and unconditional and joint and several, and any subsidiaries of the Company other than the Guarantor Subsidiaries are minor. There are no restrictions on the ability of our subsidiaries to transfer cash to the Company or to co-guarantors. All consolidated amounts in the Company’s financial statements are representative of the combined guarantors.

 

Debt Covenants

 

The terms of the Senior Notes, the Revolving Credit Facility, and the Term Loan Facility limit the Company’s ability to, among other things, incur additional indebtedness, create liens, pay dividends on or redeem capital stock, make certain investments, make restricted payments, make certain dispositions of assets, engage in transactions with affiliates, engage in certain business activities and engage in mergers, consolidations and certain sales of assets. At March 31, 2012, the Company was in compliance with all covenants under these debt agreements.

 

NOTE H COMMITMENTS AND CONTINGENT LIABILITIES

 

Contingencies

 

The Company is subject to legal proceedings and claims which arise from time to time in the ordinary course of its business, including additional payments under business purchase agreements.  In the opinion of management, the amount of ultimate liability, if any, with respect to these actions will not have a materially adverse effect on the financial position, liquidity or results of operations of the Company.

 

The Company is in a highly regulated industry and receives regulatory agency inquiries from time to time in the ordinary course of its business, including inquiries relating to the Company’s billing activities. To date these inquiries have not resulted in material liabilities, but no assurance can be given that future regulatory agencies’ inquiries will be consistent with the results to date or that any discrepancies identified during a regulatory review will not have a material adverse effect on the Company’s consolidated financial statements.

 

Guarantees and Indemnifications

 

In the ordinary course of its business, the Company may enter into service agreements with service providers in which it agrees to indemnify or limit the service provider against certain losses and liabilities arising from the service provider’s performance of the agreement. The Company has reviewed its existing contracts containing indemnification or clauses of guarantees and does not believe that its liability under such agreements is material to the Company’s operations.

 

NOTE I — NET INCOME PER COMMON SHARE

 

Basic per common share amounts are computed using the weighted average number of common shares outstanding during the year. Diluted per common share amounts are computed using the weighted average number of common shares outstanding during the year and dilutive potential common shares. Dilutive potential common shares consist of stock options and restricted shares and are calculated using the treasury stock method.

 

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Table of Contents

 

NOTE I — NET INCOME PER COMMON SHARE (CONTINUED)

 

Net income per share is computed as follows:

 

 

 

Three Months Ended

 

 

 

March 31,

 

(In thousands, except share and per share data)

 

2012

 

2011

 

 

 

(Unaudited)

 

(Unaudited)

 

 

 

 

 

 

 

Net income

 

$

7,555

 

$

6,213

 

 

 

 

 

 

 

Shares of common stock outstanding used to compute basic per common share amounts

 

34,036,539

 

33,360,840

 

Effect of dilutive restricted stock and options (1)

 

603,121

 

773,227

 

Shares used to compute dilutive per common share amounts

 

34,639,660

 

34,134,067

 

 

 

 

 

 

 

Basic income per share

 

$

0.22

 

$

0.19

 

Diluted income per share

 

$

0.22

 

$

0.18

 

 


(1) There were no anti-dilutive options for the three months ended March 31, 2012 and 2011.

 

NOTE J — SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN

 

The Company’s unfunded noncontributory defined benefit plan (the “Plan”) covers certain senior executives, is administered by the Company and calls for annual payments upon retirement based on years of service and final average salary. Benefit costs and liabilities balances are calculated based on certain assumptions including benefits earned, discount rates, interest costs, mortality rates and other factors. Actual results that differ from the assumptions are accumulated and amortized over future periods, affecting the recorded obligation and expense in future periods.

 

The following assumptions were used in the calculation of the net benefit cost and obligation at March 31, 2012:

 

Discount rate

 

3.90

%

Average rate of increase in compensation

 

3.00

%

 

The Company believes the assumptions used are appropriate; however, changes in assumptions or differences in actual experience may affect our benefit obligation and future expenses. The change in the Plan’s net benefit obligation for the three months ended March 31, 2012 and 2011 is as follows:

 

 

 

(in thousands)

 

Net benefit cost accrued at December 31, 2011 (unaudited)

 

$

20,230

 

Service cost

 

230

 

Interest cost

 

190

 

Payments

 

(525

)

Net benefit cost accrued at March 31, 2012 (unaudited)

 

$

20,125

 

 

 

 

(in thousands)

 

Net benefit cost accrued at December 31, 2010 (unaudited)

 

$

17,510

 

Service cost

 

247

 

Interest cost

 

202

 

Net benefit cost accrued at March 31, 2011 (unaudited)

 

$

17,959

 

 

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Table of Contents

 

NOTE K - STOCK-BASED COMPENSATION

 

The Company utilizes the authoritative guidance using the modified prospective method. Compensation expense for all awards granted is calculated according to the provisions of such guidance.

 

On May 13, 2010, the stockholders of the Company approved the 2010 Omnibus Incentive Plan (the “2010 Plan”) and terminated the Amended and Restated 2002 Stock Incentive and Bonus Plan (the “2002 Plan”) and the 2003 Non-Employee Directors’ Stock Incentive Plan (the “2003 Plan”). No new awards will be granted under the 2002 Plan or the 2003 Plan; however, awards granted under either the 2002 Plan or the 2003 Plan that were outstanding on May 13, 2010 remain outstanding and continue to be subject to all of the terms and conditions of the 2002 Plan or the 2003 Plan, as applicable.

 

The 2010 Plan provides that 2.5 million shares of Common Stock are reserved for issuance, subject to adjustment as set forth in the 2010 Plan; provided, however, that only 1.5 million shares may be issued pursuant to the exercise of incentive stock options. Of these 2.5 million shares, 2.0 million are shares that are newly authorized for issuance under the 2010 Plan and 0.5 million are unissued shares not subject to awards that have been carried over from the shares previously authorized for issuance under the terms of the 2002 Plan and the 2003 Plan. Unless earlier terminated by the Board of Directors, the 2010 Plan will remain in effect until the earlier of (i) the date that is ten years from the date the plan is approved by the Company’s stockholders, which is the effective date for the 2010 plan, namely May 13, 2020, or (ii) the date all shares reserved for issuance have been issued.

 

As of March 31, 2012, of the 2.5 million shares of common stock authorized for issuance under the Company’s 2010 Plan, approximately 1,061,000 shares have been issued. During the first three months of 2012, the Company issued approximately 448,000 shares of restricted stock under the 2010 Plan. The total fair value of these grants is $9.0 million. Total unrecognized share-based compensation cost related to unvested restricted stock awards was approximately $19.1 million as of March 31, 2012 and is expected to be expensed as compensation expense over approximately four years.

 

During the three months ended March 31, 2012 and 2011, no options were cancelled under either the 2002 Plan or the 2003 Plan.

 

For the three months ended March 31, 2012 and 2011, the Company has included approximately $2.0 million and $1.7 million, respectively, for share-based compensation cost in the accompanying condensed consolidated statements of income for the 2002, 2003 and 2010 Plans. Compensation expense relates to restricted share grants. The Company calculates the fair value of stock options using the Black-Scholes model. The total value of the stock option awards is expensed ratably over the requisite service period of the employees receiving the awards. The Company had no unrecognized expense related to its stock option grants for the periods ended March 31, 2012 and 2011.

