UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER 001-15223 OPTICARE HEALTH SYSTEMS, INC. (Exact Name of Registrant as Specified in Its Charter) DELAWARE 76-0453392 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 87 GRANDVIEW AVENUE, WATERBURY, CONNECTICUT 06708 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (203) 596-2236 Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). [ ] Yes [X] No The aggregate market value of the registrant's Common Stock held by non-affiliates of the registrant (without admitting that any person whose shares are not included in such calculation is an affiliate) computed by reference to the closing market price as reported on the American Stock Exchange on June 30, 2004, the last business day of the registrant's most recently completed second fiscal quarter, was $4,116,126. The number of shares outstanding of the registrant's Common Stock, par value $.001 per share, at July 31, 2004 was 30,686,800 shares. INDEX TO FORM 10-Q Page No. -------- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets at June 30, 2004, December 31, 2003, and June 30, 2003, as restated (unaudited) 3 Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2004 and 2003 (unaudited) 4 Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003 (unaudited) 5 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Item 3. Quantitative and Qualitative Disclosures about Market Risk 22 Item 4. Controls and Procedures 22 PART II. OTHER INFORMATION Item 1. Legal Proceedings 23 Item 3. Defaults Upon Senior Securities 23 Item 4. Submission of Matter to a Vote of Security Holders 23 Item 6. Exhibits and Reports on Form 8-K 23 SIGNATURE 24 2 PART I FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (AMOUNTS IN THOUSANDS) (UNAUDITED) JUNE 30, DECEMBER 31, JUNE 30, 2004 2003 2003 ---------------- ----------------- ----------------- AS RESTATED See Note 3 ASSETS CURRENT ASSETS: Cash and cash equivalents $ 2,362 $ 1,695 $ 3,881 Accounts receivable, net 9,031 7,867 9,600 Inventories 5,243 5,770 6,463 Deferred income taxes, current - - 1,660 Assets held for sale 1,115 1,652 1,656 Other current assets 1,090 565 841 ---------------- ----------------- ----------------- TOTAL CURRENT ASSETS 18,841 17,549 24,101 ---------------- ----------------- ----------------- Property and equipment, net 4,037 4,647 5,551 Goodwill, net 17,892 17,892 19,531 Intangible assets, net 1,124 1,179 1,235 Deferred income taxes, non-current - - 3,320 Assets held for sale, non-current 792 1,339 1,496 Other assets 3,139 3,249 3,028 ---------------- ----------------- ----------------- TOTAL ASSETS $ 45,825 $ 45,855 $ 58,262 ================ ================= ================= LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 8,936 $ 5,525 $8,114 Accrued expenses 6,590 5,379 4,990 Current portion of long-term debt 9,306 10,828 12,395 Liabilities of held for sale business 1,057 1,241 1,389 Other current liabilities 1,022 548 435 ---------------- ----------------- ----------------- TOTAL CURRENT LIABILITIES 26,911 23,521 27,323 ---------------- ----------------- ----------------- Long-term debt, less current portion 63 1,775 54 Other liabilities 539 512 550 ---------------- ----------------- ----------------- TOTAL NON-CURRENT LIABILITIES 602 2,287 604 ---------------- ----------------- ----------------- Series B 12.5% mandatorily redeemable, convertible preferred stock--related party 5,986 5,635 5,317 STOCKHOLDERS' EQUITY: Series C preferred stock--related party 1 1 1 Common stock 31 30 30 Additional paid-in-capital 79,534 79,700 79,966 Accumulated deficit (67,240) (65,319) (54,979) --------------- ----------------- ----------------- TOTAL STOCKHOLDERS' EQUITY 12,326 14,412 25,018 --------------- ----------------- ----------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 45,825 $ 45,855 $58,262 =============== ================= ================= See notes to condensed consolidated financial statements. 3 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA) (UNAUDITED) THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, --------------------------- ---------------------------- 2004 2003 2004 2003 ------------ ----------- ------------ ------------ NET REVENUES: Managed vision $ 6,267 $ 7,480 $12,317 $ 14,888 Product sales 17,880 19,174 35,837 36,938 Other services 5,517 4,819 10,460 9,173 Other income 1,098 530 1,718 2,368 ------------ ----------- ------------ ------------ Total net revenues $30,762 32,004 60,332 63,367 ------------ ----------- ------------ ------------ OPERATING EXPENSES: Medical claims expense 4,717 5,514 9,360 11,257 Cost of product sales 13,761 14,626 27,963 28,568 Cost of services 2,427 2,043 4,468 3,898 Selling, general and administrative 9,234 9,318 18,017 17,739 Loss from early extinguishment of debt - 1,847 - 1,847 Depreciation 420 359 811 702 Amortization 27 29 56 58 Interest 277 630 596 1,389 ------------ ----------- ------------ ------------ Total operating expenses 30,863 34,366 61,271 65,458 ------------ ----------- ------------ ------------ Loss from continuing operations before taxes (101) (2,362) (939) (2,091) Income tax expense (benefit) 46 (183) 52 (72) ------------ ----------- ------------ ------------ Loss from continuing operations (147) (2,179) (991) (2,019) Discontinued operations (Note 5) Income (loss) from discontinued operations (including loss on disposal of $580) in 2004 (810) 9 (929) 5 Income tax expense (benefit) - (3) - (2) ------------ ----------- ------------ ------------ Income (loss) on discontinued operations (810) 6 (929) 3 Net loss (957) (2,173) (1,920) (2,016) Preferred stock dividends (177) (160) (351) (300) ------------ ----------- ------------ ------------ Net loss to common stockholders $ (1,134) $ (2,333) $(2,271) $ (2,316) ============ =========== ============ ============ LOSS PER SHARE- BASIC AND DILUTED: Loss from continuing operations $ (0.01) $ (0.08) $ (0.04) $ (0.08) Discontinued operations (0.03) 0.00 (0.03) 0.00 Net loss (0.04) (0.08) (0.07) (0.08) See notes to condensed consolidated financial statements. 4 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (AMOUNTS IN THOUSANDS) (UNAUDITED) FOR THE SIX MONTHS ENDED JUNE 30, ---------------------------------- 2004 2003 --------------- -------------- OPERATING ACTIVITIES: Net (loss) $ (1,920) $ (2,016) (Income) loss on discontinued operations 929 (3) --------------- -------------- Loss from continuing operations (991) $ (2,019) Adjustments to reconcile net (loss) to net cash provided by (used in) operating activities: Depreciation 811 701 Amortization 56 58 Non-cash interest expense 79 855 Non-cash loss on early extinguishment of debt - 1,847 Non-cash gain on contract settlements (530) Deferred taxes - (180) Changes in operating assets and liabilities: Accounts receivable (963) 633 Inventory 528 1,135 Other assets (749) (57) Accounts payable and accrued expenses 4,802 (3,064) Other liabilities 466 (59) Cash provided by discontinued operations 3 39 --------------- -------------- Net cash provided by (used in) operating activities 4,042 (641) --------------- -------------- INVESTING ACTIVITIES: Cash received on notes receivable 91 180 Purchase of fixed assets (207) (552) Refunds of deposits 775 Acquisition of business, net of cash acquired (6,192) Purchase of restricted certificates of deposit (600) --------------- -------------- Net cash used in investing activities (116) (6,389) --------------- -------------- FINANCING ACTIVITIES: Net increase (decrease) in revolving credit facility (3,097) 8,777 Principal payments on long-term debt (220) (801) Principal payments on capital lease obligations (11) (28) Payment of financing costs (25) (209) Equipment financing 81 - Proceeds from issuance of common stock 13 86 --------------- -------------- Net cash (used in) provided by financing activities (3,259) 7,825 --------------- -------------- Increase in cash and cash equivalents 667 795 Cash and cash equivalents at beginning of period 1,695 3,086 --------------- -------------- Cash and cash equivalents at end of period $ 2,362 $ 3,881 =============== ============== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest $ 528 $ 508 Cash paid for income taxes $ 76 $ 76 See notes to condensed consolidated financial statements. 