-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, WTPDzeWAXgxNtFykox6xVzJ/HqeFTEuoSqxq7pJqMuq7MVrApBDPp/lHPiqSrVSW KPSkjIrF6BnLYqT+Wh6gcA== 0000899243-97-000511.txt : 19970401 0000899243-97-000511.hdr.sgml : 19970401 ACCESSION NUMBER: 0000899243-97-000511 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970331 SROS: AMEX FILER: COMPANY DATA: COMPANY CONFORMED NAME: DRCA MEDICAL CORP CENTRAL INDEX KEY: 0000807144 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-HEALTH SERVICES [8000] IRS NUMBER: 760203483 STATE OF INCORPORATION: TX FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-10677 FILM NUMBER: 97568599 BUSINESS ADDRESS: STREET 1: 3 RIVERWAY STE 1430 CITY: HOUSTON STATE: TX ZIP: 77056 BUSINESS PHONE: 7134397511 MAIL ADDRESS: STREET 1: THREE RIVERWAY STREET 2: STE 1430 CITY: HOUSTON STATE: TX ZIP: 77056 FORMER COMPANY: FORMER CONFORMED NAME: DOCTORS REHABILITATION CORPORATION OF AMERICA DATE OF NAME CHANGE: 19910107 10-K 1 FORM 10-K SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-KSB (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1996 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition period from _______________ to _____________ Commission file number 1-10677 Integrated Orthopaedics, Inc. (formerly DRCA Medical Corporation) (Exact name of small business issuer as specified in its charter) Texas 76-0203483 (State or other jurisdiction of (IRS Employer incorporation or orgainzation Identification No.) 3 Riverway, Suite 1430, Houston, Texas 77056 (Address of principal executive offices, including zip code) (713) 439-7511 (Issuer's telephone number, including area code) Securities registered under Section 12(b) of the Exchange Act: Name of each exchange Title of each class on which registered Common Stock American Stock Exchange Securities registered under Section 12(g) of the Exchange Act: None Check whether the issuer (1) filed all reports required by Section 13 or 15(d) of the Exchange Act during the past 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 [ ] Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of registrant's knowledge in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [ ] Net revenues of the issuer for the fiscal year ended December 31, 1996 were $14,313,154. The aggregate market value of Common Stock held by non-affiliates of the issuer as of March 17, 1997, computed by reference to the closing price at which the stock was sold, was $13,852,137. As of March 17, 1997, 5,286,641 shares of Common Stock were outstanding Transitional Small Business Disclosure Format: Yes [ ] No [X] Documents Incorporated by Reference Portions of the Proxy Statement for registrant's 1997 Annual Meeting of Shareholders are incorporated by reference in Part III. The Exhibit Index is located on pages 34 - 37. PART I ITEM 1. DESCRIPTION OF BUSINESS GENERAL DESCRIPTION OF COMPANY Integrated Orthopaedics, Inc. (formerly DRCA Medical Corporation) was formed on April 1, 1990 as a successor corporation ("IOI", "DRCA" or the "Company"). The Company has organized its operations through wholly- and majority-owed subsidiaries and affiliates controlled through contract and otherwise. DESCRIPTION OF SERVICES IOI is a Physician Practice Management ("PPM") company specializing in the management of orthopaedic medicine practices and other musculoskeletal-related patient services. In December, 1996, the Company divested substantially all assets not directly related to the planned expansion of its management of musculoskeletal-related healthcare delivery systems in selected geographic markets. IOI's current business strategy is to acquire, develop and manage orthopaedic and other musculoskeletal-related medical practices and ancillary services in selected markets so as to provide a cost effective, broad continuum of health care services required by patients with musculoskeletal injuries and illnesses. Pursuant to a long term management agreement, the Company currently manages a musculoskeletal-related healthcare delivery system in Houston, Texas which consists of orthopaedic and orthopaedics-related medical services, diagnostic imaging, physical and occupational rehabilitation, pain management and work hardening. These operations provide a broad range of orthopaedic medicine and ancillary services to diagnose, treat and rehabilitate patients with musculoskeletal injuries and illnesses. The musculoskeletal-related healthcare delivery system currently managed by the Company includes an orthopaedic medicine practice, three work hardening clinics, two physical/occupational therapy centers (one of which is operated under a facility management contract with a major hospital system), and one magnetic resonance imaging center in Houston, Texas. During 1996, the Company, in a strategic effort to restructure its operations towards a single focus musculoskeletal-related physician practice management company, divested its interests in eight occupational medicine centers, four physical and medical therapy centers associated with the occupational medicine centers, seven mobile health testing units operated in conjunction with the occupational medicine programs in Houston, Texas and Little Rock, Arkansas, and one magnetic resonance imaging ("MRI") center in Little Rock, Arkansas. Services provided by medical providers under management by the Company include diagnostic, treatment and rehabilitation programs for patients experiencing disabilities due to a variety of physical or orthopaedic problems principally related to musculoskeletal disorders common to on-the-job injuries, sports injuries, and age-related musculoskeletal injuries and illnesses. Services are provided to patients who are members of preferred provider or managed care organizations, as well as those who are covered by workers' compensation insurance. Revenues are also derived by the medical group from services to personal injury patients and, to a small extent, from patients covered under Medicare. In March 1995, the Company reorganized its Houston operations whereby substantially all medical and ancillary services are provided by a medical group practice affiliated with the Company. In connection with this reorganization, the Company entered into a long term management services agreement with a newly formed medical group in Houston, Texas. At its inception, this group included the Houston-based non-medical, ancillary and rehabilitation services previously provided directly by DRCA, the occupational 1 medicine and mobile health testing components of the managed occupational health care program previously provided by a professional medical association under management contract with DRCA, and one orthopaedic medicine practice with two clinic locations in Houston. In this regard, the Company assisted in the formation of this professional limited liability partnership ("PLLP") and all medical and ancillary services in the Houston region have been consolidated within the PLLP. This structure is designed to streamline the Company's billing and collection procedures as well as provide a vehicle through which to contract all services with managed care payors. It is the intention of the Company and its affiliated medical groups to comply with federal and state laws which prohibit the corporate practice of medicine, referrals by physicians to certain ancillary service providers in which the physician has a financial interest, and kick backs (or payments to physicians for patient referrals). The legal structure described above was designed to address these prohibitions. By aggregating these physicians and facilities in one musculoskeletal-related healthcare delivery system under the Company's management, IOI intends to position the practice as a comprehensive solution to managed care payors while also setting the stage to expand its physician practice management business through the acquisition and consolidation of other orthopaedic and related medical practices. IOI's near term growth strategy includes continuation of its vertical integration strategy through physician practice management programs in orthopaedics and orthopaedics-related medical specialties, expansion of services at existing and acquired locations, and the continued development in targeted geographical markets of a broad base of referral sources among physicians, employers, and payors. IOI's long term strategic plan is to expand its operations through affiliations with orthopaedic practices and related medical specialties and ancillary services in selected geographic markets. Orthopaedic practices are uniquely positioned as the focal point of a multi-disciplinary, musculoskeletal-related healthcare delivery system which can include the ancillary services on which DRCA was founded. IOI expects to pursue its expansion program by affiliating with orthopaedic practices in both new and existing geographic markets. Because of its significant experience in orthopaedics-related medical and ancillary services, IOI believes it holds a competitive advantage in negotiating for affiliations with these practices. The Company intends to increase the scope of these orthopaedic practices by implementing ancillary services such as rehabilitation, ambulatory surgery, diagnostic imaging, and pain treatment programs based upon the profile and volume of the group's existing patient base. Targeted geographic areas for expansion will be those with well established, reputable orthopaedic or related medical specialty practices with which the Company could affiliate by acquiring their non-medical assets and entering into long-term management services agreements with the practices. Targeted areas would, ideally, also possess a high incidence of workers' compensation claims, favorable workers' compensation reimbursement rates, available qualified professionals to staff the facilities and other favorable demographic factors such as population density and projected growth rate, although expansion through orthopaedic consolidation is not limited to only such areas. The Company also intends to selectively expand through other means which might include the establishment of joint ventures, strategic alliances and management contracts with major health care service providers, workers' compensation insurance carriers, and strategically appropriate merger candidates. PHYSICIAN PRACTICE MANAGEMENT ("PPM") OVERVIEW IOI has identified the consolidation of orthopaedic and orthopaedic-related practices as a potentially significant growth opportunity within the PPM marketplace. Pioneered in the late 1980's, PPM companies offer a mechanism by which physicians can "partner" with corporate entities. The physician's practice benefits from the management talent, business skills, operating structures, business systems, economies of 2 scale, and access to capital of its corporate partner. The PPM company benefits from potentially significant growth through expanding numbers of practice management contracts and increasing management fees. The early 1990's saw the emergence of PPM as a significant segment of the health care industry. Alex. Brown and Sons Incorporated attributes this emerging industry to four key elements: (i) The complexity of having numerous managed care contracts with multiple insurance carriers called for billing and collections systems more sophisticated than an average physician could afford or manage. (ii) The increasing cost and sophistication of medical equipment required greater capital resources and more professional purchasing systems than that available to the average physician. (iii) The increasing penetration of managed care payors diminished the influence of solo practitioners and small, isolated groups. (iv) The uncertainty of health care reform made group practice a more attractive alternative. Physicians provide approximately $200 billion annually in personal services to patients, and control an estimated $700 - 800 billion in health care expenditures by deciding what non-physician health care services and products are required by their patients. Orthopaedic physicians provide approximately $12 billion or 6% of the $200 billion spent annually on professional medical services. Along with other physicians, orthopaedic physicians control the utilization of services in the entire musculoskeletal-related component of the healthcare market, approximately $120 billion or 16% of total healthcare expenditures. The PPM industry has tapped this vast pool of dollars by consolidating both single- and multi-specialty practices for the mutual benefit of the physicians and the shareholders of their corporate "partners". Although structures vary, PPM companies generally do not provide medical services. Instead, the medical services are provided by medical group practices which contract with the PPM company on a long term basis. The PPM company generally acquires the hard assets of the medical groups with which it contracts and structures its provision of those assets and its management services in such a way as to promote a long term relationship with the medical groups it manages. OPERATIONS DIVESTITURE OF CERTAIN OPERATIONS During 1996, the Company significantly altered the composition of its operations to restructure itself for expansion as a single focus musculoskeletal-related PPM company. Toward that goal, the Company sold a wholly-owned subsidiary which owned the MRI center in Little Rock, Arkansas on March 29, 1996, and the Company and its affiliated medical groups divested all occupational medicine operations in Houston, Texas and Little Rock, Arkansas on December 31, 1996 (see Liquidity and Capital Resources and Notes to the Consolidated Financial Statements). Following the divestiture of these operations, the Company continues to manage a musculoskeletal-related healthcare delivery system in Houston, Texas. 