 

NOTE L — SEGMENT AND RELATED INFORMATION

 

The Company has identified three reportable segments in which it operates based on the products and services it provides. The Company evaluates segment performance and allocates resources based on the segments’ income from operations. The reportable segments are: (i) Patient-Care Services (ii) Distribution, and (iii) Therapeutic solutions. The reportable segments are described further below:

 

Patient-Care Services—This segment consists of the Company’s owned and operated patient-care centers. The patient-care centers provide services to design and fit O&P devices to patients. These centers

 

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Table of Contents

 

NOTE L — SEGMENT AND RELATED INFORMATION (CONTINUED)

 

also instruct patients in the use, care and maintenance of the devices. The principal reimbursement sources for the Company’s services are:

 

·                  Commercial and other, which consist of individuals, rehabilitation providers, private insurance companies, HMOs, PPOs, hospitals, vocational rehabilitation, workers’ compensation programs and similar sources;

 

·                  Medicare, a federally funded health insurance program providing health insurance coverage for persons aged 65 or older and certain disabled persons, which provides reimbursement for O&P products and services based on prices set forth in fee schedules for 10 regional service areas;

 

·                  Medicaid, a health insurance program jointly funded by federal and state governments providing health insurance coverage for certain persons in financial need, regardless of age, which may supplement Medicare benefits for financially needy persons aged 65 or older; and

 

·                  U.S. Department of Veterans Affairs.

 

The Company estimates that government reimbursement, comprised of Medicare, Medicaid and the U.S. Department of Veterans Affairs, in the aggregate, accounted for approximately 41.2% and 40.4%, of the Company’s net sales for the three months ended March 31, 2012 and 2011, respectively.

 

Distribution—This segment distributes O&P products and components to both the O&P industry and the Company’s own patient-care practices. This segment also includes the Company’s Fabrication centers which are involved in the fabrication of O&P components for both the O&P industry and the Company’s own patient-care centers.

 

Therapeutic Solutions—This segment consists of the leasing of rehabilitation equipment from, and the provision of clinical program by, ACP as well the operations of IN, Inc. ACP is a developer of specialized rehabilitation technologies and provides evidence-based clinical programs for post-acute rehabilitation. IN, Inc. specializes in bringing emerging neuromuscular technologies to the O&P market.

 

Other—This consists of Hanger corporate and Linkia. Linkia is a national managed-care agent for O&P services and a patient referral clearing house.

 

The accounting policies of the segments are the same as those described in the summary of “Significant Accounting Policies” in Note B to the consolidated financial statements.

 

Summarized financial information concerning the Company’s reportable segments is shown in the following table. Intersegment sales mainly include sales of O&P components from the Distribution segment to the Patient-Care Services segment and were made at prices which approximate market values.

 

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Table of Contents

 

NOTE L — SEGMENT AND RELATED INFORMATION (CONTINUED)

 

(In thousands)

 

Patient-Care
Services

 

Distribution

 

Therapeutic
Solutions

 

Other

 

Consolidating
Adjustments

 

Total

 

 

 

(Unaudited)

 

(Unaudited)

 

(Unaudited)

 

(Unaudited)

 

(Unaudited)

 

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended March 31, 2012

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

 

 

 

 

 

 

 

 

 

 

 

 

Customers

 

$

176,369

 

$

26,241

 

$

15,333

 

$

148

 

$

 

$

218,091

 

Intersegments

 

 

47,569

 

844

 

 

(48,413

)

 

Depreciation and amortization

 

3,417

 

324

 

2,673

 

1,871

 

 

8,285

 

Income (loss) from operations

 

24,870

 

8,542

 

268

 

(13,447

)

(277

)

19,956

 

Interest (income) expense

 

7,582

 

832

 

1,440

 

(2,077

)

 

7,777

 

Income (loss) before taxes

 

17,288

 

7,710

 

(1,172

)

(11,370

)

(277

)

12,179

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital Expenditures

 

2,541

 

90

 

624

 

2,061

 

 

5,316

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended March 31, 2011

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

 

 

 

 

 

 

 

 

 

 

 

 

Customers

 

$

160,551

 

$

23,461

 

$

16,257

 

$

170

 

$

 

$

200,439

 

Intersegments

 

 

41,627

 

745

 

 

(42,372

)

 

Depreciation and amortization

 

2,961

 

284

 

2,474

 

1,573

 

 

7,292

 

Income (loss) from operations

 

22,373

 

6,887

 

751

 

(11,728

)

101

 

18,384

 

Interest (income) expense

 

7,116

 

849

 

1,440

 

(1,026

)

 

8,379

 

Income (loss) before taxes

 

15,257

 

6,038

 

(689

)

(10,702

)

101

 

10,005

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital Expenditures

 

3,082

 

168

 

90

 

2,047

 

 

5,387

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

March 31, 2012

 

1,292,294

 

178,481

 

134,733

 

(479,061

)

 

1,126,447

 

December 31, 2011

 

1,279,481

 

170,077

 

135,781

 

(456,839

)

 

1,128,500

 

 

NOTE M — CORPORATE OFFICE RELOCATION

 

The Company moved its corporate headquarters from Bethesda, Maryland to Austin, Texas in 2010. As of 1/1/2012 the relocation of the corporate office was complete. The following is a summary of the costs of the relocation incurred and to be paid in future periods:

 

(in thousands)

 

Employee
Separation

 

Other
Relocation

 

Lease
Termination

 

Total

 

Balance as of December 31, 2011

 

$

226

 

$

 

$

3,085

 

$

3,311

 

Expenses incurred

 

 

 

 

 

Amounts paid

 

(35

)

 

(104

)

(139

)

Balance as of March 31, 2012

 

$

191

 

$

 

$

2,981

 

$

3,172

 

 

 

 

Employee
Separation

 

Other
Relocation

 

Lease
Termination

 

Total

 

Balance as of December 31, 2010

 

$

1,895

 

$

 

$

5,206

 

$

7,101

 

Expenses incurred

 

36

 

340

 

 

376

 

Amounts paid

 

(926

)

(340

)

(641

)

(1,907

)

Balance as of March 31, 2011

 

$

1,005

 

$

 

$

4,565

 

$

5,570

 

 

16



Table of Contents

 

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

The following is a discussion of our results of operations and financial condition for the periods described below. This discussion should be read in conjunction with the Consolidated Financial Statements included in this report. Our discussion of our results of operations and financial condition includes various forward-looking statements about our markets, the demand for our products and services and our future results. These statements are based on our current expectations, which are inherently subject to risks and uncertainties. Refer to risk factors disclosed in Part II, Item 1A of this filing as well as the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 for further discussion of risks and uncertainties. Our actual results and the timing of certain events may differ materially from those indicated in the forward looking statements.

 

Business Overview

 

General

 

The goal of Hanger Orthopedic Group, Inc. (the “Company”) is to be the world’s premier provider of services and products that enhance human physical capabilities. We provide orthotic and prosthetic patient-care services, distribute O&P devices and components, manage O&P networks, and provide therapeutic solutions to the broader post acute market. We are the largest owner and operator of orthotic and prosthetic patient-care centers in the United States and, through our distribution subsidiary, Southern Prosthetic Supply, Inc. (“SPS”), the largest dedicated distributor of O&P products in the United States. We operate in excess of 700 O&P patient-care centers located in 45 states and the District of Columbia and six strategically located distribution facilities. In addition to providing O&P services and products we, through our subsidiary, Linkia LLC (“Linkia”), manage an O&P provider network and develop programs to manage all aspects of O&P patient care for insurance companies. We also provide therapeutic solutions through our subsidiaries Innovative Neurotronics (“IN, Inc.”) and Accelerated Care Plus Corp (“ACP”). IN, Inc. introduces emerging neuromuscular technologies developed through independent research in a collaborative effort with industry suppliers worldwide. ACP is a developer of specialized rehabilitation technologies and a leading provider of evidence-based clinical programs for post-acute rehabilitation serving more than 4,200 long-term care facilities and other sub-acute rehabilitation providers throughout the U.S.

 

For the three months ended March 31, 2012, our net sales were $218.1 million and we recorded net income of $7.6 million. For the three months ended March 31, 2011, our net sales were $200.4 million and we recorded net income of $6.2 million.