5 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share data) 1. BASIS OF PRESENTATION The accompanying condensed consolidated financial statements of OptiCare Health Systems, Inc., a Delaware corporation, and its subsidiaries (collectively the "Company") for the three and six months ended June 30, 2004 and 2003 have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934, as amended, and are unaudited. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of only normal recurring accruals) necessary for a fair presentation of the condensed consolidated financial statements have been included. The results of operations for the three and six months ended June 30, 2004 are not necessarily indicative of the results to be expected for the full year. The condensed consolidated balance sheet as of December 31, 2003 was derived from the Company's audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Certain prior period amounts have been reclassified to conform to the current period presentation. 2. MANAGEMENT'S PLAN The Company incurred net operating losses in 2003 that have continued into 2004, due primarily to substantial operating losses at Wise Optical which in 2003 resulted in a significant use of cash from operations. The losses at Wise Optical were initially attributable to significant expenses incurred for integration, but have continued due to weakness in gross margins and higher operating expenses resulting from an operating structure built to support higher sales volume. As a result of the losses at Wise Optical, the Company did not comply with the minimum fixed charge ratio covenant under the term loan and revolving credit facility with CapitalSource Finance, LLC as of March 31, 2004 April 30, 2004 or May 31, 2004, which could have allowed CapitalSource to demand payment in full of the credit facility. However, Capital Source has amended the terms and covenants of the credit facility, waived current covenant violations and provided additional credit, which has been guaranteed by Palisades Capital. In late 2003, the Company began implementing strategies and operational changes designed to improve the operations of Wise Optical. Those efforts included developing the Company's sales force, improving customer service, enhancing productivity, eliminating positions and streamlining the warehouse and distribution processes. The Company has reduced ongoing costs to better match the operations and has engaged consultants, who the Company believes will assist in increasing sales and improving product margins at Wise Optical. In addition, in 2003 the Managed Vision segment began shifting away from the lower margin and long sales cycle of the Company's third party administrator ("TPA") style business to the higher margin and shortened sales cycle of a direct-to-employer business. This new direct-to-employer business also removes some of the volatility that is often experienced in the Company's TPA-based revenues. The Company now has the sales force and infrastructure necessary to expand the direct-to-employer business and expect increased profitability as a result of this product shift that has lead to new contracts and improved gross margins. The Company experienced significant improvements in revenue and profitability in the Consumer Vision segment from 2003 to 2004, largely from growth in existing store sales and enhanced margins as a result of sales incentives that the Company expects to continue. OptiCare has also continued to settle outstanding litigation with positive results through June of 2004. Although Wise operating losses have continued into 2004, the Company has generated approximately $4.0 million of cash from operations in the six months ended June 30, 2004, which has resulted in reductions of senior debt of approximately $3.3 million and increased borrowing availability to the Company. In addition, in May 2004, management made the decision to dispose of the Technology operation, CC Systems. The Company anticipates the sale of that operation will generate cash proceeds while reducing demands on working capital and corporate personnel. The Company believes the combination of the above initiatives executed in the operating segments will continue to improve the Company's liquidity and should ensure compliance with the CapitalSource covenants going forward. 6 3. RESTATEMENT The loan agreement with CapitalSource requires the Company to maintain a lock-box arrangement with banks whereby amounts received into the lock-boxes are applied to reduce the revolving credit facility outstanding. The agreement also contains certain subjective acceleration clauses in the event of a material adverse event. Subsequent to the issuance of the Company's consolidated financial statements for the year ended December 31, 2003, the Company's management determined that the amounts outstanding pursuant to certain provisions contained in the credit facility should have been classified as current liabilities rather than long-term debt, pursuant to the provisions of consensus 95-22 issued by the Financial Accounting Standards Board Emerging Issues Task Force. Accordingly, the accompanying balance sheets have been restated to reflect the reclassification of the amounts outstanding pursuant to this credit facility as current liabilities. A summary of the significant effects of the restatement is as follows: AS OF JUNE 30, 2003 ---------------------------- AS PREVIOUSLY REPORTED AS RESTATED -------- ----------- Current Portion of Long Term Debt 2,061 12,395 Long Term Debt Less Current Portion 10,388 54 Current Liabilities 16,989 27,323 Non-current Liabilities 10,938 604 4. STOCK BASED COMPENSATION The Company accounts for its stock-based compensation plans under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations in accounting for the stock options granted to its employees and directors. Accordingly, employee and director compensation expense is recognized only for those options whose price is less than fair market value at the measurement date. Statement of Financial Standards ("SFAS") No. 123 "Accounting for Stock-Based Compensation, as amended by SFAS No. 148 "Accounting for Stock-Based Compensation--Transition and Disclosure--an amendment of Statement of Financial Accounting Standards No. 123" requires that companies which do not elect to account for stock-based compensation as prescribed by this statement, disclose the pro forma effects on earnings and earnings per share as if SFAS No. 123 had been adopted. If the Company applied the recognition provisions of SFAS No. 123, the Company's reported net loss and loss per share, using the Black Scholes option pricing model, would have been adjusted to the pro forma amounts indicated below. THREE MONTHS ENDED JUNE SIX MONTHS ENDED 30, JUNE 30, --------------------------- -------------------------- 2004 2003 2004 2003 ----------- ------------ ----------- ----------- Net loss, as reported $ (957) $ (2,173) $ (1,920) $ (2,016) Less: Total stock-based employee compensation expense, net of related tax effects, determined (37) (114) (59) (222) under the fair value method for all awards ----------- ------------ ----------- ----------- Pro forma net loss $ (994) $(2,287) $ (1,979) $ (2,238) =========== ============ =========== =========== Basic and diluted net loss per share: As reported $ (0.03) $ (0.08) $ (0.07) $ (0.08) Pro forma (0.03) (0.08) (0.08) $ (0.09) 7 5. DISCONTINUED OPERATIONS - CC SYSTEMS In May 2004, the Company's Board of Directors approved management's plan to exit the technology business (formerly reported in the Distribution and Technology segment) and dispose of the Company's CC Systems division. The Company expects to complete the sale of the net assets of CC Systems within the next six months. In accordance with SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets," the disposal of CC Systems is accounted for as a discontinued operation. During the quarter ended June 30, 2004, the Company recorded a $580 loss on disposal of discontinued operations based on the estimated fair value of the net assets held for sale. Amounts in the financial statements and related notes for all periods presented have been reclassified to reflect treatment as held for sale. The carrying amount of the assets and liabilities of the disposal group held for sale at June 30, 2004, December 31, 2003 and June 30, 2003 were as follows: June 30, December 31, June 30, 2004 2003 2003 ---------- ------------ ---------- Assets: Accounts receivable $ 1,019 $ 1,502 $ 1,577 Inventory 84 148 72 Property and equipment, net 19 36 58 Intangible assets, net 773 1,303 1,333 Other assets 12 2 112 ---------- ------------ ---------- Total assets $ 1,907 $ 2,991 $ 3,152 ========== ============ ========== Liabilities: Accounts payable $ 91 $ 119 $ 45 Accrued expenses 116 129 188 Other liabilities 850 993 1,156 ---------- ------------ ---------- Total liabilities $1,057 $ 1,241 $ 1,389 ========== ============ ========== Operating results of the discontinued operations are as follows: Three Months Ended Six months Ended June 30, June 30, -------------------------- ---------------------------- 2004 2003 2004 2003 ----------- ----------- ------------ ------------ Net revenues $ 455 $ 921 $ 1,077 $ 1,596 =========== =========== ============ ============ Income (loss) from discontinued operations before income taxes $ (230) $ 9 $ (349) $ 5 Income tax expense - 3 - 2 ----------- ----------- ------------ ------------ Income (loss) from discontinued operations (230) 6 (349) 3 Loss on disposal of discontinued operations (580) - (580) - ----------- ----------- ------------ ------------ Total income (loss) from discontinued operations $ (810) $ 6 $ (929) $ 3 =========== =========== ============ ============ Income (loss) per share from discontinued operations $ (0.03) $ 0.00 $ (0.03) $ 0.00 =========== =========== ============ ============ 8 6. RECENT ACCOUNTING PRONOUNCEMENTS In March 2004, the Financial Accounting Standards Board ratified the consensus reached in Emerging Issues Task Force ("EITF") Issue 03-6 "Participating Securities and the Two-Class Method under FAS 128." EITF 03-6 supersedes the guidance in Topic No, D-95, Effect of Participating Convertible Securities on the Computation of Basic Earnings per Share, and requires the use of the two-class method for participating securities. The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. In addition, EITF Issue 03-6 addresses other forms of participating securities, including options, warrants, forwards and other contracts to issue an entity's common stock, with the exception of stock-based compensation (unvested options and restricted stock) subject to the provisions of Opinion 25 and FAS 123, EITF Issue 03-6 is effective for reporting periods beginning after March 31, 2004 and should be applied by restating previously reported earnings per share. The adoption of EITF Issue 03-6 did not have a material impact on the Company's condensed consolidated financial statements. 7. ACQUISITION OF WISE OPTICAL VISION GROUP, INC. On February 7, 2003, the Company acquired substantially all of the assets and certain liabilities of the contact lens distribution business of Wise Optical Vision Group, Inc. ("Wise Optical"), a New York corporation. The results of operations of Wise Optical are included in the consolidated financial statements from February 1, 2003, the effective date of the acquisition for accounting purposes. Assuming the acquisition of Wise Optical had occurred on January 1, 2003, pro forma net revenue, net loss from continuing operations and net loss of the Company for the six months ended June 30, 2003 would have been $70,045, $1,869 and $1,866, respectively. On the same pro forma basis, basic and diluted loss per common share for the six months ended June 30, 2003 would have been $0.07. This unaudited pro forma information is for informational purposes only and is not necessarily indicative of the results that would have been obtained had these events actually occurred at the beginning of the periods presented, nor does it intend to be a projection of future results. 8. INTANGIBLE ASSETS Intangible assets subject to amortization are comprised of a service agreement and non-compete agreements. The fifteen year service agreement has a gross carrying amount of $1,658 and accumulated amortization of $534, $479 and $424 at June 30, 2004, December 31, 2003 and June 30, 2003, respectively. The non-compete agreements, which had a gross carrying amount of $265, were fully amortized at June 30, 2004 and December 31, 2003 and had accumulated amortization of $234 at June 30, 2003. Amortization expense for the three months ended June 30, 2004 and 2003 was $28 and $44, respectively, and for the six months ended June 30, 2004 and 2003 was $55 and $88, respectively. Estimated annual amortization expense is expected to be $111 in each of the years 2004 through 2008. 9. DEBT The Company's revolving credit facility requires a lockbox arrangement, which provides for all receipts to be swept daily to reduce borrowings outstanding under the credit facility. This arrangement, combined with the existence of a subjective acceleration clause in the revolving credit facility, necessitates the revolving credit facility be classified a current liability on the balance sheet in accordance with FASB's Emerging Issues Task Force Issue No. 95-22, "Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements that Include Both a Subjective Acceleration Clause and a Lock-Box Arrangement" ("EITF 95-22"). The Company has classified its revolving debt with CapitalSouce, its senior lender, totaling $9,222 as of June 30, 2004, as a current liability. On August 16, 2004, however, the Company and CapitalSource amended the loan 9 agreement and in connection with this amendment, the Company received a waiver from CapitalSource for any non-compliance of this covenant as of March 31, 2004, April 30, 2004, May 31, 2004 and June 30, 2004 (see Note 14 for a discussion of the amendment and waiver). In addition, on August 27, 2004, the Company amended its loan agreement with CapitalSource to eliminate a material adverse change as an event of default or to prevent further advances under the loan agreement. This amendment eliminates the lender's ability to declare a default based upon subjective criteria as described in consensus 95-22 issued by the Financial Accounting Standards Board Emerging Issues Task Force. Palisade Concentrated Equity Partnership, L.P., provided a $1,000 guarantee against the loan balance due to CapitalSource related to this amendement. 