3 MUSCULOSKELETAL-RELATED HEALTHCARE DELIVERY SYSTEM In March, 1995, the Company facilitated the creation of a medical group practice in Houston, Texas which consolidated all medical and ancillary services previously provided by DRCA and its affiliated medical group with one orthopaedic medicine practice. Following the divestiture of assets in 1996, the remaining operations constitute the first musculoskeletal-related healthcare delivery system with which the Company holds a management contract. Under the terms of the management agreement, the Company provides all operating assets, leaseholds, non-clinical personnel, business office functions, and the management of the non-medical aspects of the system's medical personnel, in exchange for a management fee and the reimbursement of expenses incurred on behalf of the group. The composition of this system includes the following: Orthopaedic Medicine. Patients are seen by the orthopaedic medicine practice for a variety of musculoskeletal illnesses and injuries. Orthopaedic surgery is the source of a significant portion of the revenues of this practice. In November, 1995, the medical group first added spinal reconstruction services to this practice. Work Hardening. The medical group practice managed by the Company currently operates work hardening clinics in Houston, Texas under the trade name "WorkWell." The physical plants of these clinics are the property of the Company and are provided to the Houston medical group pursuant to a long term management services contract. Work hardening is a therapy philosophy based on a comprehensive, multi- disciplinary approach to industry's need for injury prevention and injury rehabilitation. Work hardening addresses the physical, psychological, behavioral and social aspects of an injured worker's ability to work. This program is carried out in a simulated job environment. A typical program consists of up to eight weeks, five days per week, eight hours per day. Patients who require physical conditioning prior to undertaking the work hardening program may receive "transitional" or "work conditioning" treatment for up to two weeks at a work hardening clinic prior to entering the work hardening program. The work hardening program requires the worker to perform the tasks usually performed on the job and provides cardiovascular, strength and flexibility conditioning. The program re-educates workers on how to use their tools and perform their tasks in a safer manner. The goals are to (i) increase physical work tolerance, endurance, and productivity, (ii) provide an early return to work, and (iii) improve the injured worker's employability. Accordingly, the patient assumes an active role in the management of his/her individual case. The work hardening clinics conduct an objective and standardized evaluation of physical function. The evaluation utilizes the ERGOS work simulator, a fully integrated computerized instrument, to measure physical capabilities as they relate to work activity. The ERGOS work simulator produces graphic and narrative reports that compare the injured patient's physical capabilities with national standards promulgated by the Department of Labor. The work hardening clinics can also provide pre-employment screening. This screening can decrease injuries by objectively evaluating an employee's physical capacity to perform the functions of a specific job description. In addition, the work hardening clinics provide vocational rehabilitation which addresses the patients' ability to meet the physical demand of a specific job. The work hardening clinics' injury prevention and wellness programs help instruct employees in techniques to prevent injury and maintain health while on the job. This program also includes classes in back care, stretching, smoking cessation, and dietary consultation and stress management. Staff personnel also offer recommendations which can modify or alter the demands on the worker or the demands of the job which may ultimately prevent on-the-job injury. 4 The work hardening program also includes vocational evaluation services. The comprehensive vocational evaluation program is a 2-6 week program designed to assess and predict disabled individuals' vocational interests and potential aptitudes through various techniques to reveal possible employment opportunities and training programs. WorkWell in Houston, Texas, has been designated by the Texas Rehabilitation Commission to serve as one of its evaluation sites for the performance of vocational evaluations. Presently, the work hardening clinics hold a one-year certification given by the Commission on Accreditation of Rehabilitation Facilities ("CARF"). The Texas Workers' Compensation Commission ("TWCC") has recognized the quality of care inherent in a CARF-certified work hardening program. Effective April 1, 1996, TWCC almost doubled the reimbursement paid to CARF-certified work hardening centers. WorkWell staffing includes varying combinations of licensed occupational therapists, licensed physical therapists, certified occupational therapy assistants, exercise physiologists, work hardening supervisors, vocational specialists and licensed social workers. In addition, each WorkWell Clinic has available a psychologist and a nutritionist. Physical/Occupational Therapy. The medical group practice managed by the Company currently operates one free standing physical therapy center and one hospital-based physical and occupational therapy department which provides services to four hospital-based programs on three campuses. The hospital-based physical and occupational therapy programs are operated pursuant to a facility management agreement with a major hospital system The physical therapy centers provide a broad view of health care, emphasizing the preventive, acute/trauma and rehabilitative healthcare needs of the patient. The services generally include physical and occupational therapy, with primary emphasis on musculoskeletal disorders. To a lesser extent, the physical/occupational therapy centers treat and instruct injured patients on how to use prosthetic and orthotic devices. Presently, the physical and occupational therapy centers are staffed with varying combinations of licensed physical and occupational therapists, licensed physical and occupational therapy assistants and unlicensed physical and occupational therapy aides. The Company also has arrangements with independent contractor therapists in Houston, Texas, to cover temporary absences of center personnel, and assist during peaks in patient loads. These independent contractor therapists are utilized by the Company only on an as needed basis. Magnetic Resonance Imaging ("MRI"). The medical group practice managed by the Company currently operates one MRI center in Houston under the name of Spectrum Imaging Centers. This unit operates a Hitachi MRP-20 which performs a full range of diagnostic studies involving magnetic resonance imaging. Patients are referred to the MRI center primarily by orthopaedists and neurologists, working often with personal injury patients who originate from attorney referrals and, to a lesser extent, preferred provider organizations and health maintenance organizations. The center is staffed by a licensed radiologic technologist who has received specialized training in magnetic resonance imaging, and by clerical personnel. Licensed radiologists are utilized in third-party contractor arrangements to interpret the studies and prepare reports for the referring physicians. Chronic Pain Treatment Program. The Company has operated a chronic pain treatment program since July 1993. In 1995, this program was consolidated into the Houston medical group and in 1996 the psychological, cognitive, physical conditioning and rehabilitation, and vocational services functions of this program were absorbed by the work hardening program. Invasive pain management services are also provided by the medical group. 5 DIVESTED OPERATIONS Occupational Medicine. Until their sale in December, 1996, the Company managed occupational medicine clinics in Houston, Texas and Little Rock, Arkansas pursuant to management agreements with medical groups in each location. Operating under the name Medi-Stat Medical Centers, these clinics provided industrial compliance testing and treatment of on-the-job injuries for both industrial employers and workers' compensation insurance carriers. Mobile Health Testing. Until its sale in December, 1996, the Company managed the operation of a fleet of mobile health testing units designed to meet industry's demands for on-site compliance with medical surveillance required by OSHA and other regulatory agencies. Mobile testing services included hearing testing, heart and lung testing, drug screen specimen collection, X-ray, EKG's and physical examinations by physicians. Magnetic Resonance Imaging. Until its sale in March, 1996, the Company owned and operated a wholly-owned subsidiary in Little Rock, Arkansas which operated an MRI center under the name Spectrum Little Rock Imaging. This unit operated a Shimadzu SMT-100X MRI which performed a full range of diagnostic studies involving magnetic resonance imaging. MARKETING AND BUSINESS DEVELOPMENT IOI's marketing and business development functions fulfill two different missions, both of which are critical elements of the Company's business strategy. IOI pursues its PPM affiliation strategy through its business development function. The Company's business development department presently consists of senior management and director level staff, and is currently recruiting additional personnel. Once a practice is under management contract with IOI, the Company intends to present the practice to the payor and patient referral markets through health care marketing professionals in each service area. IOI intends to follow the strategy of marketing a practice's services both on a stand-alone basis and as part of a vertically integrated musculoskeletal-related healthcare delivery system. There are presently three full-time marketing professionals calling on the industrial, insurance, and medical communities for the Houston musculoskeletal-related healthcare delivery system. EMPLOYEES At March 17, 1997, the Company and its affiliated medical groups had approximately 70 full time employees and approximately 4 part time employees. None of the Company's employees is covered by collective bargaining agreements. COMPETITION, MAJOR CUSTOMERS AND REIMBURSEMENT Competition. The healthcare services market in general, and the PPM business in particular, is highly competitive. The Company is aware of at least one other publicly traded company and several private companies which compete or intend to compete for the right to manage orthopaedic and musculoskeletal-related medical and ancillary service practices. In addition, several, large multi-specialty medical management companies also compete with the Company and the Company believes others in the healthcare industry may employ strategies similar to those of the Company. Many of these current and potential 6 competitors are significantly larger and have substantially greater resources than the Company. The success of the medical group practice presently managed by the Company and of those practices with which the Company contracts in the future will be a determining factor in the Company's success. These medical groups encounter competition, in various forms, from many sources including other single- and multi-specialty physician groups, hospitals, managed care organizations, and sole practitioners. Major Customers. The services of eight full time and numerous part time physicians which were under the Company's management throughout 1996 were included in the divestiture of the occupational medicine business on December 31, 1996. After the divestiture, the Company provides substantially all of its services to one affiliated musculoskeletal-related healthcare delivery system in Houston, Texas which has a total of one full-time and three part-time physicians. The loss of the services of any of the physicians could have a material adverse effect on the Company's revenues and profits. The professional medical services provided to the medical groups' patients by William F. Donovan, M.D., a Company shareholder and director, was 15% of reported revenues in 1996 and 16% in 1995. A majority of the ancillary service revenues provided by the Houston musculoskeletal-related healthcare delivery system also originated from patients treated by Dr. Donovan. Personal injury claimants have injuries similar to those of workers' compensation injury patients and are pursuing settlement or damage awards through the judicial system. Due to the judicial backlog of such cases and related factors, revenues related to personal injury claimants may take more than two years to collect. Revenue derived from services provided to personal injury claimants, as a percent of revenues, was 12% in 1996, 16% in 1995, and 12% in 1994. The medical group practice managed by the Company also operates a physical and occupational therapy program under contract with a major hospital corporation. These programs provided approximately 8%, 7%, and 10% of the Company's revenues in 1996, 1995, and 