 

We have three segments—Patient-Care Services, Distribution and Therapeutic Solutions. For the three months ended March 31, 2012, net sales attributable to our Patient-Care Services, Distribution and Therapeutic Solutions segments were $176.5 million, $26.3 million and $15.3 million, respectively.  See Note L to our consolidated financial statements contained herein for further information related to our segments.

 

Industry Overview

 

We provide goods and services to the O&P, post-acute, and other rehabilitation markets. We estimate that the O&P patient-care market in the United States is approximately $2.6 billion, of which we account for approximately 29%, and the post-acute rehabilitation and other rehabilitation markets, combined, are approximately $1.3 billion, of which we account for 5%. We commissioned a study in the past which identified additional opportunities to leverage our expertise beyond the traditional O&P market, and we

 

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Table of Contents

 

believe these additional opportunities could potentially expand our available O&P market by an additional $1.4 billion to $4.0 billion.

 

The O&P patient-care services market is highly fragmented and is characterized by local, independent O&P businesses, with the majority of these businesses generally having a single facility with annual revenues of less than $1.0 million. We do not believe that any single competitor accounts for more than 2% of the country’s total estimated O&P patient-care services revenue.

 

The O&P services industry is characterized by stable, recurring revenues, primarily resulting from new patients as well as the need for periodic replacement and modification of O&P devices. Based on our experience, the average replacement time for orthotic devices is one to three years, while the average replacement time for prosthetic devices is three to five years. There is also an attendant need for continuing O&P patient-care services. In addition to the inherent need for periodic replacement and modification of O&P devices and continuing care, we expect the demand for O&P services to continue to grow as a result of several key trends, including the aging of the U.S. population, resulting in an increase in incidence of disease, and the demands for new and advanced devices.

 

We estimate the post-acute rehabilitation market to include approximately 15,000 skilled nursing facilities (“SNFs”) and to have a market potential of approximately $200 million. We provide technologically advanced rehabilitation equipment and clinical programs to approximately 31% of the post-acute market. We estimate the broader rehabilitation markets, which include independent rehabilitation providers and providers in other post-acute settings, to be approximately $1.1 billion. We currently provide goods and services to very few customers in this portion of the market, however, we believe this market would benefit from our products and services.

 

Business Description

 

Patient-Care Services

 

As of March 31, 2012, we provided O&P patient-care services through over 700 patient-care centers and over 1,180 clinicians in 45 states and the District of Columbia. Substantially all of our clinicians are certified, or are candidates for formal certification, by the O&P industry certifying boards. A clinician manages each of our patient-care centers. Our patient-care centers also employ highly trained technical personnel who assist in the provision of services to patients and who fabricate various O&P devices, as well as office administrators who schedule patient visits, obtain approvals from payors and bill and collect for services rendered.

 

In our orthotics business, we design, fabricate, fit and maintain a wide range of custom-made braces and other devices (such as spinal, knee and sports-medicine braces) that provide external support to patients suffering from musculoskeletal disorders, such as ailments of the back, extremities or joints and injuries from sports or other activities. In our prosthetics business, we design, fabricate, fit and maintain custom-made artificial limbs for patients who are without limbs as a result of traumatic injuries, vascular diseases, diabetes, cancer or congenital disorders. O&P devices are increasingly technologically advanced and are custom-designed to add functionality and comfort to patients’ lives, shorten the rehabilitation process and lower the cost of rehabilitation. Patients are referred to Hanger by an attending physician who determines a patient’s treatment and writes a prescription. Our clinicians then consult with both the referring physician and the patient with a view toward assisting in the design of an orthotic or prosthetic device to meet the patient’s needs.

 

The fitting process often involves several stages in order to successfully achieve desired functional and cosmetic results. The clinician creates a cast and takes detailed measurements, frequently using our digital imaging system (Insignia), of the patient’s residual limb to ensure an anatomically correct fit. Prosthetic

 

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devices are custom fabricated and fit by skilled clinicians. The majority of the orthotic devices provided by us are custom designed, fabricated and fit; the remainder are prefabricated but custom fit.

 

Custom devices are fabricated by our skilled technicians using plaster castings, measurements and designs made by our clinicians and by utilization of our proprietary Insignia system. The Insignia system replaces plaster casting of a patient’s residual limb with a computer generated image. Insignia provides a very accurate image, faster turnaround for the patient, and a more professional overall experience. Technicians use advanced materials and technologies to fabricate a custom device under quality assurance guidelines. Custom designed devices that cannot be fabricated at the patient-care centers are fabricated at one of several central fabrication facilities.

 

To provide timely service to our patients, we employ technical personnel and maintain laboratories at many of our patient-care centers. We have earned a strong reputation within the O&P industry for the development and use of innovative technology in our products, which has increased patient comfort and capability, and can significantly enhance the rehabilitation process. The quality of our services and the success of our technological advances have generated broad media coverage, building our brand equity among payors, patients and referring physicians.

 

The principal reimbursement sources for our services are:

 

·                  Commercial and other, which consist of individuals, rehabilitation providers, private insurance companies, HMOs, PPOs, hospitals, vocational rehabilitation, workers’ compensation programs and similar sources;

 

·                  Medicare, a federally funded health insurance program providing health insurance coverage for persons aged 65 or older and certain disabled persons, which provides reimbursement for O&P products and services based on prices set forth in fee schedules for 10 regional service areas;

 

·                  Medicaid, a health insurance program jointly funded by federal and state governments providing health insurance coverage for certain persons in financial need, regardless of age, which may supplement Medicare benefits for financially needy persons aged 65 or older; and

 

·                  U.S. Department of Veterans Affairs.

 

We estimate that government reimbursement, comprised of Medicare, Medicaid and the U.S. Department of Veterans Affairs, in the aggregate, accounted for approximately 41.2% and 40.4% of our net sales for the three months ended March 31, 2012 and 2011, respectively. These payors have set maximum reimbursement levels for O&P services and products. Medicare prices are adjusted each year based on the Consumer Price Index-Urban (“CPIU”) unless congress acts to change or eliminate the adjustment. The Medicare price (decreases)/increases for 2012, 2011, 2010, 2009, and 2008 were 2.4%, (0.1%), 0.0%, 5.0%, and 2.7%, respectively. There can be no assurance that future changes will not reduce reimbursements for O&P services and products from these sources.

 

We enter into contracts with third-party payors that allow us to perform O&P services for a referred patient and be paid under the contract with the third- party payor. These contracts typically have a stated term of one to three years. These contracts generally may be terminated without cause by either party on 60 to 90 days’ notice or on 30 days’ notice if we have not complied with certain licensing, certification, program standards, Medicare or Medicaid requirements or other regulatory requirements. Reimbursement for services is typically based on a fee schedule negotiated with the third-party payor that reflects various factors, including geographic area and number of persons covered.

 

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Through the normal course of business, we receive patient deposits on devices not yet delivered. At March 31, 2012 and 2011, we held $1.1 million and $1.3 million of deposits, respectively, from our patients.

 

Provider Network Management

 

Linkia is the only provider network management company dedicated solely to serving the O&P market. Linkia is dedicated to managing the O&P services of national and regional insurance companies. Linkia partners with healthcare insurance companies by securing a national or regional contract either as a preferred provider or to manage their O&P network of providers. Linkia’s network now includes approximately 1,030 O&P provider locations, including approximately 350 independent providers. As of March 31, 2012, Linkia had 52 contracts with national and regional providers.