10. SEGMENT INFORMATION The Company is an integrated eye care services company focused on providing managed vision and professional eye care products and services. The Company has the following three reportable operating segments: (1) Managed Vision, (2) Consumer Vision, and (3) Distribution. The Distribution segment, formerly known as Distribution and Technology, was renamed in May 2004 in connection with the Company's decision to dispose of its Technology business (see Note 5). These operating segments are managed separately, offer separate and distinct products and services, and serve different customers and markets, although there is some cross-marketing and selling between the segments. Discrete financial information is available for each of these segments and the Company's President assesses performance and allocates resources among these three operating segments. The Managed Vision segment contracts with insurers, insurance fronting companies, employer groups, managed care plans and other third party payors to manage claims payment administration of eye health benefits for those contracting parties. The Consumer Vision segment sells retail optical products to consumers and operates integrated eye health centers and surgical facilities in Connecticut where comprehensive eye care services are provided to patients. The Distribution segment provides products and services to eye care professionals (ophthalmologists, optometrists and opticians) through (i) Wise Optical, a distributor of contact and ophthalmic lenses and other eye care accessories and supplies, and (ii) a Buying Group program, which provides group purchasing arrangements for optical and ophthalmic goods and supplies. In addition to its reportable operating segments, the Company's "All Other" category includes other non-core operations and transactions, which do not meet the quantitative thresholds for a reportable segment. Included in the "All Other" category is revenue earned under the Company's health service organization ("HSO") operation, which receives fee income for providing certain support services to individual ophthalmology and optometry practices. The Company is in the process of disengaging from its HSO arrangements. Management assesses the performance of its segments based on income before income taxes, interest expense, depreciation and amortization, and other corporate overhead. Summarized financial information, by segment, for the three and six months ended June 30, 2004 and 2003 is as follows: THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ----------------------------- ----------------------------- 2004 2003 2004 2003 ------------ ------------ ------------ ------------- REVENUES: Managed vision $ 6,267 $ 7,480 $12,317 $ 14,888 Consumer vision 8,768 7,796 16,911 15,102 Distribution 16,705 17,448 33,091 33,235 ------------ ------------ ------------ ------------- Reportable segment totals 31,740 32,724 62,319 63,225 All other 891 573 1,524 2,434 Elimination of inter-segment revenues (1,869) (1,293) (3,511) (2,292) ------------ ------------ ------------ ------------- Total net revenue $ 30,762 $ 32,004 $ 60,332 $ 63,367 ============ ============ ============ ============= INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE TAX: Managed vision $239 $ 643 $ 406 $1,069 Consumer vision 1,130 836 2,061 1,432 Distribution (376) (779) (1,187) (1,067) ------------ ------------ ------------ ------------- Reportable segment totals 993 700 1,280 1,434 All other 756 334 1,180 2,012 Loss from extinguishment of debt - (1,847) - (1,847) Depreciation (420) (359) (811) (702) Amortization (27) (29) (56) (58) Interest expense (277) (630) (596) (1,389) Corporate (1,126) (531) (1,938) (1,541) ------------ ------------ ------------ ------------- Loss from continuing operations before tax $ (101) $ (2,362) $ (939) $ (2,091) ============ ============ ============ ============= 10 11. LOSS ON EXTINGUISHMENT OF DEBT On May 12, 2003, the Company recorded a $1.8 million loss on the exchange of $16.2 million of debt for Series C Preferred Stock. The $1.8 million loss represents the write-off of the deferred financing fees and debt discount associated with the extinguished debt. 12. EARNINGS (LOSS) PER COMMON SHARE The following table sets forth the computation of basic and diluted earnings (loss) per share: THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------------------- ------------------------------ 2004 2003 2004 2003 -------------- ------------- ------------- ------------- EARNINGS (LOSS) PER SHARE: Loss from continuing operations $ (147) $ (2,179) (991) $ (2,019) Preferred stock dividend (177) (160) (351) (300) -------------- ------------- ------------- ------------- Loss from continuing operations to common (324) (2,339) (1,342) (2,319) stockholders Discontinued operations (810) 6 (929) 3 -------------- ------------- ------------- ------------- Net loss to common stockholders $ (1,134) $ (2,333) $ (2,271) $ (2,316) ============== ============= ============= ============= Weighted average common shares outstanding-- Basic and diluted 30,663,562 30,013,991 30,526,227 29,779,834 Earnings (loss) per share--basic and diluted: Loss from continuing operations to common stockholders $ (0.01) $ (0.08) $ (0.04) $ (0.08) Discontinued operations $ (0.02) $ 0.00 $ (0.03) $ 0.00 Net loss to common stockholders $ (0.03) $ (0.08) $(0.07) $ (0.08) The following table reflects the potential common shares of the Company at June 30, 2004 and 2003 that have been excluded from the calculation of diluted earnings per share for the three and six month periods due to anti-dilution. 2004 2003 --------------- -------------- Options 6,076,685 6,132,066 Warrants 3,125,000 3,125,000 Convertible Preferred Stock 63,065,507 58,302,314 --------------- -------------- 72,267,192 67,559,380 =============== ============== 13. CONTINGENCIES The Company is both a plaintiff and defendant in lawsuits incidental to its current and former operations. Such matters are subject to many uncertainties and outcomes are not predictable with assurance. Consequently, the ultimate aggregate amount of monetary liability or financial impact with respect to these matters at June 30, 2004 cannot be ascertained. Management is of the opinion that, after taking into account the merits of defenses and established reserves, the ultimate resolution of these matters will not have a material adverse impact on the Company's consolidated financial position or results of operations. 