1994, respectively. Reimbursement. The various services rendered by the medical practices under Company management are generally covered by employers, private insurance, workers' compensation insurance, settlement or adjudication of personal injury litigation, and Medicare or Medicaid. The current group practice provides an insignificant amount of services under Medicare and Medicaid programs, although it is likely that practices acquired in the future may have a higher incidence of such patients. To some extent, professional medical services are covered by all payors of medical care. Certain of the ancillary services are more likely to be covered by employers and workers' compensation insurance than by other payors due to the nature of the services rendered. Patients pursuing personal injury claims may require the services of any or all elements of the musculoskeletal-related healthcare delivery system. TRADEMARKS The Company obtained a certificate of trademark and service mark registration for the mark "WorkWell" and the WorkWell design from the State of Texas in January 1990. These marks are registered for a term of ten years, and can be reserved for an additional ten-year period. The Company obtained Certificates of Registration on the Principal Register of the U.S. Patent and Trademark Office on March 17, 1992 for the mark "Work Hardening Dynamics" and on April 7, 1992 for the "Work Hardening Dynamics" design logo. These marks are registered for a term of ten years, and can be reserved for an additional ten-year period. The Company obtained Certificates of Registration on the Principal Register of the U.S. Patent and Trademark Office on January 19, 1993, for the mark "Medi- Stat" and on May 11, 1993 for the "Medi-Stat" design logo. These marks are registered for a term of ten years, and can be reserved for an additional ten- year period. These marks were sold in December, 1996 in conjunction with the divestiture of the 7 occupational medicine business. The Company obtained Certificates of Registration on the Principal Register of the U.S. Patent and Trademark Office on September 12, 1995, for the mark "DRCA". This mark is registered for a term of ten years, and can be reserved for an additional ten-year period. In late 1996 and early 1997, the Company filed applications for Certificates of Registration on the Principal Register of the U.S. Patent and Trademark Office for the marks "Integrated Orthopaedics" and "IOI", and for the "IOI" design logo. Registration is pending determination by the U.S. Patent and Trademark Office. REGULATION General. The health care industry is highly regulated, and there can be no assurance that the regulatory environment in which the Company operates will not change significantly in the future. The Company believes that health care regulations will continue to change and will monitor these changes. The Company expects to modify its agreements and operations from time to time as the business and regulatory environments change. While the Company believes it will be able to structure all its agreements and operations in accordance with applicable law, there can be no assurance that it will be able to successfully address changes in the regulatory environment. Every state imposes licensing requirements on individual physicians and on facilities and services operated by physicians. In addition, federal and state laws regulate HMOs and other managed care organizations with which affiliated practices or their affiliated physicians may have contracts. Many states require regulatory approval, including certificates of need, before establishing or expanding certain types of health care facilities, offering certain services or making expenditures for health care equipment, facilities or programs in excess of statutory thresholds. Some states also require licensing of collection agencies and employee leasing companies. In connection with its operations and its expansion into new markets, the Company believes it is in compliance with all such laws and regulations and current interpretations thereof, but there can be no assurance that such laws, regulations, or interpretations will not change in the future or that additional laws and regulations will not be enacted. The ability of the Company to operate profitably will depend in part upon the Company and its affiliated medical practices obtaining and maintaining all necessary licenses, certificates of need, and other approvals and operating in compliance with applicable health care regulations. In addition to extensive, existing health care regulation, there have been numerous federal and state initiatives for comprehensive reforms affecting the payment for and availability of health care services. The Company believes that such initiatives will continue. Aspects of certain of these reforms as previously proposed, such as further reductions in insurance payments and additional restrictions on direct or indirect physician ownership of facilities to which they refer patients, if adopted, could adversely affect the Company. Other aspects of such initiatives, such as universal health insurance coverage and coverage of certain previously uncovered services, could have a positive impact on the Company's business. The ability of the Company to operate profitably will depend, in part, upon the Company and its affiliated medical practices obtaining and maintaining all necessary licenses, certificates of need and other approvals, and operating in compliance with applicable health care regulations. Fee Splitting; Corporate Practice of Medicine. The laws of many states prohibit physicians from splitting fees with non-physicians and prohibit non-physician entities, such as the Company, from practicing medicine. Under such laws, the Company is prohibited from exercising control over the provision of 8 medical services. These laws vary from state to state and are enforced by regulatory authorities with broad discretion. The Company believes its operations will be in compliance with existing applicable laws. There can be no assurance that review of the Company's business by courts or regulatory authorities will not result in determinations that could adversely affect the operations of the Company, or that changes in health care regulations will not restrict the Company's existing or expanding operations. In addition, the regulatory framework of certain jurisdictions may limit the Company's ability to expand into such jurisdictions. Fraud and Abuse. Federal law prohibits the offer, payment, solicitation or receipt of any form of remuneration in return for, or in order to induce, (i) the referral of a person for services, (ii) the furnishing or arranging for the furnishing of items or services, or (iii) the purchase, lease or order or arranging or recommending purchasing, leasing or ordering of any item or service, in each case, reimbursable under Medicare or Medicaid. Pursuant to this anti-kickback law, the federal government recently announced a policy of increased scrutiny of joint ventures and other transactions among health care providers in an effort to reduce potential fraud and abuse related to Medicare and Medicaid costs. Many states, including Texas, have similar anti-kickback laws and in the case of Texas these laws apply to all types of patients, not just Medicare and Medicaid beneficiaries. The applicability of these federal and state laws to many business transactions in the health care industry, including those intended by the Company, has not yet been subject to significant judicial interpretation. Noncompliance with, or violation of, the federal anti-kickback legislation can result in exclusion for Medicare and Medicaid programs and civil and criminal penalties. Similar penalties are provided for violation of state and anti- kickback laws. The federal government has promulgated "safe harbor" regulations that identify certain business and payment practices which are deemed not to violate the federal anti-kickback statute. Although the Company' business does not fall within certain of the current or proposed safe harbors, the Company believes that its intended operations materially comply with the anti-kickback statutes and regulations. Prohibitions on Referrals to Certain Entities. The so-called "Stark Law" (named after its chief sponsor, Congressman Fortney "Pete" Stark) originally prohibited a physician from referring a Medicare patient to an entity for the provision of clinical laboratory services if the physician or an immediate family member of the physician had a financial relationship, which includes an ownership or investment interest or compensation arrangement, with the entity. The revised Stark Law, known as "Stark II," dramatically enlarged the field of physician- owned or physician-interested entities to which the referral prohibitions apply. Effective January 31, 1995, Stark II prohibits a physician from referring Medicare or Medicaid patients to an entity providing "designated health services" in which the physician has an ownership or investment interest, or with which the physician has entered into a compensation agreement. The penalties for violating Stark II include a prohibition on payment by these government programs and civil penalties. Many states have similar restrictions on referrals by physicians. The applicability of these federal and state laws to many business transactions in the health care industry, including those intended by the Company, has not yet been subject to significant judicial interpretation. To the extent that the Company or any affiliated medical practice is deemed to be subject to Stark I or II or similar state laws, the Company believes its intended activities will materially comply with such statutes and regulations. In addition, the Company also believes that the methods used to acquire the assets of existing practices do not violate anti-kickback or anti-referral laws and regulations. Specifically, the Company believes the consideration paid to physicians to acquire the tangible and intangible assets associated with their practices is consistent with fair market value in arm's-length transactions and not intended to induce the referral of patients. Should this practice be deemed to constitute an arrangement designed to induce the referral of 9 patients, then such could be viewed as possibly violating anti-kickback and anti-referral laws and regulations. A determination of liability under any such laws could have a material adverse effect on the Company's revenue. HMO and Insurance Laws. Federal and state laws regulate insurance companies, HMOs and other managed care organizations. Generally, these laws apply to entities that accept financial risk. There is a potential that certain risk arrangements that may be entered into by the Company could be characterized by some states as the business of insurance or an HMO. The Company, however, believes that the acceptance of capitation payments by a health care provider does not constitute the conduct of the business of insurance or of an HMO. Many states also regulate the establishment and operation of networks of health care providers. Generally, these laws do not apply to the hiring and contracting of physicians by other health care providers. There can be no assurance that regulators of the states in which the Company operates would not apply these laws to require licensure of the Company's operations as an insurer or provider network. The Company believes that its intended activities are and will be in compliance with these laws in the states in which it does or intends to do business, but there can be no assurance that interpretations of these laws by the regulatory authorities in these states or the states in which the Company may expand will not require licensure or a restructuring of some or all of the Company's operations. In the event that the Company is required to become licensed under these laws, the licensure process can be lengthy and time consuming and, unless the regulatory authority permits the Company to continue to operate while the licensure process is progressing, the Company could experience a material adverse change in its business while the licensure process is pending. In addition, many of the licensing requirements mandate strict financial and other requirements which the Company may not immediately be able to meet. Further, once licensed, the Company would be subject to continuing oversight by and reporting to the respective regulatory agency. Antitrust. As the Company expands, the Company and its affiliated medical groups will be subject to various antitrust laws which prohibit anti-competitive conduct, including such issues as price fixing, concerted refusal to deal and division of markets. The company believes it is presently in compliance with applicable law, but there can be no assurance that a regulatory review would not result in an adverse determination or that the regulatory environment might not change in a manner which could have a material adverse effect on the Company's operations and its expansion strategy. Certificate of Need. A majority of states require that providers of certain health care services and facilities obtain a Certificate of Need ("CON") prior to commencement of construction and/or operation. The types of facilities and services covered by CON requirements as well as the spending threshold below which CON statutes do not apply varies on a state-by-state basis. While the Company's development plans presently emphasize operations in non-CON states and several states in recent years have discontinued their CON programs altogether, there is no assurance that some or all of these states may not at some future time institute such programs. In addition, the Company may elect in the future to operate in CON states. As a result, CON regulations may have an adverse affect on the Company's expansion policy. Accreditation. The Commission on Accreditation of Rehabilitation Facilities ("CARF") is an independent organization that reviews rehabilitation facilities and accredits those facilities that meet its guidelines. While participation in the CARF accreditation is currently voluntary, some states have passed legislation requiring that certain workers' compensation treatment be provided by CARF-accredited facilities. Currently, all of the Company's work hardening clinics are accredited by CARF. (See Work Hardening under Item 1). 