 

Distribution Services

 

We distribute O&P components to independent customers and to our own patient-care centers through our wholly-owned subsidiary, SPS, which is the nation’s largest dedicated O&P distributor. We are also a leading manufacturer and distributor of therapeutic footwear for diabetic patients in the podiatric market. SPS maintains in inventory approximately 29,000 individual SKUs manufactured by more than 300 different companies. SPS operates distribution facilities in California, Florida, Georgia, Illinois, Pennsylvania, and Texas, which allows us to deliver products via ground shipment anywhere in the contiguous United States typically within two business days.

 

Our Distribution business enables us to:

 

·                  centralize our purchasing and thus lower our material costs by negotiating purchasing discounts from manufacturers;

 

·                  reduce our patient-care center inventory levels and improve inventory turns;

 

·                  perform inventory quality control;

 

·                  encourage our patient-care centers to use clinically appropriate products that enhance our profit margins; and

 

·                  coordinate new product development efforts with key vendor “partners”.

 

Marketing of our Distribution services is conducted on a national basis through a dedicated sales force, print and e-commerce catalogues, and exhibits at industry and medical meetings and conventions. We direct specialized catalogues to segments of the healthcare industry, such as orthopedic surgeons, physical and occupational therapists, and podiatrists.

 

Therapeutic Solutions

 

We provide therapeutic solutions to the O&P market and post-acute rehabilitation market through our subsidiaries IN, Inc. and ACP. ACP is the nation’s leading provider of rehabilitation technologies and integrated clinical programs to rehabilitation providers. ACP’s unique value proposition is to provide its customers with a full-service “total solutions” approach encompassing proven medical technology, evidence based clinical programs, and continuous onsite therapist education and training. ACP’s services support increasingly advanced treatment options for a broader patient population and more medically complex conditions. ACP has contracts to serve more than 4,200 skilled nursing facilities nationwide, including 21 of the 25 largest national providers. ACP’s contracts contain negotiated pricing and service

 

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levels with terms ranging from one to five years. ACP generally bills its customers monthly and revenue is recognized based upon the contractual terms of the agreements.

 

IN, Inc. specializes in the product development and commercialization of emerging products in the Orthotic Prosthetic and Rehabilitation markets. Working with inventors under licensing and consulting agreements, IN, Inc. commercializes the design, obtains regulatory approvals, develops clinical protocols for the technology, and then introduces the devices to the marketplace through a variety of distribution channels. IN, Inc. currently has two commercial products: the WalkAide System which benefits patients with a condition referred to as drop foot and the V-Hold which is active vacuum technology used in lower extremity prosthetic devices. The V-Hold is primarily sold through our patient care centers. The WalkAide System is currently reimbursable for Medicare beneficiaries with foot drop due to incomplete spinal cord injuries. IN, Inc. is currently conducting clinical trials in an effort to gain additional coverage for stroke patients with foot drop, which represents the largest potential foot drop patient population. These trials are now fully enrolled with submission of data to CMS anticipated in 2013. In addition to reimbursement with Medicare, IN, Inc. has been working with commercial insurance companies and has had limited success in receiving coverage for the WalkAide. The WalkAide is sold in the United States through our patient-care centers and SPS. IN, Inc. is also marketing the WalkAide internationally through a network of distributors in Europe, the Middle East/Africa, Latin America, Canada, and Asia.

 

Critical Accounting Policies and Estimates

 

Our analysis and discussion of our financial condition and results of operations is based upon our Consolidated Financial Statements that have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  GAAP provides the framework from which to make these estimates, assumptions and disclosures. We have chosen accounting policies within GAAP that management believes are appropriate to accurately and fairly report our operating results and financial position in a consistent manner. Management regularly assesses these policies in light of current and forecasted economic conditions. Our accounting policies are stated in Note B to the Consolidated Financial Statements included elsewhere in this report.  We believe the following accounting policies are critical to understanding our results of operations and the more significant judgments and estimates used in the preparation of our Consolidated Financial Statements.

 

·                  Revenue Recognition:  Revenues in our Patient-Care Services segment are derived from the sale of O&P devices and the maintenance and repair of existing devices and are recorded net of all contractual adjustments and discounts. The sale of O&P devices includes the design, fabrication, assembly, fitting and delivery of a wide range of braces, limbs and other devices. Revenues from the sale of these devices are recorded when (i) acceptance by and delivery to the patient has occurred; (ii) persuasive evidence of an arrangement exists and there are no further obligations to the patient; (iii) the sales price is fixed or determinable; and (iv) collectability is reasonably assured. Revenues from maintenance and repairs are recognized when the service is provided. Revenues on the sale of O&P devices to customers by the Distribution segment are recorded upon the shipment of products, in accordance with the terms of the invoice, net of merchandise returns received and the amount established for anticipated returns. Discounted sales are recorded at net realizable value. Revenues in our Therapeutic Solutions are primarily derived from leasing rehabilitation technology combined with clinical therapy programs and education and training. The revenue is recorded on a monthly basis according to terms of the contracts with our customers.

 

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Certain accounts receivable may be uncollectible, even if properly pre-authorized and billed. Regardless of the balance, accounts receivable amounts are periodically evaluated to assess collectability. In addition to the actual bad debt expense recognized during collection activities, we estimate the amount of potential bad debt expense that may occur in the future. This estimate is based upon our historical experience as well as a review of our receivable balances.

 

On a quarterly basis, we evaluate cash collections, accounts receivable balances and write-off activity to assess the adequacy of our allowance for doubtful accounts. Additionally, a company-wide evaluation of collectability of receivable balances older than 180 days is performed at least semi-annually, the results of which are used in the next allowance analysis. In these detailed reviews, the account’s net realizable value is estimated after considering the customer’s payment history, past efforts to collect on the balance and the outstanding balance, and a specific reserve is recorded if needed. From time to time, we may outsource the collection of such accounts to collection agencies after internal collection efforts are exhausted. In cases where valid accounts receivable cannot be collected, the uncollectible account is written off to bad debt expense.

 

The following represents the composition of our accounts receivable balance by type of payor:

 

March 31, 2012

 

 

 

 

 

 

 

 

 

(In thousands)

 

0-60 days

 

61-120 days

 

Over 120 days

 

Total

 

Patient Care Services

 

 

 

 

 

 

 

 

 

Commercial insurance

 

$

40,808

 

$

10,377

 

$

12,789

 

$

63,974

 

Private pay

 

4,453

 

3,513

 

9,216

 

17,182

 

Medicaid

 

11,262

 

3,255

 

4,411

 

18,928

 

Medicare

 

25,111

 

3,608

 

5,275

 

33,994

 

VA

 

1,974

 

370

 

263

 

2,607

 

Distribution & Therapeutic Solutions Trade accounts receivable

 

11,688

 

3,011

 

3,946

 

18,645

 

 

 

$

95,296

 

$

24,134

 

$

35,900

 

$

155,330

 

 

December 31, 2011

 

 

 

 

 

 

 

 

 

(In thousands)

 

0-60 days

 

61-120 days

 

Over 120 days

 

Total

 

Patient Care Services

 

 

 

 

 

 

 

 

 

Commercial insurance

 

$

50,136

 

$

9,594

 

$

11,759

 

$

71,489

 

Private pay

 

3,936

 

3,791

 

9,219

 

16,946

 

Medicaid

 

12,018

 

3,678

 

4,173

 

19,869

 

Medicare

 

25,438

 

3,489

 

4,433

 

33,360

 

VA

 

1,428

 

373

 

159

 

1,960

 

Distribution & Therapeutic Solutions Trade accounts receivable

 

11,367

 

2,663

 

3,200

 

17,230

 

 

 

$

104,323

 

$

23,588

 

$

32,943

 

$

160,854

 

 

·                  Inventories:  Inventories, which consist principally of raw materials, work in process and finished goods, are stated at the lower of cost or market using the first-in, first-out method. At our Patient-Care Services segment, we calculate cost of goods sold—materials in accordance with the gross profit method for all reporting periods. We base the estimates used in applying the gross profit method on the actual results of the most recently completed physical inventory and other factors, such as sales mix and purchasing trends among other factors. Cost of goods sold—materials is adjusted once the annual physical inventory is taken and the valuation is completed in the fourth quarter. We treat these inventory adjustments as changes in accounting estimates.