11 14. SUBSEQUENT EVENTS As a result of operating losses of Wise Optical, the Company did not meet its minimum fixed charge ratio covenant under its loan agreement with CapitalSource as of March 31, 2004, April 30, 2004 or May 31, 2004. On August 16, 2004, the Company received a waiver from CapitalSource for any non-compliance with this covenant as of March 31, 2004, April 30, 2004, May 31, 2004 and June 30, 2004. The Company and CapitalSource also amended the term loan and revolving credit facility with CapitalSource to, among other things, extend the maturity date of the revolving credit facility from January 25, 2006 to January 25, 2007, (ii) provide access to a $2,000 temporary over-advance bearing interest at prime plus 5 1/2%, and in no event less than 6%, which is to be repaid in eleven monthly installments of $100 (principal and interest) commencing on October 1, 2004 with the remaining balance to be repaid in full by August 31, 2005, which is guaranteed by the Company's largest stockholder, Palisade Concentrated Equity Partnership, L.P., (iii) change the fixed charge ratio covenant from 1.5 to 1 to not less than 1 and to extend the next test period for this covenant to March 31, 2005, (iv) decrease the minimum tangible net worth financial covenant from $(2,000) to $(3,000) and (v) add a debt service coverage ratio covenant of between 0.7 to 1.0. In addition, the waiver and amendment increased the termination fee payable if the Company terminates the revolving credit facility by 2% and increased the yield maintenance amount payable, in lieu of the termination fee, if the Company terminates the revolving credit facility pursuant to a refinancing with another commercial financial institution, by 2%. The yield maintenance amount was also changed to mean an amount equal to the difference between (i) the all-in effective yield which could be earned on the revolving balance through January 25, 2007 and (ii) the total interest and fees actually paid to CapitalSource on the revolving credit facility prior to the termination or repayment date. The Company agreed to pay CapitalSource $25 in financing fees in connection with this waiver and amendment. In addition, on August 27, 2004, the Company amended its loan agreement with CapitalSource to eliminate a material adverse change as an event of default or to prevent further advances under the loan agreement. This amendment eliminates the lender's ability to declare a default based upon subjective criteria as described in consensus 95-22 issued by the Financial Accounting Standards Board Emerging Issues Task Force. Palisade Concentrated Equity Partnership, L.P., provided a $1,000 guarantee against the loan balance due to CapitalSource related to this amendment. 12 ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion may be understood more fully by reference to our consolidated financial statements, notes to the consolidated financial statements, and management's discussion and analysis contained in our Annual Report on Form 10-K/A for the year ended December 31, 2003, as filed with the Securities and Exchange Commission. OVERVIEW We are an integrated eye care services company focused on vision benefits management (managed vision), retail optical sales and eye care services to patients and the distribution of products and software services to eye care professionals. In September 2003, we began implementing strategies and operational changes to improve operating results at Wise Optical. These strategies included growing sales through improved customer service, improving gross margin through pricing discipline and active purchasing strategies as well as reducing operating expenses through the elimination of positions and tightening of expense policies. In the first quarter of 2004, as a result of these strategies, Wise Optical reduced operating expenses. We expect modest improvement in the operating results of Wise Optical in the future as we continue executing these strategies. In May 2004, our Board of Directors approved management's plan to exit and dispose of our Technology business, CC Systems. We expect to complete the sale of the net assets of CC Systems within the next six months. In accordance with Statement of Financial Accounting Standards (SFAS) No. 144 "Accounting for the impairment or Disposal of Long-Lived Assets," the disposal of CC Systems is accounted for as a discontinued operation. Our business is comprised of three reportable operating segments: (1) Managed Vision, (2) Consumer Vision, and (3) Distribution. The Distribution segment, formerly known as Distribution and Technology, was renamed in May 2004 in connection with our decision to dispose of our Technology business. Our Managed Vision segment contracts with insurers, managed care plans and other third party payers to manage claims payment administration of eye health benefits for those contracting parties. Our Consumer Vision segment sells retail optical products to consumers and operates integrated eye health centers and surgical facilities in Connecticut where comprehensive eye care services are provided to patients. The Distribution segment provides products and services to eye care professionals (ophthalmologists, optometrists and opticians) through (i) Wise Optical, a distributor of contact and ophthalmic lenses and other eye care accessories and supplies and (ii) a Buying Group program, which provides group purchasing arrangements for optical and ophthalmic goods and supplies. In addition to these segments, we receive income from other non-core operations and transactions, including our health service organization (HSO) operation, which receives fee income for providing certain support services to individual ophthalmology and optometry practices. We are in the process of disengaging from our HSO arrangements. As a result of our non-compliance with the fixed charge ratio covenant under our term loan and revolving credit facility with CapitalSource Finance, LLC, on August 16, 2004, our term loan and revolving credit facility with CapitalSource was amended to, among other things, waive our non-compliance with this covenant, extend the maturity date of the revolving credit facility to January 25, 2007 and provide us a $2.0 million temporary over-advance. RESULTS OF OPERATIONS Three Months Ended June 30, 2004 Compared to the Three Months Ended June 30, 2003 Managed Vision revenue. Managed Vision revenue represents fees received under our managed care contracts. Managed Vision revenue decreased to approximately $6.3 million for the three months ended June 30, 2004 compared to approximately $7.5 million for the three months ended June 30, 2003, a decrease of approximately $1.2 million or 16.4%. This decrease resulted from approximately $1.2 million in lost revenue from terminated contracts, primarily as a result of changes made by the Texas state legislature to its Medicaid and Children's Health Insurance Programs, and $0.8 million of lost revenues resulting from a decline in membership in existing contracts with one of our large health plan customers, which were partially offset by increases in revenue of approximately $0.7 million from new contracts 13 and approximately $0.1 million from net growth in existing contracts. We expect the decrease in revenue associated with our large health plan customer contracts to be more than offset by revenue under new contracts with different payors, which became effective in 2004. We expect managed vision revenue to increase in the future as we enter into new direct-to-employer contracts. Product sales revenue. Product sales include the retail sale of optical products in our Consumer Vision segment, the sale of optical products through our Buying Group and the sale of contact and ophthalmic lenses through Wise Optical. Product sales revenue decreased to approximately $17.9 million for the three months ended June 30, 2004 compared to approximately $19.2 million for the three months ended June 30, 2003, a decrease of approximately $1.3 million or 6.6%. This represents a decrease in revenue from Wise Optical of approximately $1.0 million and a decrease in revenue from the Buying Group of approximately $0.5 million, which were partially offset by an increase in revenue from Consumer Vision of approximately $0.2 million. The decrease in Wise Optical revenue was primarily due to a decrease in sales volume that we experience after we purchased Wise Optical. In