10 Sales Tax. The Company does not charge or collect sales tax relating to the services provided by the Company to the medical group it manages pursuant to a management services agreement. The Company believes the provision of services, as set forth in the management services agreement, does not constitute a taxable event for sales tax purposes in any state in which the Company has operated. The Company has not sought any judicial or administrative ruling on this issue. Should a review of the Company's operations occur and result in a determination contrary to the Company's position, such a determination could have a material adverse effect on the Company's earnings and could adversely impact the Company's expansion strategy. Sales tax statutes vary from state to state and the Company's ability to successfully contract with medical groups in certain states may be adversely impacted by the state sales tax environment. Regulatory Compliance. The Company believes that regulations and statutes will continue to change and, as a result, it regularly monitors developments in related law. The Company expects to modify its agreements and operations from time to time as the business, statutory and regulatory environment changes. While the Company believes it will be able to structure all its agreements and operations in accordance with applicable laws, there can be no assurance that its arrangements will not be successfully challenged in the future. ITEM 2. DESCRIPTION OF PROPERTY The Company does not own any real property. All clinic facilities are leased at commercial property rates for the size, location, and tenant finish included in the lease. Clinic facilities range in size from 1,500 square feet to 11,500 square feet and all facilities are of a size and configuration and house various types of equipment appropriate to the services rendered within the facility. All facilities are on or near major thoroughfares serviced by public transportation, are insured and are maintained in good operating condition. (See Note 11, Related Party Transactions) The Company leases approximately 8,700 square feet in Houston, Texas which houses the Company's Houston regional office and executive offices. Prior to the sale of the occupational medicine program in Little Rock, Arkansas, the Company's regional office was located in approximately 1,150 square feet of leased space adjacent to one of the Little Rock Medi-Stat clinics. ITEM 3. LEGAL PROCEEDINGS In the ordinary course of its business, the Company may be subject, from time to time, to claims and legal actions. While the Company cannot predict the outcome of litigation actions, it is management's opinion that these matters will not have a material impact on the Company's financial position or results of operations. As of March 17, 1997, no actual or unasserted material claims or actions are pending against the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1996. 11 PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS During 1996, the Company's Common Stock was principally traded on the American Stock Exchange under the symbol "DRC". On March 12, 1997 the shareholders of the Company voted to change the name of the Company to Integrated Orthopaedics, Inc. Immediately following that vote the Board of Directors of the Company voted to change the trading symbol of the Company to "IOI". Closing Sales Price (American Stock Exchange) ------------------------- Low High ------- -------- 1995 - ---- 1st Quarter 2 1/4 3 7/8 2nd Quarter 3 1/8 4 3rd Quarter 3 1/16 6 1/8 4th Quarter 2 3/4 4 1/2 1996 - ---- 1st Quarter 3 3/8 5 5/8 2nd Quarter 3 5/8 5 7/16 3rd Quarter 2 9/16 4 4th Quarter 2 15/16 5 1997 - ---- 1st Quarter (through March 17, 1997) 4 5 1/8 On March 17, 1997, the Company had 129 shareholders of record. A significant portion of the Company's common stock not held by affiliates of the Company is held through securities depositories. The Company has not declared or paid any dividend since it was formed. It is the present policy of the Company not to pay cash dividends and to retain future earnings to support the Company's growth. Any payment of cash dividends in the future will be dependent upon the amount of funds legally available, the Company's earnings, financial condition, capital requirements and other factors that the Board of Directors may deem relevant. Pursuant to the terms of the Company's Series A Cumulative Convertible Preferred Stock (the "Preferred Stock"), no dividends can be paid on the common stock until all dividends accrued on the Preferred Stock have been paid. Dividends on the Preferred Stock are cumulative from the date of issuance and are payable quarterly after June 30, 1999. At December 31, 1996, the Company has accrued unpaid dividends of $127,167 on the Preferred Stock. 12 ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION RESULTS OF OPERATIONS The following table presents revenues by category and the statement of operations items as percentages of total revenues: 1996 1995 1994 ---- ---- ---- Houston musculoskeletal-related delivery system Medical services 22.0% 16.8% 1.5% Ancillary services 34.2 35.9 43.2 Operations divested in 1996 43.8 45.7 55.3 Other revenue 0.0 1.6 0.0 ----- ----- ----- Revenues 100.0% 100.0% 100.0% ===== ==== ===== Direct operating costs Compensation costs and medical services 52.2% 41.8% 38.9% Other direct costs 26.6 23.9 25.0 Selling, general and administrative 18.6 14.0 18.2 Depreciation and amortization 5.5 7.0 8.7 Provision for doubtful accounts 9.9 5.7 2.2 Net gain from restructuring (22.1) 0.0 0.0 ----- ----- ----- Income from operations 9.3% 7.6% 7.0% Interest expense (0.8) (2.0) (2.3) Minority interest and other 0.0 .2 .3 (Provision for) income taxes (3.0) (2.4) (1.8) ----- ----- ----- Net income 5.5% 3.4% 3.2% ===== ==== ===== Year ended December 31, 1996, compared with the year ended December 31, 1995. Revenues Revenues declined from 1995 to 1996 by $1,226,000 (8%). Approximately $836,000 or 68% of this decrease is attributable to declining revenues in the occupational medicine and diagnostic imaging businesses which were divested in 1996 at a reported gain of $3,272,000. Another $235,000 of this reduction is due to the one-time inclusion in 1995 of collection fee revenue arising from an accounts receivable collection agreement entered into in March, 1995 as one component of the creation of the Houston medical group limited liability partnership. The remaining decline of $155,000 relates to the medical and ancillary services which now remain as part of the Houston musculoskeletal- related healthcare delivery system. This decline represents less than a 2% variance from prior year revenues. Compensation Costs and Medical Services Overall compensation costs and medical services increased approximately $977,000 (15%) from 42% of revenues in 1995 to 52% of revenues in 1996. Compensation costs and medical services at the occupational medicine and diagnostic imaging businesses which were divested in 1996 showed an immaterial change from year to year. The remaining increase is primarily related to the physician 13 compensation component of the medical and ancillary services which now remain as part of the Houston musculoskeletal-related healthcare delivery system. Other Direct Costs Other direct costs increased from 1995 to 1996 by approximately $88,000 (2%) from 24% of revenues in 1995 to 26% of revenues in 1996. Other direct costs at the occupational medicine and diagnostic imaging businesses which were divested in 1996 rose $15,000 (less than 1%). The other direct costs of the medical and ancillary services which now remain as part of the Houston musculoskeletal- related healthcare delivery system increased by $73,000 (2%). Selling, General and Administrative Selling, general and administrative costs rose approximately $437,000 from 14% in revenues in 1995 to 18% of revenues in 1996. This increase is attributable to increased salary, compensation and recruiting costs related to additional senior management staff to support the Company's PPM strategy, to legal and accounting costs related to the development of transaction documents for practice affiliations, and to normal operating variances. During 1996 the Company incurred approximately $482,000 in selling, general and administrative expenses which were directly related to the occupational medicine business divested in December, 1996. Depreciation and Amortization Depreciation and amortization expense declined approximately $304,000 in 1996. This decline is due primarily to (i) reduced expenses arising from the sale of a wholly-owned subsidiary which owned a magnetic resonance imaging center in March, 1996, (ii) cost savings arising from the full amortization in 1995 of a non-competition covenant relating to the acquisition of the occupational medicine clinics in Little Rock, Arkansas, and (iii) the full depreciation of certain fixed assets in 1995. Provision for Doubtful Accounts The Company increased its provision for doubtful accounts by approximately $524,000 from 1995 to 1996, or about $82,000 less than the $606,000 increase incurred in 1995. Overall, the provision for doubtful accounts rose by 4% of revenue from 6% in 1995 to 10% in 1996. The provision for doubtful accounts requires the Company to make an accounting estimate of amounts which may be uncollectable in the future. The Company reviews these estimates on a regular basis and adjusts its estimate of the provision for doubtful accounts as indicated by that review. The increase in the provision for doubtful accounts in 1996 is primarily attributable to increased write-offs realized in 1996 related to all medical and ancillary service components of the Houston musculoskeletal-related healthcare delivery system plus the resultant increase in the estimate of future write-offs which may be realized on accounts receivable. Minority Interest and Other The Company reported no minority interest or other expense in 1996. 14 Interest Expense Interest expense decreased by approximately $131,000 from 1995 to 1996. This savings is due to the reduction and retirement of notes payable and is significantly reduced usage of the company's line of credit during 1996. Net Gain from Restructuring During 1996, the Company, in a strategic effort to restructure its operations towards a single focus musculoskeletal-related physician practice management company, divested its interests in eight occupational medicine centers , four physical and medical therapy centers associated with the occupational medicine centers, seven mobile health testing units operated in conjunction with the occupational medicine programs in Houston, Texas and Little Rock, Arkansas, and one magnetic resonance imaging ("MRI") center in Little Rock, Arkansas. The consideration and net gain from restructuring is as follows: Occupational Little Rock Net Medicine MRI Gain ------------ ----------- ---------- Cash proceeds $7,773,234 $ 700,000 $8,473,234 Note receivable 156,859 156,859 Assumption of capital leases, net 166,945 166,945 ---------- ---------- ---------- Total consideration 8,097,038 700,000 8,797,038 ---------- ---------- ---------- Accounts receivable, net sold 1,165,951 1,165,951 Property and equipment sold 1,195,571 804,154 1,999,725 Intangible assets, net sold 782,565 782,565 Other assets sold 16,407 16,407 Divestiture costs 1,664,689 1,664,689 ---------- ---------- ---------- Net gain from restructuring $3,271,855 $ (104,154) $3,167,701 ========== ========== ========== Year ended December 31, 1995, compared with the year ended December 31, 1994 Revenues Revenues in 1995 increased by $2,650,531 or 20.6% over 1994. The increase in revenues was mainly due to the orthopaedic and spinal reconstruction practice. Revenues were also higher at the other Houston medical clinics, mobile testing service and MRI facility, and at the Little Rock occupational medicine clinics. Revenues from other business units were flat or lower. Changes in those revenues are generally attributable to changes in the number of patient visits. Compensation Costs and Medical Services Compensation costs and medical services in 1995 increased $1,484,490 or 29.6% over 1994. This increase is due mainly to the addition of two orthopaedic clinics to the medical group in March, 1995. The increase as a percentage of revenues was also due principally to higher compensation costs in the orthopaedic clinics compared to other operations. 