 

·                  Goodwill and Other Intangible Assets:  Goodwill represents the excess of purchase price over the fair value of net identifiable assets of purchased businesses. We assess goodwill for impairment annually on October 1, or when events or circumstances indicate that the carrying value of the reporting units may not be recoverable. Any impairment would be recognized by a charge to

 

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operating results and a reduction in the carrying value of the intangible asset. Our annual impairment test for goodwill primarily utilizes the income approach and considers the market approach and the cost approach in determining the value of our reporting units. Non-compete agreements are recorded based on agreements entered into by us and are amortized, using the straight-line method, over their terms ranging from five to seven years. Other definite-lived intangible assets are recorded at cost and are amortized, using the straight-line method, over their estimated useful lives of up to 17 years. Whenever the facts and circumstances indicate that the carrying amounts of these intangibles may not be recoverable, we review and assess the future cash flows expected to be generated from the related intangible for possible impairment. Any impairment would be recognized as a charge to operating results and a reduction in the carrying value of the intangible asset. As of October 1, 2011, there were no indicators of impairment as the fair value of the reporting units is substantially in excess of their carrying value.

 

·                  Income taxes:  We are required to estimate income taxes in each of the jurisdictions in which we operate. This process involves estimating the actual current tax liability together with assessing temporary differences in recognition of income (loss) for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the Consolidated Balance Sheet. We then assess the likelihood that the deferred tax assets will be recovered from future taxable income and, to the extent that we believe that recovery is not likely, we establish a valuation allowance against the deferred tax asset.

 

We recognize liabilities for uncertain tax positions based on a two-step process. The first step requires us to determine if the weight of available evidence indicates that the tax position has met the threshold for recognition; therefore, we must evaluate whether it is more likely than not that the position will be sustained on audit, including resolution of any related appeals or litigation processes. The second step requires us to measure the tax benefit of the tax position taken, or expected to be taken, in an income tax return as the largest amount that is more than 50% likely of being realized upon ultimate settlement. This measurement step is inherently complex and requires subjective estimations of such amounts to determine the probability of various possible outcomes. We re-evaluate the uncertain tax positions each quarter based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, expirations of statutes of limitation, effectively settled issues under audit, and new audit activity. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision in the period.

 

Although we believe the measurement of our liabilities for uncertain tax positions is reasonable, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the historical income tax provisions and accruals. If additional taxes are assessed as a result of an audit or litigation, it could have a material effect on the income tax provision and net income in the period or periods for which that determination is made. We operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. These audits can involve complex issues which may require an extended period of time to resolve and could result in additional assessments of income tax. We believe adequate provisions for income taxes have been made for all periods.

 

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New Accounting Guidance

 

In May 2011, the FASB issued Accounting Standards Update (“ASU”) 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs,” which amends ASC 820, “Fair Value Measurement.” The amended guidance changes the wording used to describe many requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. Additionally, the amendments clarify the FASB’s intent about the application of existing fair value measurement requirements. The guidance provided in ASU No. 2011-04 is effective for interim and annual periods beginning after December 15, 2011 and is applied prospectively. The provisions are effective for the Company’s year ended December 31, 2012. The Company adopted the amendments of this ASU effective January 1, 2012, and the initial adoption of the amendments in this ASU did not have a material impact on our condensed consolidated financial statements.

 

In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220),” which changes the presentation of comprehensive income. The amended guidance gives companies the option to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The guidance provided in ASU No. 2011-05 is effective for interim and annual periods beginning after December 15, 2011 and is applied prospectively. The provisions are effective for the Company’s year ended December 31, 2012. The Company adopted the amendments of this ASU effective January 1, 2012, and the initial adoption of the amendments in this ASU did not have a material impact on our condensed consolidated financial statements.

 

In July 2011, the FASB issued ASU No. 2011-07 “Presentation and Disclosures of Patient Service Revenue, Provision for Bad Debts and the Allowance for Doubtful Accounts for Certain Health Care Entities.”  The objective of this update is to provide financial statement users with greater transparency about a health care entity’s net patient service revenue and the related allowance for doubtful accounts. This update provides information to assist financial statement users in assessing an entity’s sources of net patient service revenue and related changes in its allowance for doubtful accounts. The amendments require health care entities that recognize significant amounts of patient service revenue at the time the services are rendered even though they do not assess the patient’s ability to pay to present the provision for bad debts related to patient service revenue as a deduction from patient service revenue (net of contractual allowances and discounts) on their statement of operations. The amendments in this update require certain health care entities to change the presentation of their statement of operations by reclassifying the provision for bad debts associated with patient service revenue from an operating expense to a deduction from patient service revenue (net of contractual allowances and discounts). Additionally, those health care entities are required to provide enhanced disclosure about their policies for recognizing revenue and assessing bad debts. The amendments also require disclosures of patient service revenue (net of contractual allowances and discounts) as well as qualitative and quantitative information about changes in the allowance for doubtful accounts. The guidance provided in ASU No. 2011-07 is effective for interim and annual periods beginning after December 15, 2011 and is applied prospectively. The provisions are effective for the Company’s year ended December 31, 2012. The Company has determined that ASU No. 2011-07 has no impact on its financial statements.

 

In September 2011, FASB issued ASU 2011-08, “Intangibles — Goodwill and Other (Topic 350):  Testing Goodwill for Impairment”, which provides entities the option to perform a qualitative assessment in order to determine whether additional quantitative impairment testing is necessary. This amendment is effective for reporting periods beginning after December 15, 2011. This amendment does not impact the quantitative testing methodology, should it be necessary. The Company adopted this standard on January 1, 2012 and the initial adoption of the amendments in this ASU did not have a material impact on our condensed consolidated financial statements.

 

Guidance and Outlook

 

The Company expects full year 2012 revenues of between $970 million and $990 million resulting from comparable store sales growth in our Patient Care Services and Distribution segments of 3% to 5%. We expect flat to slightly higher revenues in our Therapeutic Services segment for the year, with sales in the first half of the year down then trending up in the second half as the rate of new contracts accelerates. The Company anticipates diluted earnings per share of between $1.67 and $1.74, which includes approximately $0.05 for one-time training costs related to the implementation of our new patient

 

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management system. As in past years, the Company’s goal is to increase operating margins by twenty to forty basis points. The Company anticipates generating cash flow from operations between $70 million and $80 million in 2012 and investing a total of $40 million to $50 million in capital additions. During 2012 the Company will continue its acquisition program with a goal of closing acquisitions that total approximately $20 million in annualized revenues.

 

Results of Operations

 

The following table sets forth for the periods indicated certain items from our Consolidated Statements of Operations as a percentage of our net sales:

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

 

 

(Unaudited)

 

(Unaudited)

 

 

 

 

 

 

 

Net sales

 

100.0

%

100.0

%

Cost of goods sold - materials

 

29.4

 

29.0

 

Personnel costs

 

38.3

 

39.4

 

Other operating expenses

 

19.3

 

18.7

 

Relocation expenses

 

 

0.2

 

Depreciation and amortization

 

3.8

 

3.6

 

Income from operations

 

9.2

 

9.1

 

Interest expense

 

3.6

 

4.2

 

Income before taxes

 

5.6

 

4.9

 

Provision for income taxes

 

2.1

 

1.9

 

Net income

 

3.5

%

3.0

%

 

Three Months Ended March 31, 2012 Compared to the Three Months Ended March 31, 2011

 

Net Sales.  Net sales for the three months ended March 31, 2012 increased $17.7 million, or 8.8%, to $218.1 million from $200.4 million for the three months ended March 31, 2011. The increase was the result of a $11.4 million, or 7.1%, increase in same-center sales in the Patient-Care Services segment; a $4.4 million increase from acquired entities; a $2.8 million, or 11.9%, increase in sales in the Distribution segment; and a $0.9 million decrease from the Therapeutic Solutions segment.