September 2003, we began implementing strategies to increase sales at Wise Optical and we have experienced improved revenue since we began that initiative. We expect future sales at Wise Optical to approximate current levels, adjusted for seasonal fluctuations. The decrease in Buying Group revenue is due to a decrease in purchasing volume primarily due to the loss of the business of Optometric Eye Care Center, P.A., which occurred during the second quarter of 2003. We expect product sales of the Buying Group to approximate current levels for the remainder of the year, adjusted for seasonality. The increase in Consumer Vision product sales is primarily due to an increase in purchasing volume associated with an improved sales force and increased sales of higher value products through incentive programs and product promotions. We expect Consumer Vision product sales to continue to increase throughout the year, adjusted for seasonal fluctuations. Other services revenue. Other services revenue primarily represents revenue earned from providing eye care services in our Consumer Vision segment. Other services revenue increased to approximately $5.5 million for the three months ended June 30, 2004 compared to approximately $4.8 million for the three months ended June 30, 2003, an increase of approximately $0.7 million or 14.6%. This increase is primarily due to increased services volume in the Consumer Vision segment, primarily in the medical services area, and is attributable to increased doctor coverage and productivity. We expect services revenue to remain at these levels or increase slightly in the future, adjusted for seasonality. Other income. Other income represents non-recurring settlements on contracts. Other income increased to approximately $1.1 million for the three months ended June 30, 2004 compared to approximately $0.5 million for the three months ended June 30, 2003, an increase of approximately $0.6 million or 120%. This increase is due to an increase in HSO contract settlements of approximately $0.3 million and the settlement of a buying group contract of approximately $0.2 million in 2004. Medical claims expense. Medical claims expense decreased to approximately $4.7 million for the three months ended June 30, 2004, from approximately $5.5 million for the three months ended June 30, 2003, a decrease of approximately $0.8 million or 14.5%. The medical claims expense loss ratio (MLR) representing medical claims expense as a percentage of Managed Vision revenue increased to 75.4% for the quarter ended June 30, 2004 from 73.7% for the quarter ended June 30, 2003. The change in MLR is a result of changes to existing contracts along with the claims expense associated with new contracts. We expect claims expense to increase in the future as we enter into additional direct-to-employer contracts. Cost of product sales. Cost of product sales decreased to approximately $13.8 million for the three months ended June 30, 2004 compared to approximately $14.6 million for the three months ended June 30, 2003, a decrease of approximately $0.8 million or 5.5%. This decrease is primarily due to a decrease in Wise Optical product costs of approximately $0.5 million and a decrease in Buying Group product costs of approximately $0.5 million, which were partially offset by an increase in product costs in Consumer Vision of approximately $0.2 million. The decrease in Wise Optical and Buying Group product costs is due to the decrease in sales volume, while the increase in Consumer Vision product costs is due to an increase in sales volume. Cost of services. Cost of services increased to approximately $2.4 million for the three months ended June 30, 2004 compared to approximately $2.0 million for the three months ended June 30, 2003, an increase of approximately $0.4 million or 20%. This increase in cost is primarily due to the increased medical services volume in the Consumer Vision area. 14 Selling, general and administrative expenses. Selling, general and administrative expenses decreased to approximately $9.2 million for the three months ended June 30, 2004 compared to approximately $9.3 million for the three months ended June 30, 2003, a decrease of approximately $0.1 million or 1.1%. The decrease in 2004 is primarily due to a decrease in compensation expense associated with the staff reductions which occurred at Wise Optical during the integration of that business. Loss from early extinguishment of debt. The approximate $1.8 million loss from early extinguishment of debt for the three months ended June 30, 2003, represents the write-off of deferred debt issuance costs and debt discount associated with the exchange of approximately $16.2 million of debt for Series C Preferred Stock, which occurred on May 12, 2003. Interest expense. Interest expense decreased to approximately $0.3 million for the three months ended June 30, 2004 from approximately $0.6 million for the three months ended June 30, 2003, a decrease of approximately $0.3 million or 50%. This decrease in interest expense is primarily due to a decrease in the average outstanding debt balance mainly as a result of the conversion of approximately $16.2 million of debt to preferred stock in May 2003. Income tax expense. Income tax expense recorded for the three months ended June 30, 2004 of less than $0.1 million primarily represents minimum state tax expense. We recorded an income tax benefit of approximately $0.2 million for the three months ended June 30, 2003, representing a tax benefit on the loss from continuing operations at the statutory rate after adjusting for non-deductible expenses. Discontinued operations. In May 2004, our Board of Directors approved management's plan to dispose of our Technology business, CC Systems, and in accordance with SFAS No. 144 this business is reported as a discontinued operation. The loss on discontinued operations of approximately $0.9 million for the three months ended June 30, 2004 includes an estimated loss on disposal of approximately $0.6 million, based on the estimated fair value of the net assets held for sale, and the loss from operations of CC Systems during the quarter of approximately $0.2 million. Six Months Ended June 30, 2004 Compared to the Six Months Ended June 30, 2003 Managed Vision revenue. Managed Vision revenue represents fees received under our managed care contracts. Managed Vision revenue decreased to approximately $12.3 million for the six months ended June 30, 2004 compared to approximately $14.9 million for the six months ended June 30, 2003, a decrease of approximately $2.6 million or 17.4%. This decrease resulted from approximately $2.5 million of lost revenue from terminated contracts, primarily as a result of changes made by the Texas state legislature to its Medicaid and Children's Health Insurance Programs, and $1.4 million of lost revenues resulting from a decline in membership in existing contracts with one of our large health plan customers, which were partially offset by increases in revenue of approximately $1.0 million from new contracts and approximately $0.3 million from net growth in existing contracts. Product sales revenue. Product sales include the retail sale of optical products in our Consumer Vision segment, the sale of optical products through our Buying Group and the sale of contact and ophthalmic lenses through Wise Optical. Product sales revenue decreased to approximately $35.8 million for the six months ended June 30, 2004 compared to approximately $36.9 million for the six months ended June 30, 2003, a