15 Other Direct Costs Other direct costs in 1995 increased $503,545 or 15.7% over 1994, due primarily to the addition of two orthopaedic clinics to the affiliated medical group in March, 1995. The slight decline in these costs as a percentage of revenues is primarily a result of the increase in orthopaedic services which generally have less direct costs as a percentage of revenues. Selling, General and Administrative Selling, general and administrative expenses in 1995 decreased by $170,285, or 7.3%, from 1994 principally because expenses incurred in 1994 included $259,000 associated with the settlement of two legal proceedings. Other selling, general and administrative expenses increased by about $88,715. As a percentage of revenues, selling, general and administrative expenses declined to 14% from 18.2% as a result of the absolute reductions described above as well as economies of scale. Depreciation and Amortization The decrease in 1995 of $26,906 is due to the full depreciation of certain older assets in 1994. Provision for Doubtful Accounts In absolute amounts and as a percentage of revenue, the provision for doubtful accounts increased in 1995 over 1994 because the allowance percentage for orthopaedic surgery cases billed to third-party payors was higher than the Company had experienced in the past for third-party claims. Generally, mandated orthopaedic reimbursement rates decline per individual patient as more procedures are performed. Minority Interest and Other Minority interest and other decreased by $7,584, reflecting the minority partners' interest in the final expenses of the partnerships which were higher in 1995 by $29,050, and a 1994 gain on the sale of an asset held for sale of $36,634. Interest Expense Interest expense increased by $1,858, or less than 1%. This was due mainly to slight increases in the prime interest rate which affects the Company's interest on the term notes and the revolving line of credit with its major lending bank. LIQUIDITY AND CAPITAL RESOURCES The Company's working capital at December 31, 1996 was $7,697,663 as compared to $2,654,842 at December 31, 1995, an improvement of $5,042,821. This is due mainly to (i) the retention of $2,347,430 in net cash proceeds from the Company's issuance of a subordinated, convertible note on April 12, 1996 and its subsequent conversion into 25,226 shares of cumulative, convertible preferred stock in May, 1996, (ii) net cash proceeds of $7,773,234 from the sale of the Company's occupational medicine and mobile health testing operations on December 31, 1996, (iii) a $1,755,443 reduction in net accounts receivable resulting from (a) the sale of the net accounts receivable of the occupational medicine and mobile health testing businesses and (b) the reduction of net accounts receivable arising from the Company's increased allowance for doubtful accounts in 1996, and (iv) a $2,926,825 increase in accounts payable, accrued 16 expenses and current and deferred income taxes payable arising primarily from the sale of the occupational medicine and mobile health testing businesses. Personal injury accounts receivable relating to the Houston musculoskeletal- related healthcare delivery system remaining after the sale of the occupational medicine and mobile health testing businesses declined approximately $173,000 during 1996 due primarily to the increased reserves and allowances provided by the Company on those accounts, resulting in a reduction in personal injury accounts receivable as a percentage of total related net accounts receivable from 45% at December 31, 1995 to 43% at December 31, 1996. Although currently due, personal injury claims usually take significantly longer to collect than claims billed to insurance carriers and employers. On January 30, 1996, the Company amended the loan agreement with its primary commercial bank to increase its revolving line of credit from $1,000,000 to $2,000,000. The line of credit is secured by substantially all the assets of the Company and its affiliated medical groups. The revolving line of credit requires the payment of a 1% annual fee. Borrowings under the line bear interest at prime + 1.25% and the line expires April 15, 1997. Advances under the line of credit are subject to a borrowing base formula under which the Company presently has sufficient collateral to support over 80% of the line availability. The Company also received a commitment to fund up to $500,000 in equipment purchases through April 15, 1997, at which time all amounts outstanding under the commitment will convert to either 3- or 4- year term notes. The line of credit, as well as other borrowings from the Company's major lender, are subject to the terms of a loan agreement which include typical financial ratio covenants and various other provisions. The Company believes these credit facilities, its cash on hand and cash provided by operations will be sufficient to provide its working capital requirements for at least the next twelve months for its existing operations. However, to pursue its PPM growth strategy of acquiring and developing orthopaedic practices and musculoskeletal- related ancillary services, additional capital is required. The Company is currently exploring a number of alternatives for additional financing, including equity investment, additional indebtedness and strategic partnering. During 1996, the Company significantly altered the composition of its operations to restructure itself for expansion as a single focus musculoskeletal-related PPM company. Toward that goal, the Company sold a wholly-owned subsidiary which owned the MRI center in Little Rock, Arkansas on March 29, 1996, and the Company and its affiliated medical groups divested all occupational medicine and mobile health testing operations in Houston, Texas and Little Rock, Arkansas on December 31, 1996. To implement this musculoskeletal-related PPM expansion strategy, the Company began building its corporate infrastructure during the fourth quarter of 1996. This building process included the hiring of certain senior management and other key management positions. The Company is presently expanding its management and operations staff and is planning for a corporate office relocation to accommodate this expansion. The execution and success of the Company's PPM strategy will be dependent, in part, on its ability to attract and retain qualified executive and management personnel in the various disciplines required to affiliate with and to operate and develop affiliated practices into multi- disciplinary musculoskeletal-related healthcare delivery systems. As of December 31, 1996, the Company reported a working capital position of $7,697,663, and held over $10,000,000 cash. It is the Company's plan to utilize its earnings and working capital to build the management and operations infrastructure as required to support the level of affiliation and practice implementation projects resulting from the Company's business development activities. The Company anticipates that the cost of building the management and operational infrastructure necessary to implement this strategy may exceed the Company's earnings for at least a portion of 1997. 17 Item 7. Financial Statements Index to Financial Statements - Consolidated Financial Statements of DRCA Medical Corporation as of December 31, 1996 and 1995 and for the three years ended December 31, 1996: Page Report of Independent Accountants 19 Consolidated Balance Sheet 20 Consolidated Statement of Operations 21 Consolidated Statement of Stockholders' Equity 22 Consolidated Statement of Cash Flows 23 Notes to Consolidated Financial Statements 24-33 18 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of DRCA Medical Corporation In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, of stockholders' equity and of cash flows present fairly, in all material respects, the financial position of DRCA Medical Corporation and its subsidiaries at December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE LLP Houston, Texas March 26, 1997 19 DRCA MEDICAL CORPORATION CONSOLIDATED BALANCE SHEET ASSETS December 31, ------------------------ 1996 1995 ----------- ---------- CURRENT ASSETS Cash and equivalents $10,176,947 $ 109,231 Accounts receivable, net 3,796,715 5,552,158 Income taxes receivable 82,495 404,717 Notes receivable, net 88,811 235,801 Other current assets 252,893 147,855 ----------- ----------- TOTAL CURRENT ASSETS 14,397,861 6,449,762 ----------- ----------- PROPERTY AND EQUIPMENT Equipment (including equipment under capital leases) 3,171,495 5,531,709 Leasehold improvements 316,999 437,676 Furniture and fixtures 386,979 368,962 Vehicles 108,301 ----------- ----------- 3,875,473 6,446,648 Less - accumulated depreciation and amortization (3,210,788) (3,999,252) ----------- ----------- 664,685 2,447,396 ----------- ----------- INTANGIBLES ASSETS, NET 904,161 OTHER ASSETS 106,165 49,620 ----------- ----------- TOTAL ASSETS $15,168,711 $ 9,850,939 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable $ 1,271,842 $1,166,557 Accrued expenses 3,129,216 683,868 Income taxes payable 584,360 Deferred income taxes 208,168 Current obligations under capital leases 14,081 139,103 Current portion of notes payable 1,700,699 1,597,224 ----------- ----------- TOTAL CURRENT LIABILITIES 6,700,198 3,794,920 ----------- ----------- NOTES PAYABLE 386,231 905,890 OBLIGATIONS UNDER CAPITAL LEASES 14,426 117,504 DEFERRED INCOME TAXES 160,174 156,586 ----------- ----------- TOTAL LIABILITIES 7,261,029 4,974,900 ----------- ----------- STOCKHOLDERS' EQUITY Preferred Stock, $.01 par value, 10,000,000 shares authorized, Series A, cumulative convertible, 25,226 shares issued and outstanding 252 (liquidating preference $100 per share, aggregating $2,522,600) Common stock, $.001 par value, 50,000,000 shares authorized, 5,302,474 and 5,301,808 issued 5,303 5,302 Additional paid-in capital 4,842,015 2,470,570 Retained earnings 3,060,128 2,400,183 Treasury shares, 15,833 shares (16) (16) ----------- ----------- TOTAL STOCKHOLDERS' EQUITY 7,907,682 4,876,039 ----------- ----------- COMMITMENTS AND CONTINGENCIES TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $15,168,711 $ 9,850,939 =========== =========== The accompanying notes are an integral part of this statement. 20 DRCA MEDICAL CORPORATION CONSOLIDATED STATEMENT OF OPERATIONS Years Ended December 31, ----------------------------------------- 1996 1995 1994 ----------- ----------- ----------- REVENUES $14,313,154 $15,539,355 $12,888,824 ----------- ----------- ----------- Costs and expenses: Compensation costs and medical services 7,471,423 6,494,792 5,010,302 Other direct costs 3,807,499 3,720,318 3,216,773 Selling, general and administrative 2,612,645 2,175,528 2,345,813 Depreciation and amortization 790,523 1,094,386 1,121,292 Provision for doubtful accounts 1,417,485 893,316 287,270 Net gain from restructuring (3,167,701) ----------- ----------- ----------- 12,931,874 14,378,340 11,981,450 ----------- ----------- ----------- INCOME FROM OPERATIONS 1,381,280 1,161,015 907,374 Minority interest and other 33,654 41,238 Interest expense (170,577) (301,532) (299,674 ----------- ----------- ----------- INCOME BEFORE INCOME TAXES 1,210,703 893,137 648,938 Provision for income taxes (423,591) (375,423) (235,201) ----------- ----------- ----------- NET INCOME $ 787,112 $ 517,714 $ 413,737 =========== =========== =========== Earnings per common and equivalent share $ .12 $ .10 $ .08 =========== =========== =========== Shares used in per share calculations 5,456,080 5,436,558 5,278,690 =========== =========== =========== The accompanying notes are an nintegral part of this statement. 21 DRCA MEDICAL CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
Amount Additional Shares -------------------- Paid-In Retained Treasury Common Preferred Common Preferred Capital Earnings Stock Total ---------- --------- ------ --------- ----------- -------- ------- ----------- Balance at December 31, 1993 5,301,808 $ 5,302 $ $ 2,470,570 $1,468,732 $ (16) $ 3,944,588 Net Income 413,737 413,737 ---------- --------- --------- --------- ----------- ---------- -------- ------------ Balance at December 31, 1994 5,301,808 5,302 2,470,570 1,882,469 (16) 4,358,325 Net Income 517,714 517,714 ---------- --------- --------- --------- ----------- ---------- -------- ------------ Balance at December 31, 1995 5,301,808 5,302 2,470,570 2,400,183 (16) 4,876,039 Issuance cost of Preferred Stock-- Series A (152,570) (152,570) Issuance of Preferred Stock--Series A 25,226 252 2,522,351 2,522,603 Dividends Preferred Stock--Series A (127,167) (127,167) Exercise of stock options 666 1 1,664 1,665 Net Income 787,112 787,112 ---------- --------- --------- --------- ----------- ---------- -------- ------------ Balance at December 31, 1996 5,302,474 25,226 $ 5,303 $ 252 $ 4,842,015 $3,060,128 $ (16) $ 7,907,682 ========== ========= ========= ========= =========== ========== ======== ============
The accompanying notes are an integral part of this statement. 22 s DRCA MEDICAL CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS
Years Ended December 31, --------------------------------------- 1996 1995 1994 ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 787,112 $ 517,714 $ 413,737 Noncash adjustments: Net gain from restructuring (3,167,701) Depreciation and amortization 790,523 1,094,386 1,121,292 Minority interest (33,654) (4,604) Deferred income taxes (283,202) 347,754 33,000 Other (36,634) Change in assets and liabilities, excluding acquisitions and dispositions: Accounts receivable, net 589,492 (1,751,830) (1,470,694) Other current assets 35,412 (27,696) (40,447) Other assets 22,077 (3,018) 9,836 Accounts payable 105,285 97,618 134,109 Accrued expenses 653,493 339,588 108,152 Income taxes receivable/payable 906,583 (393,443) 326,202 ----------- ----------- ----------- Net cash provided by operating activities 439,074 187,419 593,949 ----------- ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment (778,546) (132,643) (50,682) Proceeds from restructuring 8,473,234 Net proceeds from assets held for sale 237,388 Issuance of notes receivable (58,089) (600,000) Collections on notes receivable 205,079 403,031 8,240 ----------- ----------- ----------- Net cash provided (used) by investing activities 7,841,678 (329,612) 194,946 ----------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Bank borrowings 3,175,000 2,066,033 Payments on bank borrowings (2,691,290) (1,780,461) Payments on other notes, net (899,894) (408,337) (458,177) Payments on capital lease obligations (168,550) (422,041) (384,584) Minority interest distributions (17,712) (36,500) Proceeds from issuance of convertible note 2,522,603 Direct costs of preferred stock issuance (152,570) Proceeds from stock option exercises 1,665 ----------- ----------- ----------- Net cash provided (used) by financing activities 1,786,964 ( 562,518) (879,261) ----------- ----------- ----------- NET CHANGE IN CASH AND EQUIVALENTS 10,067,716 (704,711) (90,366) CASH AND EQUIVALENTS: BEGINNING OF YEAR 109,231 813,942 904,308 ----------- ----------- ----------- END OF YEAR $10,176,947 $ 109,231 $ 813,942 =========== =========== =========== SUPPLEMENTAL DISCLOSURES: Interest paid $ 147,973 $ 330,749 $ 306,311 Income taxes paid (recovered) (416,653) 405,000 (204,058) Dividends accrued on preferred stock 127,167 Note payable converted to preferred stock 2,522,603 Equipment acquired under capital leases 107,396 24,065 180,415
The accompanying notes are an integral part of this statement. 23 DRCA MEDICAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: DRCA Medical Corporation ("DRCA" or the "Company") is a physician practice management company specializing in the management of orthopaedic medicine practices and other musculoskeletal-related patient services. In 1996, the Company divested all assets not directly related to the planned expansion of its management of musculoskeletal-related healthcare delivery systems in selected geographic markets. The divested assets included the managed occupational health care program previously developed by DRCA. Prior to this divestiture, the Company operated principally in the Houston, Texas and Little Rock and North Little Rock, Arkansas areas. After the divestiture, the Company manages a musculoskeletal-related healthcare delivery system in Houston, Texas which consists of orthopaedic and orthopaedics-related medical services, diagnostic imaging, physical and occupational rehabilitation, pain management, and work hardening. These operations provide a broad range of orthopaedic medicine and ancillary services to diagnose, treat and rehabilitate patients with musculoskeletal injuries and illnesses. Effective March 12, 1997, the Company changed its legal name from DRCA Medical Corporation to Integrated Orthopaedics, Inc. The following is a summary of the Company's significant accounting policies: Principles of Consolidation The consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries and limited partnerships in which the Company holds majority control through its general and limited partner interests. The equity of limited partner investors in consolidated partnerships is reported as minority interest. The consolidated financial statements also include the results of operations of the affiliated medical groups which the Company effectively controls through contractual relationships. The Company believes that it exercises perpetual and unilateral control over such entities as a result of (i) the long term, noncancellable nature of the related management services agreements, (ii) the nominal capital of the affiliated medical groups, (iii) economic interdependency of operations and (iv) the Company's right to designate the physician owners, and successors thereto, of the affiliated medical groups. All significant intercompany transactions and balances have been eliminated in consolidation. Use of Estimates in the Consolidated Financial Statements The preparation of consolidated financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the disclosures of contingent assets and liabilities. Because of the inherent uncertainties in this process, actual future results could differ from those expected at the reporting date. Revenue Recognition Revenue is recognized at the net amounts expected to be received as the related patient care, management or related services are rendered. A substantial portion of the Company's revenues are billed to insurance companies and other third-party payors, and as such are subject to retrospective review and possible reduction. Such adjustments, if any, are charged or credited to income when they become known. Revenues related to 24 DRCA MEDICAL CORPORATION NOTES TO CONSOLIDTED FINANCIAL STAEMENTS services provided to personal injury claimants is subject to reduction based on the outcome of the related legal actions. A provision is made for revenues estimated to be uncollectible. Cash and Equivalents For purposes of the Consolidated Statement of Cash Flows, the Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. Property and Equipment Property and equipment are stated at cost. Depreciation and amortization of property and equipment, including assets under capital leases, is provided over estimated useful lives ranging from 5 to 7 years using the straight-line method. Expenditures for additions, renewals, and betterments are capitalized and expenditures for repairs and maintenance are charged to expense as incurred. Intangible Assets Intangible assets arising from historical acquisitions, consisting principally of noncompete agreements, patient medical records and goodwill, are amortized on a straight-line basis over their estimated useful lives of 4 to 20 years. The Company periodically assesses the recoverability of long-lived assets based on their related future cash flows and provides for impairment, if any, at that time. Income Taxes Deferred income taxes are provided using the liability method for the temporary differences between the financial reporting basis and income tax basis of the Company's assets and liabilities. Deferred income taxes are measured using the rates expected to be in effect when the temporary differences are expected to be included in the Company's consolidated tax return. In estimating future tax consequences, all expected future events are considered other than enactments of changes in the tax laws or rates. Earnings Per Share Computations of earnings or loss per common share are based upon the weighted- average number of shares of common stock outstanding during the periods and the dilutive effect of common stock equivalents of outstanding options and warrants to purchase common stock. Fully diluted per share amounts have not been presented since they do not differ significantly from the primary presentation. Fair Values of Financial Instruments Due, generally, to their short term nature and current interest rates and terms, where applicable, the carrying value of the Company's assets and liabilities is believed to approximate their fair values unless otherwise indicated. NOTE 2 - REVENUE AND ACCOUNTS RECEIVABLE CONCENTRATIONS: During 1996, the Company provided substantially all of its services through affiliated medical groups in Texas and Arkansas which had a total of ten full- time and numerous part-time physicians. As a result of the 25 December 31, 1996 divestiture of the Company's occupational medicine business (See Note 9), services are provided primarily in the state of Texas through one full-time and three part-time physicians. The loss of the services of any of the remaining physicians could have a material effect on the Company's revenues. In 1996 and 1995, the medical services provided to the medical group's patients by William F. Donovan, M.D., a Company shareholder and director, was 15% and 16%, respectively, of the Company's revenues. A majority of the ancillary service revenues relating to non-divested operations also originated from patients treated by Dr. Donovan. In the years ended December 31, 1996, 1995 and 1994, the Company's payor mix as a percentage of net revenues was follows: state workers' compensation programs - 41%, 47% and 49%; direct billings to industrial clients - 20%, 22% and 23%; personal injury claims subject to legal action -12%, 16% and 12%; indemnity insurance; and other - 27%, 15% and 16%. Included in net accounts receivable at December 31, 1996 and 1995 are amounts due from patients pursuing personal injury cases of approximately $1,633,000 and $2,396,000, respectively. Due to the nature of the judicial process, these receivables frequently have a collection cycle which could approach two or more years. The Company provides contractual allowances on personal injury claimant revenues based on historical collection experience and related factors. While the Company believes that the allowances provided are adequate, changes in the court and public attitudes toward such claims, levels of judicial backlogs of such claims, the quality and validity of related legal actions and other factors can affect the ultimate amounts which will be collected. Texas continues to experience claims backlogs in the courts; however, payment experience currently indicates that recoverability rates do not vary significantly based on the age of the claim. Changes in factors affecting collectibility are reflected as revenue adjustments in the period they become known. Accounts receivable are net of an allowance for doubtful accounts of $711,214 and $180,070 at December 31, 1996 and 1995, respectively. Substantially all the Company's revenues are billed to third-party payors, principally insurance companies, self-insured employers and industry insurers, and the related receivables are generally not collateralized. Due to the numerous payors with which the Company operates, the more significant of which are large established entities, as well as the ongoing review conducted by the Company of the adequacy of its allowances for doubtful accounts and contractual adjustments, additional credit risk in accounts receivable is not believed to be significant. NOTE 3 - INTANGIBLE ASSETS: The intangible assets reported in 1995 related to the occupational medicine business and were divested in conjunction with the Company's restructuring (See Note 9). Intangible assets consist of the following at December 31, 1995: Useful Lives Noncompete agreements 4 - 5 $ 625,000 Patient medical records 8 - 15 774,661 Goodwill 20 372,368 ---------- 1,772,029 Accumulated amortization (867,868) ---------- $ 904,161 ========== Amortization expense amounted to $121,596 in 1996 and $234,096 in 1995. 26 NOTE 4 - NOTES PAYABLE: On June 5, 1996, the Company obtained a $275,000 fixed rate term loan which bears interest at 9/15% and is payable in 36 monthly installments of $8,781. The term loan is secured by MRI equipment. On April 12, 1996, the Company issued a $2,500,000 subordinated note payable to Chartwell Capital Investors, LP. The note bears interest at 10% and is convertible into preferred stock at a conversion price of $100 per share. The note and accumulated interest of $2,522,603 was converted into 25,226 shares of cumulative, convertible preferred stock on May 15, 1996. The Company's bank credit facilities are secured by substantially all assets of the Company, its subsidiaries and affiliated medical groups. The revolving line of credit requires the payment of a 1% annual fee. Borrowings under the line bear interest at prime + 1.25% and the line expires April 15, 1997. Advances under the line of credit are subject to a borrowing base formula under which the Company presently has sufficient collateral to support approximately 80% of the line availability. The line of credit as well as other borrowings from the lender are subject to the terms of a loan agreement which includes financial ratio covenants and various other provisions. The term loan is payable monthly at $19,061 with interest at prime +1.5% and it matures in January, 1999. The Company also received a commitment to fund up to $500,000 in equipment purchases. Amounts advanced against this commitment will convert to term notes with 3- and 4- year maturities as of April 15, 1997. Notes payable consisted of the following at December 31: 1996 1995 ----- ----- Bank credit facilities: Revolving line of credit, 9.75% in 1996, expires April 1997 $ 1,400,000 $ 858,953 Term note, 10% in 1996, payable monthly, due January 1999 427,870 604,248 9.15% note, secured by MRI equipment, monthly payment of $8,781, principal and interest, due June 1999 233,498 7.75% note, secured by MRI equipment, paid in March, 1996 727,544 10% acquisition notes, monthly payments of $8,000 principal and interest, remaining paid in January 1996 127,354 8.5% acquisition note, $5,221 payable monthly through January 3, 1997 25,562 64,629 Equipment notes at various rates, paid in 1996 120,386 ----------- ----------- 2,086,930 2,503,114 Less current portion (1,700,699) (1,597,224) ----------- ----------- $ 386,231 $ 905,890 =========== =========== Maturities of indebtedness are $1,700,699 in 1997, $283,509 in 1998 and $102,722 in 1999. 