 

Cost of Goods Sold - Materials.  Cost of goods sold - materials for the three months ended March 31, 2012 was $64.1 million, an increase of $6.0 million, or 10.3%, over $58.1 million for the three months ended March 31, 2011. The increase was the result of growth in sales.  Cost of goods sold - materials as a percentage of net sales increased 40 basis points due to mix of revenue.

 

Personnel Costs.  Personnel costs for the three months ended March 31, 2012 increased by $4.7 million to $83.6 million from $78.9 million for the three months ended March 31, 2011. The increase was due to costs from acquired entities and increased employee benefit costs, staffing and merit increases. As a percentage of net sales, personnel costs decreased 1.1% to 38.3% in 2012 from 39.4% in 2011 due to leveraging existing resources over increased sales volume.

 

Other Operating Expenses.  Other operating expenses for the three months ended March 31, 2012 increased $4.7 million, to $42.1 million, from $37.4 million for the three months ended March 31, 2011. The increase was primarily due to: (i) the addition of $1.0 million in operating expenses from acquired entities; (ii) $1.2 million in increased expenses related bad debt; (iii) $0.8 million in increased incentive compensation; (iv) $0.6 million related to Instride trials; and (v) $0.6 million of non-recurring benefit in the first quarter of 2011, which reduced general insurance costs.  Other operating expenses as a percentage of net revenues increased 0.6% to 19.3% in 2012 from 18.7% in the prior year.

 

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Relocation Expenses.  As of January 1, 2012, we had completed the relocation of our corporate office from Bethesda, Maryland to Austin, Texas.  During the three months ended March 31, 2011, we incurred $0.4 million of employee relocation costs.

 

Depreciation and Amortization. Depreciation and amortization for the three months ended March 31, 2012 increased $1.0 million, to $8.3 million, compared to $7.3 million in the first quarter of 2011. The increase was primarily due to operating assets purchased over the last 12 months.

 

Income from Operations.  Income from operations increased $1.6 million, to $20.0 million, for the three months ended March 31, 2012 compared to $18.4 million for the three months ended March 31, 2011 due to increased sales volume.

 

Interest Expense.  Interest expense decreased $0.6 million for the three months ended March 31, 2012, to $7.8 million, compared to $8.4 million, for the three months ended March 31, 2011,  primarily due to lower interest rates resulting from the amendment to our credit facilities in March of 2011.

 

Provision for Income Taxes.  The provision for income taxes for the three months ended March 31, 2012 was $4.6 million, or 38.0% of pre-tax income, compared to $3.8 million, or 37.9% of pre-tax income, for the three months ended March 31, 2011. The effective tax rate consists principally of the 35% federal statutory tax rate and state income taxes, less permanent tax differences.

 

Net Income.  Net income increased $1.4 million, to $7.6 million, for three months ended March 31, 2012, from $6.2 million for the three months ended March 31, 2011, due primarily to increased sales volume.

 

Financial Condition, Liquidity and Capital Resources

 

Cash Flows

 

Our working capital at March 31, 2012 was $250.9 million, compared to $194.1 million at March 31, 2011. The increase in working capital is primarily due to increases in cash, inventory, and accounts receivable. Days sales outstanding (“DSO”), which is the number of days between the billing date of O&P services and the date of receipt of payment thereof, for the three months ended March 31, 2012 increased to 51 days from 47 days for the same period last year. Net cash provided by operating activities was $1.3 million for the quarter ended March 31, 2012 compared to $12.3 million used in operating activities in the prior year. The increase in cash provided by operating activities in the current year resulted primarily from increased net sales, and a decrease in incentive compensation payments in 2012.

 

Net cash used in investing activities was $10.8 million for the quarter ended March 31, 2012, compared to $10.4 million in the prior year. In 2012, we acquired one O&P company operating 2 patient-care centers at an aggregate purchase price of $2.0 million.  During the same period in 2011, we acquired one O&P company operating one patient-care center for an aggregate purchase price of $5.8 million. Additionally, in 2012, we invested $5.3 million in capital assets, compared to $5.4 million for the same period in 2011. Capital assets acquired in 2012 related to the development of the Company’s new patient management system and machinery and equipment purchases. During the first quarter of 2012 we restricted $3.1 million of cash in order to eliminate letters of credit obligations.

 

Net cash (used in)/provided by financing activities was $(1.1) million and $6.0 million for the quarters ended March 31, 2012 and 2011, respectively. During the first quarter of 2012 we: (i) repaid $1.4 million related to term loan borrowings under our credit facilities (“Term Loans”); (ii) made $0.5 million of required repayments of promissory notes issued in connection with acquisitions (“Seller Notes”); and (iii) received $0.6 million of proceeds from issuance of stock under employee stock compensation plans. During the first quarter of 2011 we: (i) borrowed $10.0 million under our revolving credit facility; (ii) repaid

 

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$0.8 million related to Term Loans; (iii) made $0.4 million of required repayments of Seller Notes; (iv) incurred $4.2 million of financing costs related to the repricing of our debt in the first quarter of 2011; and (v) received $0.6 million of proceeds from issuance of stock under employee stock compensation plans.

 

Debt

 

Long-term debt consisted of the following:

 

 

 

March 31,

 

December 31,

 

(In thousands)

 

2012

 

2011

 

 

 

(Unaudited)

 

(Unaudited)

 

Revolving Credit Facility

 

$

 

$

 

Term Loan

 

295,550

 

297,000

 

7 1/8% Senior Notes due 2018

 

200,000

 

200,000

 

Subordinated seller notes, non-collateralized, net of unamortized discount with principal and interest payable in either monthly, quarterly or annual installments at effective interest rates ranging from 3.00% to 7.00%, maturing through November 2016

 

10,545

 

11,033

 

 

 

506,095

 

508,033

 

Less current portion

 

(7,927

)

(8,065

)

 

 

$

498,168

 

$

499,968

 

 

Amendment to Credit Agreement

 

On March 11, 2011, the Company entered into an amendment to its Credit Agreement dated as of December 1, 2010 (as amended, the “Credit Agreement”). The amendment (i) reduced the interest rate margin applicable to the Term Loans under the Credit Agreement by 0.75% to 3.0% and (ii) reduced the LIBOR floor applicable to the Term Loans under the Credit Agreement from 1.5% to 1.0%. The Company incurred $4.1 million of fees related to this amendment, which will be amortized into interest expense over the remaining term of the debt.

 

Revolving Credit Facility

 

The $100.0 million Revolving Credit Facility matures on December 1, 2015 and bears interest at LIBOR plus 3.75%, or the applicable rate (as defined in the Credit Agreement). The Revolving Credit Facility requires compliance with various covenants including but not limited to (i) minimum consolidated interest coverage ratio of 3.25:1.00 from October 1, 2011 to September 30, 2012, and 3.50:1.00 thereafter until maturity; (ii) maximum total leverage ratio of 5.00:1.00 until December 31, 2011, 4.50:1.00 from January 1, 2012 to September 30, 2012, and 4.00:1.00 from October 1, 2012 thereafter until maturity; and (iii) maximum annual capital expenditures of 7.5% of consolidated net revenues of the preceding fiscal year with an additional maximum rollover of $15.0 million from the prior year’s allowance if not expended in the fiscal year for which it is permitted. As of March 31, 2012, the Company had $99.5 million available under the Revolving Credit Facility. Availability under the Revolving Credit Facility as of March 31, 2012 was net of standby letters of credit of approximately $0.5 million. As of March 31, 2012, the Company had no funds drawn on the Revolving Credit Facility. The obligations under the Revolving Credit Facility are senior obligations, are guaranteed by the Company’s subsidiaries, and are secured by a first priority perfected interest in the Company’s subsidiaries’ shares, all of the Company’s assets, and all the assets of the Company’s subsidiaries.