decrease of approximately $1.1 million or 3.0%. This decrease primarily represents a decrease in Buying Group revenue of $1.3 million, which was partially offset by a decrease in Consumer Vision revenue of $0.4 million. The decrease in Buying Group revenue is due to a decrease in purchasing volume primarily due to the loss of the business of Optometric Eye Care Center, P.A., which occurred in the second quarter of 2003. The increase in Consumer Vision product sales is primarily due to an increase in purchasing volume associated with an improved sales force and increased sales of higher value products through incentive programs and product promotions. Other services revenue. Other services revenue primarily represents revenue earned from providing eye care services in our Consumer Vision segment. Other services revenue increased to approximately $10.5 million for the six months ended June 30, 2004 compared to approximately $9.2 million for the six months ended June 30, 2003, an increase of approximately $1.3 million or 14.1%. This increase is primarily due to increased services volume in the medical, optometry and surgical areas attributable to increased doctor coverage and productivity. Other income. Other income represents non-recurring settlements on contracts. Other income for the six months ended June 30, 2004 was approximately $1.7 million compared to approximately $2.4 million for the six months ended June 30, 2003, representing a decrease of approximately $0.7 million or 29.3%. This decrease is primarily due to a 15 decrease in HSO contract settlements of approximately $0.9 million, which was partially offset by the settlement of a buying group contract of approximately $0.2 million. Medical claims expense. Medical claims expense decreased to approximately $9.4 million for the six months ended June 30, 2004, from approximately $11.3 million for the six months ended June 30, 2003, a decrease of approximately $1.9 million or 16.9%. The MLR increased to 76.1% in 2004 from 75.6% in 2003. The change in MLR is a result of changes to existing contracts along with the claims expense associated with new contracts. Cost of product sales. Cost of product sales decreased to approximately $28.0 million for the six months ended June 30, 2004 compared to approximately $28.6 million for the six months ended June 30, 2003, a decrease of approximately $0.6 million or 2.1%. This decrease is primarily due to a decrease in product costs of the Buying Group of approximately $1.3 million, which was partially offset by an increase in product costs of Wise Optical of approximately $0.4 million and an increase in product costs in Consumer Vision of approximately $0.3 million. The decrease in Buying Group costs is driven by the decrease in Buying Group sales. The increase in product costs of Consumer Vision is due to the related increase in sales in this division. During 2003, product cost at Wise Optical included a write-up of inventory to fair value due to a purchase accounting adjustment related to the acquisition of Wise Optical. Cost of services. Cost of services increased to approximately $4.5 million for the six months ended June 30, 2004 compared to approximately $3.9 million for the six months ended June 30, 2003, an increase of approximately $0.6 million or 15.1%. This increase is primarily due to the increased services volume in the Consumer Vision area. Selling, general and administrative expenses. Selling, general and administrative expenses remained relatively unchanged at $18.0 million for the six months ended June 30, 2004 compared to approximately $17.8 million for the six months ended June 30, 2003, an increase of approximately $0.2 million or 1.1%. Loss from early extinguishment of debt. The approximate $1.8 million loss from early extinguishment of debt for the six months ended June 30, 2003, represents the write-off of deferred debt issuance costs and debt discount associated with the exchange of approximately $16.2 million of debt for Series C Preferred Stock, which occurred on May 12, 2003. Interest expense. Interest expense decreased to approximately $0.6 million for the six months ended June 30, 2004 from approximately $1.4 million for the six months ended June 30, 2003, a decrease of approximately $0.8 million or 57.1%. This decrease in interest expense is primarily due to a decrease in the average outstanding debt balance mainly as a result of the conversion of approximately $16.2 million of debt to preferred stock in May 2003. Income tax expense. Income tax expense of less than $0.1 million recorded for the six months ended June 30, 2004 primarily represents minimum state tax expense. The income tax benefit of less than $0.1 million for the six months ended June 30, 2003, represented a tax benefit on the loss from continuing operations at the statutory rate after adjusting for non-deductible expenses. Discontinued operations. In May 2004, our Board of Directors approved management's plan to dispose of our Technology business, CC Systems, and in accordance with SFAS No. 144 this business is reported as a discontinued operation. The loss on discontinued operations of approximately $0.9 million for the six months ended June 30, 2004 includes an estimated loss on disposal of approximately $0.6 million, based on the estimated fair value of the net assets held for sale, and the loss from operations of CC Systems during the period of approximately $0.3 million. CRITICAL ACCOUNTING POLICIES The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of our financial statements. Management bases its estimates and judgments on historical experience, current economic and industry conditions and on various other facts that are believed to be reasonable under the circumstances. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions. . The accounting policies and judgments, estimates and assumptions are described in greater detail in the Company's Annual Report on Form 10-K/A in the "Critical Accounting Policies and Estimates" of Managements Discussion and Analysis and in Note 4 to the Consolidated Financial Statements for the year ended December 31, 2003. 16 Management believes critical accounting estimates are used in determining the adequacy of the allowance for doubtful accounts, insurance disallowances, managed care claims accrual, valuation allowance for deferred tax assets and in evaluating goodwill and intangibles for impairment. LIQUIDITY AND CAPITAL RESOURCES Liquidity Our primary sources of liquidity have been cash flows generated from operations in our Managed Vision and Consumer Vision segments, other income from litigation settlements and borrowings under our term loan and revolving credit facility with CapitalSource Finance LLC. We have continued to settle outstanding litigation with positive results through June 2004. As of June 30, 2004, we had cash and cash equivalents of approximately $2.4 million and additional availability under our revolving credit facility with CapitalSource of approximately $2.6 million. As a result of operating losses at Wise Optical, we were not in compliance with the minimum fixed charge ratio covenant under our term loan and revolving credit facility with CapitalSource as of March 31, 2004. In addition, we were not in compliance with this covenant as of April 30 or May 31 2004. As discussed below, we amended our term loan and revolving credit facility with CapitalSource on August 16, 2004 and received a waiver from CapitalSource for any non-compliance with this covenant as of March 31, 2004, April 30, 