27 NOTE 5 - INCOME TAXES: The provisions (benefit) for income taxes for the years ended December 31 are comprised of: 1996 1995 1994 ---------- --------- --------- Federal: Current $ 584,360 $ 2,862 $ 151,075 Deferred (251,256) 337,138 33,000 State 90,487 35,423 51,126 ---------- --------- --------- $ 423,591 $ 375,423 $ 235,201 ========== ========= ========= The difference between the effective income tax rate and the amount which would be determined by applying the statutory U.S. income tax rate to income before income taxes for the years ended December 31 is as follows: 1996 1995 1994 ---------- --------- --------- Provision (benefit) for income taxes at U.S. statutory rates $ 411,639 $ 303,667 $ 220,639 State income taxes 90,487 35,423 51,126 Refund on amended returns (42,277) Nondeductible expenses and other (78,535) 36,333 5,713 ---------- --------- --------- $ 423,591 $ 375,423 $ 235,201 ========== ========= ========= Deferred income taxes at December 31 are comprised of: 1996 1995 ---------- --------- Deferred tax assets: Accrued expenses $ 107,769 $ 21,179 Allowance for doubtful accounts 44,878 30,676 Operating loss carryforward 93,295 Depreciation 78,622 Other 6,741 6,335 ---------- --------- 238,010 151,485 ---------- --------- Deferred tax liabilities: Accrued expenses (32,602) Amortization of intangible assets (83,869) Depreciation (72,718) Cash basis for certain revenues for tax reporting (319,562) (327.050) ---------- --------- (319,562) (516,239) ---------- --------- Net deferred liability $ (81,552) $(364,754) ========== ========= NOTE 6 - LEASES: The Company leases office space, clinic facilities and certain equipment under noncancelable operating and capital leases expiring through the year 1999. Rent expense for all noncancellable operating leases amounted to $1,060,934 in 1996, $1,128,783 in 1995 and $1,081,542 in 1994. 28 Future minimum payments by year and in the aggregate related to capital and noncancelable operating leases at December 31, 1996 are: Capital Operating Leases Leases ---------- ---------- 1997 $ 16,091 $ 937,774 1998 12,271 145,081 1999 4,039 86,002 ---------- ---------- Total minimum lease payments 32,401 $1,168,857 ========== Amounts representing interest (3,894) Present value of net minimum lease payments 28,507 ---------- Less current portion (14,081) Long-term obligation $ 14,426 ========== Included in equipment are assets acquired under capital leases of $60,215 at December 31, 1996 and $1,850,867 at December 31, 1995. Accumulated amortization of assets under capital leases amounted to $14,498 at December 31, 1996 and $1,349,349 at December 31, 1995. Contingent rentals based on utilization of certain MRI equipment amounted to $1,198 in 1996, $42,201 in 1995 and $55,456 in 1994. The contingent rental obligation expired in March, 1996. NOTE 7 - STOCK OPTIONS AND WARRANTS: The Company has a Stock Option Plan which provides for the granting of options at not less than market value to purchase up to 1,000,000 shares of common stock by eligible employees of the Company. Option prices and other terms are determined by the Board of Directors. Transactions for the years ended December 31, 1996, 1995 and 1994 for employee stock options granted under the plan are as follows: Weighted Average Shares Exercise Price --------- ---------------- Balance, December 31, 1993 319,000 $3.91 Granted 24,500 $3.13 Forfeited (103,500) $4.14 --------- Balance, December 31, 1994 240,000 $3.73 Granted 141,750 $2.56 Forfeited (40,000) $3.96 --------- Balance, December 31, 1995 341,750 $3.22 Granted 265,000 $3.49 Exercised (666) $2.50 Forfeited (10,500) $4.36 Expired (9,002) $2.94 --------- Balance, December 31, 1996 586,582 $3.33 ========= 29 Weighted Average Shares Exercise Price --------- ---------------- Exercisable at December 31, 1994 170,667 $3.88 Exercisable at December 31, 1995 321,582 $3.23 Exercisable at December 31, 1996 316,582 $3.19 The following table summarizes information about the Company's stock options outstanding at December 31, 1996:
Options Outstanding Options Exercisable ------------------------------------------------------------- ------------------------------------- Range of Number Weighted-Average Weighted-Average Number Weighted-Average Exercise Outstanding Remaining Exercise Exercisable Exercise Prices at 12/31/96 Contractual Life Price at 12/31/96 Price ---------- ----------- ---------------- ---------------- ----------- ---------------- $2.50 - 3.75 551,082 7.32 years $ 3.24 291,082 $ 3.03 $3.76 - 5.13 35,500 5.75 years $ 4.73 25,500 $ 5.02 ------- ------- Total 586,582 7.23 years $ 3.33 316,582 $ 3.19 ======= =======
During 1995, the exercise price for a total of 142,500 options to purchase common stock granted under the plan was reduced from $4.525 to $3.50 per share, the market price at the repricing date. No compensation expense was recognized with this repricing. In February 1989, the Company issued warrants to purchase 100,000 shares of common stock each to Jose E. Kauachi, the Company's Chairman of the Board of Directors, President and CEO (Mr. Kauachi) and Mr. William F. Donovan, M. D., Director of the Company and Medical Director of the Company's affiliated medical groups (Dr. Donovan). These warrants were issued as compensation for services rendered and for the officers' personal guarantee of corporate debt and other obligations. The warrant exercise price was $1.75 per share and were originally exercisable through February 22, 1994. By amendments effective in February 1994 and 1995, the expiration dates of the warrants have been extended to February 22, 1999 and the exercise price has been adjusted to the then market value of $2.125 per share. The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No.123 ("SFAS No. 123"), "Accounting for Stock-Based Compensation." Accordingly, no compensation cost has been recognized for fixed options granted to Company employees. Had compensation cost for the Company's stock option plan been determined based on the fair market value at grant for awards in 1996 and 1995 consistent with the provisions of SFAS No. 123, the Company's net income and net income per share would have been reduced to the pro forma amounts indicated below: 1996 1995 --------- --------- Net income - as reported $ 787,112 $ 517,714 Net income - pro forma $ 783,100 $ 405,829 Earnings per share - as reported $ .12 $ .10 Earnings per share - pro forma $ .12 $ .07 30 Options granted in 1996 and 1995 had weighted average fair values of $1.95 and $1.34, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: 1996 1995 ------- ------- Expected dividend yield 0% 0% Expected stock price votability 44% 35% Expected life 7 years 7 years Expected risk-free interest rate 6.3% 7.5% NOTE 8 - PREFERRED STOCK: In May 1996, the Company's shareholders approved the amendment of its Articles of Incorporation to authorize 10,000,000 shares of preferred stock at a par value of $.01 per share. Pursuant thereto, the Company established 26,000 shares of cumulative convertible preferred stock ("Series A Preferred Stock"). The Series A Preferred Stock has a liquidation value of $100 per share plus unpaid dividends and is convertible at the option of the holder into common stock of the Company at a conversion price calculated as the liquidation value divided by $3.50, subject to adjustment in certain events. The Company, at its option, may require conversion of the preferred stock into common stock at any time, provided that certain trading and pricing levels are met. The holders of Series A Preferred Stock are entitled to receive cumulative dividends at the rate of (i) $8.00 per share from the date of issuance to June 30, 2001, (ii) $10.00 per share for the period beginning July 1, 2001 and ending June 30, 2002, (iii) $12.00 per share for the period beginning July 1, 2002 and ending June 30, 2003, and (iv) $16.00 per share after July 1, 2003. Such dividends shall be payable in preference and priority to any payment of any cash dividend on common stock. Dividends are cumulative from the date of issuance and are payable quarterly after June 30, 1999. At December 31, 1996 the Company has accrued unpaid dividends on the Series A Preferred Stock of $127,167. The Series A Preferred Stock is redeemable at the option of the Company after June 30, 2001 at a redemption price of $100 per share plus unpaid dividends. 31 NOTE 9 NET GAIN FROM RESTRUCTURING: During 1996, the Company, in a strategic effort to restructure its operations towards a single focus musculoskeletal-related physician practice management company, divested its interests in eight occupational medicine centers, four physical and medical therapy centers associated with the occupational medicine centers, seven mobile health testing units operated in conjunction with the occupational medicine programs in Houston, Texas and Little Rock, Arkansas, and one magnetic resonance imaging ("MRI") center in Little Rock, Arkansas. The consideration and net gain from restructuring is as follows: Occupational Little Rock Net Medicine MRI Gain ------------ ----------- ----------- Cash proceeds $ 7,773,234 $ 700,000 $ 8,473,234 Note receivable 156,859 156,859 Assumption of capital leases, net 166,945 166,945 ------------ ----------- ----------- Total consideration 8,097,038 700,000 8,797,038 ------------ ----------- ----------- Accounts receivable, net sold 1,165,951 1,165,951 Property and equipment sold 1,195,571 804,154 1,999,725 Intangible assets, net sold 782,565 782,565 Other assets sold 16,407 16,407 Divestiture Costs 1,664,689 1,664,689 ------------ ----------- ----------- Net gain from restructuring $ 3,271,855 $ (104,154) $ 3,167,701 ============ =========== =========== The following unaudited pro forma information assumes that the sale of the occupational medicine business occurred on January 1, 1996 and 1995, respectively. The pro forma information does not purport to be indicative of the results of operations that actually would have been attained if the sale had occurred at these earlier dates or results which may occur in the future. Year ended December 31, ----------------------- 1996 1995 --------- --------- Revenues (in thousands) $ 8,100 $ 8,877 Net Income (in thousands) $ 1,238 $ 804 Earnings per common share: Primary $ .20 $ .15 Assuming full dilution $ .20 $ .15 NOTE 10 - CONTINGENCIES: The Company maintains professional liability insurance in levels it believes to be adequate in the circumstances. In the ordinary course of its business, the Company is subject, from time to time, to claims and legal actions, including as a named party to professional liability claims involving medical groups and physicians affiliated with the Company. As of March 21, 1997, management is not aware of any material actual or unasserted claims or actions pending against the Company. 32 NOTE 11 - RELATED PARTY TRANSACTIONS: The Company, either directly or through an affiliated medical group, paid William F. Donovan, M.D., a Company director, and Northshore Orthopedics Assoc. ("NSO"), a professional corporation owned by Dr. Donovan, $728,731 in 1996 and $504,878 in 1995 for Dr. Donovan's professional medical services to patients of an affiliated medical group, medical director's fees, equipment and leasehold rentals, and contracted services. Dr. Donovan began practicing medicine full time with the Company's Houston affiliated medical group during 1995 and, pursuant to such affiliation, the Company loaned NSO $500,000 for operating expenses. The loan was collateralized by NSO's accounts receivable and was payable as receivables were collected. Interest at 9.5% was earned by the Company in the amount of $7,481 in 1996 and $13,792 in 1995. The balance of the note at December 31, 1995 of $135,802 was paid off during 1996. In 1995, the Company retained a fee for collecting NSO's receivables totaling $242,480. There were no such fees collected from NSO during 1996. The Company leased several office suites used for clinic and administrative functions at prevailing market rates from Pacati, Inc., a company which is jointly owned by Jose E. Kauachi, Chairman and Chief Executive Officer of the Company, and Dr. Donovan. The leases were canceled in October, 1996, as a result of Pacati, Inc.'s sale of the property to an unrelated party. The Company paid Pacati, Inc. $160,623 in 1996, $210,099 in 1995 and $174,763 in 1994 under the rental arrangements. Dr. Donovan purchased a medical clinic from the Company in March 1994 for $240,000. The original cost to the Company was $190,000 and the gain on the transaction was $36,634. In 1996, the Company converted a $2,522,603 loan with Chartwell Capital Investors (Chartwell) into 25,226 shares of cumulative, convertible preferred stock. In addition, Chartwell received $30,215 in management fees relating to investment consultations. ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT. This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. ITEM 10. EXECUTIVE COMPENSATION This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. 