 

Term Loan

 

The $300.0 million Term Loan Facility matures on December 1, 2016 and requires quarterly principal payments which commenced March 31, 2011. From time to time, mandatory prepayments may be

 

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required as a result of excess free cash flow as defined in the Credit Agreement, certain additional debt incurrences,  certain asset sales, or other events as defined in the Credit Agreement. The Term Loan Facility bears interest at LIBOR plus 3.0%, or applicable rate (as defined in the Credit Agreement), and includes a 1.0% LIBOR floor. There were no mandatory prepayments required during the first three months of 2012 or 2011. As of March 31, 2012, the interest rate on the Term Loan Facility was 4.0%. The obligations under the Term Loan Facility are senior obligations, are guaranteed by the Company’s subsidiaries, and are secured by a first priority perfected interest in the Company’s subsidiaries’ shares, all of the Company’s assets, and all the assets of the Company’s subsidiaries.

 

71/8% Senior Notes

 

The 71/8% Senior Notes mature November 15, 2018 and are senior indebtness which is guaranteed on a senior unsecured basis by all of the Company’s current and future subsidiaries. Interest is payable semi-annually on May 15 and November 15 of each year, commencing May 15, 2011.

 

On or prior to November 15, 2013, the Company may redeem up to 35% of the aggregate principal amount of the notes at a redemption price of 107.125% of the principal amount thereof, plus accrued and unpaid interest and additional interest to the redemption date with the proceeds of a public offering of its equity securities. On or after November 15, 2014, the Company may redeem all or from time to time a part of the notes, upon not less than 30 days and not more than 60 days’ notice, for the twelve month period beginning on November 15, of the indicated years at (i) 103.563% during 2014; (ii) 101.781% during 2015; and (iii) 100.00% during 2016 and thereafter through November 15, 2018.

 

Subsidiary Guarantees

 

The Revolving and Term Loan Facilities and the 71/8% Senior Notes are guaranteed by all of the Company’s subsidiaries. Separate condensed consolidating information is not included as the Company does not have independent assets or operations. The Guarantees are full and unconditional and joint and several, and any subsidiaries of the Company other than the Guarantor Subsidiaries are minor. There are no restrictions on the ability of our subsidiaries to transfer cash to the Company or to co-guarantors. All consolidated amounts in the Company’s financial statements are representative of the combined guarantors.

 

Debt Covenants

 

The terms of the Senior Notes, the Revolving Credit Facility, and the Term Loan Facility limit the Company’s ability to, among other things, incur additional indebtedness, create liens, pay dividends on or redeem capital stock, make certain investments, make restricted payments, make certain dispositions of assets, engage in transactions with affiliates, engage in certain business activities and engage in mergers, consolidations and certain sales of assets. At March 31, 2012, the Company was in compliance with all covenants under these debt agreements.

 

General

 

As of March 31, 2012, $295.6 million, or 58.4%, of our total debt of $506.1 million was subject to variable interest rates. We believe that, based on current levels of operations and anticipated growth, cash generated from operations, together with other available sources of liquidity, including borrowings available under the Revolving Credit Facility, will be sufficient for at least the next twelve months to fund anticipated capital expenditures, to fund our acquisition plans and make required payments of principal and interest on our debt, including payments due on our outstanding debt.

 

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Obligations and Commercial Commitments

 

The following table sets forth our contractual obligations and commercial commitments as of March 31, 2012 (unaudited):

 

 

 

Payments Due by Period

 

(In thousands)

 

Remainder of 2012

 

2013

 

2014

 

2015

 

2016

 

Thereafter

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Long-term debt

 

$

6,763

 

$

5,448

 

$

4,415

 

$

4,222

 

$

285,247

 

$

200,000

 

$

506,095

 

Interest payments on long-term debt

 

23,400

 

26,098

 

25,885

 

25,723

 

24,165

 

26,719

 

$

151,990

 

Operating leases

 

32,302

 

35,286

 

28,261

 

18,780

 

12,927

 

30,791

 

$

158,347

 

Capital leases and other long-term obligations (1)

 

12,960

 

14,027

 

11,347

 

8,570

 

3,369

 

12,357

 

$

62,630

 

Total contractual cash obligations

 

$

75,425

 

$

80,859

 

$

69,908

 

$

57,295

 

$

325,708

 

$

269,867

 

$

879,062

 

 


(1) Other long-term obligations include commitments under our SERP plan. Refer to Note K of the Company’s Annual Report on Form 10-K for additional disclosure.

 

The carrying value of our long-term debt, excluding the Senior Notes, approximates fair value based on rates currently available to the Company for debt with similar terms and remaining maturities (level 2). The fair value of the Senior Notes, as of March 31, 2012, was $210.5 million, as compared to the carrying value of $200.0 million at that date. The fair values of the Senior Notes were based on the quoted market price as of March 31, 2012 (level 1).

 

Market Risk

 

We are exposed to the market risk that is associated with changes in interest rates.  As of March 31, 2012, all our outstanding debt, with the exception of the $295.6 million borrowed under the Term Loan Facility, was subject to fixed interest rates (see Item 3 below).

 

Forward Looking Statements

 

This report contains forward-looking statements setting forth our beliefs or expectations relating to future revenues, contracts and operations, as well as the results of an internal investigation and certain legal proceedings. Actual results may differ materially from projected or expected results due to changes in the demand for our O&P products and services, uncertainties relating to the results of operations or recently acquired O&P patient-care centers, our ability to enter into and derive benefits from managed-care contracts, our ability to successfully attract and retain qualified O&P clinicians, federal laws governing the health-care industry, uncertainties inherent in incomplete investigations and legal proceedings, governmental policies affecting O&P operations and other risks and uncertainties generally affecting the health-care industry. Readers are cautioned not to put undue reliance on forward-looking statements.  Refer to risk factors disclosed in Part II, Item 1A of this filing as well as the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011 for discussion of risks and uncertainties. We disclaim any intent or obligation to publicly update these forward-looking statements, whether as a result of new information, future events or otherwise.

 

ITEM 3.  Quantitative and Qualitative Disclosures about Market Risk

 

We have existing obligations relating to our 71/8% Senior Notes, Term Loan Facility, Revolver and Subordinated Seller Notes. As of March 31, 2012, we had cash flow exposure to the changing interest rates on the $295.6 million borrowed under the Term Loan Facility. The other obligations have fixed interest rates.

 

Presented below is an analysis of our financial instruments as of March 31, 2012 that are sensitive to changes in interest rates. The table demonstrates the changes in estimated annual cash flow related to the outstanding balance under the Term Loan Facility, calculated for an instantaneous parallel shift in interest rates, plus or minus 50 basis points (“BPS”), 100 BPS and 150 BPS. The LIBOR floor and applicable rate pursuant to the Term Loans under the Credit Agreement prevents the rate from dropping below 4.0%. As

 

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of March 31, 2012, the current LIBOR and applicable rate, is 4.0%; therefore, a 76 BPS increase or decrease in LIBOR would not reduce or increase estimated annual cash flows related to the outstanding balance on the Term Loan Facility.

 

Cash Flow Risk

 

Annual Interest Expense Given an Interest Rate
Decrease of X Basis Points

 

No Change in
Interest Rates

 

Annual Interest Expense Given an Interest
Rate Increase of X Basis Points

 

(In thousands)

 

(150 BPS)

 

(100 BPS)

 

(50 BPS)

 

 

 

50 BPS

 

100 BPS

 

150 BPS

 

Term Loan

 

$

11,822

 

$

11,822

 

$

11,822

 

$

11,822

 

$

11,822

 

$

12,531

 

$

14,009

 

 

ITEM 4.  Controls and Procedures

 

Disclosure Controls and Procedures

 

The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed by it in its periodic reports filed with the Securities and Exchange Commission is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Based on an evaluation of the Company’s disclosure controls and procedures conducted by the Company’s Chief Executive Officer and Chief Financial Officer, such officers concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2012 to ensure that information required to be disclosed in the reports filed under the Exchange Act was accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.

 

Change in Internal Control Over Financial Reporting

 

In accordance with Rule 13a-15(d) under the Securities Exchange Act of 1934, management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, determined that there was no change in the Company’s internal control over financial reporting that occurred during the three months ended March 31, 2012, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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Part II.  Other Information

 

ITEM 1A.  RISK FACTORS.

 

Part I, Item 1A (“Risk Factors”) of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 sets forth information relating to important risks and uncertainties that could materially adversely affect the Company’s business, financial condition or operating results. Those risk factors continue to be relevant to an understanding of the Company’s business, financial condition and operating results.  Certain of those risk factors have been updated in this Form 10-Q to provide updated information, as set forth below. References to “we,” “our” and “us” in these risk factors refer to the Company.

 

Changes in government reimbursement levels could adversely affect our net sales, cash flows and profitability.

 

We derived 41.2% and 40.4% of our net sales for the three months ended March 31, 2012 and 2011, respectively, from reimbursements for O&P services and products from programs administered by Medicare, Medicaid and the U.S. Department of Veterans Affairs. Each of these programs set maximum reimbursement levels for O&P services and products. If these agencies reduce reimbursement levels for O&P services and products in the future, our net sales could substantially decline. In addition, the percentage of our net sales derived from these sources may increase as the portion of the U.S. population over age 65 continues to grow, making us more vulnerable to maximum reimbursement level reductions by these organizations. Reduced government reimbursement levels could result in reduced private payor reimbursement levels because fee schedules of certain third-party payors are indexed to Medicare. Furthermore, the healthcare industry is experiencing a trend towards cost containment as government and other third-party payors seek to impose lower reimbursement rates and negotiate reduced contract rates with service providers. This trend could adversely affect our net sales. For example, a number of states have reduced their Medicaid reimbursement rates for O&P services and products, or have reduced Medicaid eligibility, and others are in the process of reviewing Medicaid reimbursement policies generally, including for prosthetic and orthotic devices. Additionally, Medicare provides for reimbursement for O&P products and services based on prices set forth in fee schedules for ten regional service areas. Medicare prices are adjusted each year based on the Consumer Price Index—Urban (“CPIU”) unless Congress acts to change or eliminate the adjustment. The Medicare price (decreases)/increases for 2012, 2011, 2010, 2009, and 2008 were 2.4%, (0.1%), 0.0%, 5.0%, and 2.7% respectively. The Patient Protection and Affordable Care Act, Pub. L. No. 111-148, March 23, 2010 (“PPACA”) changed the Medicare inflation factors applicable to O&P (and other) suppliers. The annual updates for years subsequent to 2011 are based on the percentage increase in the CPI-U for the 12-month period ending with June of the previous year. Section 3401(m) of PPACA required that for 2011 and each subsequent year, the fee schedule update factor based on the CPI-U for the 12-month period ending with June of the previous year is to be adjusted by the annual economy-wide private nonfarm business multifactory productivity (“the MFP Adjustment”). The MFP Adjustment may result in that percentage increase being less than zero for a year and may result in payment rates for a year being less than such payment rates for the preceding year. CMS has not yet issued a final rule implementing these adjustments for years beyond 2011, but has indicated in a proposed rule that it will do so as part of the annual program instructions to the O&P fee schedule updates. See 75 Fed. Reg. 40040, 40122, et seq. (July 13, 2010). If the U.S. Congress were to legislate additional modifications to the Medicare fee schedules, our net sales from Medicare and other payors could be adversely and materially affected.

 

We cannot predict whether any such modifications to the fee schedules will be enacted or what the final form of any modifications might be.

 

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Our substantial indebtedness could impair our financial condition and our ability to fulfill our obligations under our indebtedness.

 

We have substantial debt. As of March 31, 2012, we had approximately $506.1 million of total indebtedness and $99.5 million available under our Revolving Credit Facility.

 

The level of our indebtedness could have important consequences to us.  For example, our substantial indebtedness could:

 

·                  make it more difficult for us to satisfy our obligations;

 

·                  increase our vulnerability to adverse general economic and industry conditions;

 

·                  require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate requirements;

 

·                  limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;

 

·                  place us at a competitive disadvantage compared to our competitors that have proportionately less debt;

 

·                  make it more difficult for us to borrow money for working capital, capital expenditures, acquisitions or other purposes;

 

·                  limit our ability to refinance indebtedness, or the associated costs may increase; and

 

·                  expose us to the risk of increased interest rates with respect to that portion of our debt that has a variable rate of interest.

 

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ITEM 6.

Exhibits

 

 

 

 

 

(a)

Exhibits.  The following exhibits are filed herewith:

 

 

 

Exhibit No.

 

Document

 

 

 

 

 

3.1

 

Amended and Restated By-Laws of Hanger Orthopedic Group, Inc., as amended effective February 2, 2012. (Incorporated herein by reference to Exhibit 3.1 to the Current Report on Form 8-K filed by the Registrant on February 2, 1012).

 

 

 

 

 

10.1

 

Fifth Amended and Restated Employment Agreement, effective as of January 1, 2012, by and between Thomas F. Kirk and the Company. (Incorporated herein by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the Registrant on January 26, 2012).

 

 

 

 

 

10.2

 

Amended and Restated Employment Agreement, effective as of January 1, 2012, by and between Vinit Asar and the Company. (Incorporated herein by reference to Exhibit 10.2 to the Current Report on Form 8-K filed by the Registrant on January 26, 2012).

 

 

 

 

 

10.3

 

Fourth Amended and Restated Employment Agreement, effective as of January 1, 2012, by and between George E. McHenry and the Company. (Incorporated herein by reference to Exhibit 10.3 to the Current Report on Form 8-K filed by the Registrant on January 26, 2012).

 

 

 

 

 

10.4

 

Fourth Amended and Restated Employment Agreement, effective as of January 1, 2012, by and between Richmond L. Taylor and the Company. (Incorporated herein by reference to Exhibit 10.4 to the Current Report on Form 8-K filed by the Registrant on January 26, 2012).

 

 

 

 

 

31.1

 

Written Statement of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

 

31.2

 

Written Statement of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

 

32

 

Written Statement of the Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

 

101

 

The following financial information from the Company’s Quarterly Report on Form 10-Q, for the period ended March 31 2012, formatted in eXtensible Business Reporting Language: (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Cash Flows, (iv) Notes to Consolidated Financial Statements (1)


(1)      Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

HANGER ORTHOPEDIC GROUP, INC.

 

 

 

 

 

 

Dated: May 4, 2012

 

/s/Thomas F. Kirk

 

 

Thomas F. Kirk

 

 

Chief Executive Officer

 

 

(Principal Executive Officer)

 

 

 

 

 

 

Dated: May 4, 2012

 

/s/George E. McHenry

 

 

George E. McHenry

 

 

Executive Vice President and

 

 

Chief Financial Officer

 

 

(Principal Financial Officer)

 

 

 

 

 

 

Dated: May 4, 2012

 

/s/Thomas C. Hofmeister

 

 

Thomas C. Hofmeister

 

 

Vice President of Finance

 

 

(Chief Accounting Officer)

 

34