33 ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits and Index to Exhibits Exhibit No. Exhibit Title Filed As - ----------- -------------------------------------- -------- 2.1 Stock and Asset Purchase Agreement dated December 31, 1996 among OccuCenters, Inc., Occupational Health Centers of the Southwest, P.A. and DRCA Medical Corporation, William F. Donovan, M.D., PhysiCare, L.L.P., and DRCA Houston Clinics, Inc. /16/Same 3.1 Articles of Incorporation of the Company, as amended to date. /15/Exhibit 3.1 3.2 Bylaws of the Company, as amended to date. /12/Exhibit 3.2 3.3 Articles of Merger of DRCA and Doctors Rehabilitation Corporation of America filed June 29, 1990. /2/Exhibit 3.3 3.4 Articles of Merger of DRCA and Doctors Rehabilitation Corporation of America filed July 16, 1990. /1/Exhibit 3.2 3.5 Plan and Agreement of Merger between DRCA and Doctors Rehabilitation Corporation of America dated May 10, 1990. /1/Exhibit 3.3 4.1 Specimen of Common Stock Certificate, $.001 par value, of the Company. /1/Exhibit 4.1 4.2 Warrant Agreement between the Company and Jose E. Kauachi dated February 23, 1989. /3/Exhibit 4.3* 4.3 Warrant Agreement extension between the Company and Jose E. Kauachi dated February 22, 1994. /11/Exhibit 4.3* 4.4 Warrant Agreement Amendment between the Company and Jose E. Kauachi dated November 21, 1994 and effective February 22, 1994 /12/Exhibit 4.4* 34 Exhibit No. Exhibit Title Filed As - ----------- -------------------------------------- -------- 4.5 Warrant Agreement between the Company and William F. Donovan, M.D. dated February 23, 1989. /3/Exhibit 4.5* 4.6 Warrant Agreement extension between the Company and William F. Donovan, M.D. dated February 22, 1994. /11/Exhibit 4.5* 4.7 Warrant Agreement Amendment between the Company and William F. Donovan, M.D. dated November 21, 1994 and effective February 22, 1994. /12/Exhibit 4.7* 4.10 Warrant Agreement between the Company and Victor M. Rivera, M.D. dated April 26, 1992. /9/Exhibit 4.8 4.11 Second Warrant Agreement Amendment dated February 2, 1995 between the Company and Jose E. Kauachi /12/Exhibit 4.11* 4.12 Second Warrant Agreement Amendment dated February 2, 1995 between the Company and William F. Donovan, M.D. /12/Exhibit 4.12* 10.1 Guaranty Agreement dated effective January 3, 1992 by the Company for the benefit of Medi-Stat, Inc. /2/Exhibit 10.39 10.2 1988 Stock Option Plan of Doctors Rehabilitation Corporation of America. /4/Exhibit 10.1* 10.3 Amendment of 1988 Stock Option Plan /10/Exhibit 10.2* 10.4 Stock Option Agreement dated September 1, 1992 between Ray Bishop and the Company /9/Exhibit 10.35 10.5 Management Agreement between DRCA Houston Clinics, Inc. and Occupational Medicine Associates of Houston, P.A. Dated effective August 1, 1993 /11/Exhibit 10.53* 10.6 Administrative Services Agreement between DRCA Houston Clinics, Inc. and the Company dated effective August 1, 1993. /11/Exhibit 10.57 10.7 Option Agreement among Occupational Medicine Associates of Houston, P.A., William F. Donovan, M.D., and DRCA Houston Clinics, Inc. dated effective August 1, 1993. /11/Exhibit 10.58* 10.8 Loan Agreement dated January 30, 1995 between the Company, its subsidiaries, affiliates and guarantors and First Interstate Bank of Texas, N.A. /12/Exhibit 10.78 10.9 Promissory Note for $750,000 dated January 30, 1995 between the Company and First Interstate Bank of Texas, N.A. /12/Exhibit 10.79 35 Exhibit No. Exhibit Title Filed As - ----------- -------------------------------------- -------- 10.10 Promissory Note for $1,000,000 dated January 30, 1995 between the Company and First Interstate Bank of Texas, N.A. /12/Exhibit 10.80 10.11 Commercial Guaranty dated January 30, 1995 between Jose E. Kauachi and First Interstate Bank of Texas, N.A. /12/Exhibit 10.81 10.12 Commercial Guaranty dated January 30, 1995 between William F. Donovan, M.D. and First Interstate Bank of Texas, N.A. /12/Exhibit 10.82 10.13 Commercial Guaranty dated January 30, 1995 between Sharon A. Donovan and First Interstate Bank of Texas, N.A. /12/Exhibit 10.83 10.14 Incentive Stock Option Agreement between the Company and William F. Donovan, M.D. dated February 2, 1995 /12/Exhibit 10.85* 10.15 Executive Employment Agreement between the Company and Jose E. Kauachi dated November 15, 1994 /12/Exhibit 10.90* 10.16 Executive Employment Agreement between the Company and Jefferson R. Casey dated January 22, 1995 /12/Exhibit 10.91* 10.17 Management Services Agreement by and between DRCA Houston Clinics, Inc. and PhysiCare, L.L.P. dated effective March 1, 1995 /13/Exhibit 10.99 10.18 Equipment Lease Agreement by and between Northshore Orthopaedics Assoc. and DRCA Houston Clinics, Inc. dated effective March 1, 1995 /13/Exhibit 10.100 10.19 Lease Agreement by and between William F. Donovan, M.D. and DRCA Houston Clinics, Inc. dated effective March 1, 1995 /13/Exhibit 10.101 10.20 Collection Services Agreement by and between DRCA Houston Clinics, Inc. and Northshore Orthopaedics Assoc. dated effective March 1, 1995 /13/Exhibit 10.102 10.21 Promissory Note for $1,000,000 by PhysiCare, 2 L.L.P. and DRCA Houston Clinics, Inc. dated effective March 1, 1995 /13/Exhibit 10.105 10.22 Security Agreement between PhysiCare, L.L.P. and DRCA Houston Clinics, Inc. dated effective March 1, 1995 /13/Exhibit 10.106 36 Exhibit No. Exhibit Title Filed As - ----------- -------------------------------------- -------- 10.23 Master Transaction Agreement by and among the Company, DRCA Houston Clinics, Inc., Occupational Medicine Associates of Houston, P.A., Northshore Orthopaedics Assoc., PhysiCare, L.L.P. and William F. Donovan, M.D. dated effective March 1, 1995 /13/Exhibit 10.107 10.24 Professional Services Agreement Medical Director between William F. Donovan, M.D. and the Company dated effective March 1, 1995 /1/3Exhibit 10.108 10.25 Amendment to Loan Agreement dated January 30, 1995 by and among the Company, Northshore Orthopaedics Assoc., PhysiCare, L.L.P., and First Interstate Bank of Texas, N.A. dated effective May 15, 1995 /13/Exhibit 10.110 10.26 Commercial Guarantee by PhysiCare, L.L.P. to First Interstate Bank of Texas, N.A. dated May 15, 1995 /13/Exhibit 10.111 10.27 Amendment to the Loan Agreement dated January 30,1995 between the Company, its Subsidiaries, affiliates and First Interstate Bank of Texas, N.A. effective January 30, 1996 /14/Exhibit 10.47 10.28 Promissory Note for $2,000,000 dated January 30,1996 between the Company and First Interstate Bank of Texas, N.A. /16/Exhibit 10.48 10.29 Promissory Note for $500,000 dated January 30,1996 between the Company and First Interstate Bank of Texas, N.A. /16/Exhibit 10.49 10.30 Investment Agreement by and between the Company and Chartwell Capital Investors, L.P. dated April 12, 1996 /16/Exhibit 10.50 10.31 Option Agreement between the Company and Thomas M. Conner dated April 11, 1996 /16/Exhibit 10.51 10.32 Option Agreement between the Company and Victor M. Rivera, M.D. dated April 11, 1996 /16/Exhibit 10.52 11 Calculations for Primary and Fully Diluted earnings per share /1/7Same 21 Subsidiaries of the Company. /17/Same 23 Consent of Independent Accountant to incorporation by reference of 1996 financial statements contained in this Report on Form 10-KSB into the Company's Registration Statement on Form S-8, Registration No. 33-42624, filed with the Securities and Exchange Commission on September 6, 1991 /17/Same 37 /1/ Incorporated by reference to the Company's Annual Report on 10-K dated March 28, 1991 (under the exhibit number indicated in the column titled "Filed As"). /2/ Incorporated by reference to the Company's Annual Report on 10-K dated March 26, 1992, (under the exhibit number indicated in the column titled "Filed As"). /3/ Incorporated by reference to Post-Effective Amendment No. 1 to the Doctors Rehabilitation Corporation of America Registration Statement on Form S-1, Registration No. 33-31691 (under the exhibit number indicated in the column titled "Filed As"). /4/ Incorporated by reference to the Doctors Rehabilitation Corporation of America Registration Statement on Form 10, Registration No. 0-17006 (under the exhibit number indicated in the column titled "Filed As"). /5/ Incorporated by reference to the Company's Current Report on Form 8-K dated November 1, 1990 (under the exhibit number indicated in the column titled "Filed As"). /6/ Incorporated by reference to the Company's Form 8 dated December 31, 1990, amending the Company's Current Report on Form 8-K dated November 1, 1990 (under the exhibit number indicated in the column titled "Filed As"). /7/ Incorporated by reference to the Company's Current Report on Form 8-K dated January 17, 1992 (under the exhibit number indicated in the column titled "Filed As"). /8/ Incorporated by reference to the Company's Current Report on Form 8-K dated February 4, 1993 (under the exhibit number indicated in the column titled "Filed As"). /9/ Incorporated by reference to the Company's Annual Report on Form 10-KSB dated March 30, 1993, (under the exhibit number indicated in the column titled "Filed As"). /10/Incorporated by reference to the Company's Quarterly Report on Form 10-QSB for the quarter ended 9/30/93 dated November 12, 1993 (under the exhibit number indicated in the column titled "Filed As"). /11/Incorporated by reference to the Company's Annual Report on Form 10-KSB dated March 30, 1994 (under the exhibit number indicated in the column titled "Filed As"). /12/Incorporated by reference to the Company's Annual Report on Form 10-KSB dated March 30, 1995 (under the exhibit number indicated in the column titled "Filed As". /13/Incorporated by reference to the Company's Quarterly Report on Form 10-QSB for the quarter ended 6/30/95 dated August 11, 1995 (under the exhibit number indicated in the column titled "Filed As". /14/Incorporated by reference to the Company's Quarterly Report on Form 10-QSB for the quarter ended 3/31/96 dated May 14, 1996 (under the exhibit number indicated in the Column titled "Filed As". /15/Incorporated by reference to the Company's Quarterly Report on Form 10-QSB for the quarter ended 6/30/96 date August 11, 1996 (under the exhibit number indicated in the Column titled "Filed As". /16/Incorporated by reference to the Company's Current Report on Form 8-K dated January 14, 1997 (under the exhibit number indicated in the column titled "Filed As". 38 /17/Filed herewith *Management contract or compensatory plan or arrangement (b) Reports on Form 8-K The Company filed no reports on Form 8-K with the Securities and Exchange Commission during the last quarter of the fiscal year ended December 31, 1996. 39 SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INTEGRATED ORTHOPAEDICS, INC. /s/ JOSE E. KAUACHI By: ______________________________ JOSE E. KAUACHI Chairman of the Board and Chief Executive Officer Dated: March 27, 1997 In Accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: Signature Title Date - --------- ----- ---- /s/ JOSE E. KAUACHI Chairman of the Board March 27, 1996 By:_____________________________ and Chief Executive JOSE E. KAUACHI Officer /s/ RONALD R. PIERCE President and Chief March 27, 1996 By:_____________________________ Operating Officer RONALD R. PIERCE /s/ JEFFERSON R. CASEY Senior Vice President, March 27, 1996 By:_____________________________ (Principal Financial & JEFFERSON R. CASEY Accounting Officer), and Secretary /s/ VICTOR M. RIVERA, M.D. Director March 27, 1996 By:_____________________________ VICTOR M. RIVERA, M.D. /s/ CLIFFORD R. HINKLE Director March 27, 1996 By:_____________________________ CLIFFORD R. HINKLE /s/ WILLIAM F. DONOVAN, M.D. Director March 27, 1996 By:_____________________________ WILLIAM F. DONOVAN, M.D. 40 EX-11 2 EXHIBIT 11 EXHIBIT 11 DRCA MEDICAL CORPORATION SCHEDULE RE: EARNINGS (LOSS) PER SHARE For the three years ended December 31, 1996 1996 1995 1994 ---------- ---------- ---------- Primary Average shares outstanding 5,286,032 5,285,975 5,269,975 Net effect of dilutive stock options and warrants, based on the treasury stock method using average market price 170,048 150,583 8,715 ---------- ---------- ---------- 5,456,080 5,436,558 5,278,690 ========== ========== ========== Net income (loss) $ 787,112 $ 517,714 $ 413,737 Dividends on preferred stock 127,167 ---------- Income after dividends on preferred stock $ 659,945 $ 517,714 $ 413,737 ---------- ---------- ---------- Earnings (loss) per share $ .12 $ .10 $ .08 ========== ========== ========== Fully diluted Average shares outstanding 5,286,032 5,285,975 5,269,975 Net effect of dilutive stock options and warrants, based on the treasury stock method using the year-end market price, if higher than average market price 241,865 150,583 8,715 ---------- ---------- ---------- 5,527,897 5,436,558 5,278,690 ========== ========== ========== Net income (loss) $ 787,112 $ 517,714 $ 413,737 Dividends on preferred stock 127,167 ---------- ---------- ---------- Income after dividends on preferred stock $ 659,945 $ 517,714 $ 413,737 ---------- ---------- ---------- Earnings (loss) per share $ .12 $ .10 $ .08 ========== ========== ========== EX-21 3 EXHIBIT 21 EXHIBIT 21 SUBSIDIARIES OF THE COMPANY TEXAS LIMITED PARTNERSHIPS: Doctors' Medical Therapy Centers - Orange, Ltd. Doctors' Medical Therapy Centers - Hemet, Ltd. Doctors' Medical Therapy Centers - Houston II, Ltd. Atlanta Work Hardening Dynamics - I, Ltd. Trade Names: Work Hardening Dynamics Work Dynamics Spectrum Imaging Centers - Houston I, Ltd. Trade Names: Spectrum Imaging TEXAS CORPORATIONS: DRCA Houston Clinics, Inc. CALIFORNIA CORPORATIONS: Rehabilitation Corporation of America EX-23 4 EXHIBIT 23 Exhibit 23 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 33-42624) of DRCA Medical Corporation of our report dated March 26, 1997 appearing on page 19 of this Form 10-KSB. PRICE WATERHOUSE LLP Houston, Texas March 26, 1997 EX-27 5 EXHIBIT 27
5 12-MOS DEC-31-1996 JAN-01-1996 DEC-31-1996 10,176,947 0 4,507,929 711,214 0 14,397,861 3,875,473 3,210,788 15,168,711 6,700,198 2,086,930 5,303 252 0 7,902,127 15,168,711 14,313,154 14,313,154 16,099,575 16,099,575 0 1,417,485 170,577 1,210,703 423,591 787,112 0 0 0 787,112 .12 .12
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