2004, May 31, 2004 and June 30, 2004. The following table sets forth a year-over-year comparison of the components of our liquidity and capital resources for the quarters ended June 30, 2004 and 2003: (In millions) $ 2004 2003 CHANGE ---- ---- ------ Cash and cash equivalents $ 2.4 $3.9 $ (1.5) Cash provided by (used in): Operating activities $4.0 $(0.6) $4.6 Investing activities $(0.1) $(6.4) $(6.3) Financing activities $(3.3) $7.8 $(11.1) Net cash provided by operating activities was approximately $4.0 million for the six months ended June 30, 2004 compared to approximately $0.6 million of net cash used in operating activities for the six months ended June 2003. Net cash provided by operating activities in 2004 included a net loss from continuing operations of approximately $1.0 million, which was offset by $0.9 million of non-cash charges for depreciation, amortization and interest. The remaining $4.0 million of net cash provided by operating activities was primarily due to increases in accounts payable and accrued expenses. Net cash provided by operating activities in 2003 included a loss from continuing operations of approximately $2.0 million, which was offset by $3.5 million of non-cash charges for depreciation, amortization, interest and early extinguishment of debt. The remaining $0.9 million of net cash used in operating activities was primarily due to a decrease in accounts payable and accrued expenses of $3.0 million offset by increases in accounts receivable and inventory of $1.1 million and $0.6 million respectively. Net cash used in investing activities was approximately $0.1 million for the six months ended June 30, 2004 compared to approximately $6.4 million for the six months ended June 30, 2003. Net cash used in investing activities in 2004 included $0.2 million of fixed asset purchases, partially offset by $0.1 million of payments received on notes receivable. Net cash used in investing activities in 2003 included $6.2 million to purchase the net assets (excluding cash) of Wise Optical, a deposit of $0.6 million into restricted certificates of deposit to secure standby letters of credit in connection with establishing our captive insurance company and $0.6 million used to purchase fixed assets. 17 These uses of cash were offset by $0.9 million of cash resulting from refunds of escrow deposits and payments on our notes receivable. Net cash used in financing activities was approximately $3.3 million for the six months ended June 30, 2004 compared to approximately $7.8 million of net cash provided by financing activities for the six months ended June 30, 2003. Net cash used in financing activities in 2004 was primarily used for repayments under our revolving credit facility and term loan with our senior lender. Net cash provided by financing activities in 2003 was primarily from borrowings under our revolving credit facility to fund the purchase of Wise Optical in February 2003. We believe that our cash flow from operations, borrowings under our amended credit facility with CapitalSource, operating and capital lease financing, and other short-term financing arrangements will provide us with sufficient funds to finance our operations for the next 12 months. In late 2003, we began implementing strategies and operational changes designed to improve the operations of Wise Optical. Those efforts included developing our sales force, improving customer service, enhancing productivity, eliminating positions and streamlining our warehouse and distribution processes. We have reduced ongoing costs to better match the operations and have engaged consultants, who we believe will assist us in increasing sales and improving product margins at Wise Optical. In addition, in 2003 our Managed Vision segment began shifting away from the lower margin and long sales cycle of our third party administrator (TPA) style business to the higher margin and shortened sales cycle of a direct-to-employer business. This new direct-to-employer business also removes some of the volatility that is often experienced in our TPA-based revenues. We now have the sales force and infrastructure necessary to expand our direct-to-employer business and expect increased profitability as a result of this product shift, which has lead to new contracts and improved gross margins. We experienced significant improvements in revenue and profitability in our Consumer Vision segment from 2003 to 2004, largely from growth in existing store sales and enhanced margins as a result of sales incentives, which we expect to continue. We have continued to settle outstanding litigation with positive results through June of 2004. In May 2004, management made the decision to dispose of our Technology operations, CC Systems. We anticipate the sale of that operation will generate cash proceeds while reducing demands on working capital and corporate personnel. We believe the combination of the above initiatives executed in our operating segments will lead to improved liquidity. However, if we incur additional operating losses and we continue to fail to comply with our financial covenants or otherwise default on our debt, our creditors could foreclose on our assets, in which case we would be obligated to seek alternate sources of financing. There can be no assurance that alternate sources of financing will be available to us on terms acceptable to us, if at all. If additional funds are needed, we may attempt to raise such funds through the issuance of equity or convertible debt securities. If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and our stockholders may experience dilution of their interest in us. If additional funds are needed and are not available or are not available on acceptable terms, our ability to fund our operations, take advantage of unanticipated opportunities, develop or enhance services or products or otherwise respond to competitive pressures may be significantly limited and may have a material adverse impact on our business and operations. The CapitalSource Loan and Security Agreement As of June 30, 2004, we had approximately $1.9 million of borrowings outstanding under our term loan with CapitalSource, approximately $7.3 million of advances outstanding under our revolving credit facility with CapitalSource and approximately $2.6 million of additional availability under our revolving credit facility. As a result of continued operating losses incurred at Wise Optical, we were not in compliance with the minimum fixed charge ratio covenant as of March 31, 2004 under our term loan and revolving credit facility with CapitalSource. In addition, we were not in compliance with this covenant as of April 30, 2004 or May 31, 2004, but were in compliance with the covenant as of June 30, 2004. In connection with a waiver and amendment to the term loan and revolving credit facility with CapitalSource entered into on August 16, 2004, we received a waiver from CapitalSource for any non-compliance with this covenant as of March 31, 2004, April 30, 2004, May 31, 2004 and June 30, 2004. 18 The August 16, 2004 waiver and amendment also amended the term loan and revolving credit facility to, among other things, extend the maturity date of the revolving credit facility from January 25, 2006 to January 25, 2007, (ii) provide access to a $2.0 million temporary over-advance bearing interest at prime plus 5 1/2%, and in no event less than 6%, which is to be repaid in eleven monthly installments of $100,000 commencing on October 1, 2004 with the remaining balance to be repaid in full by August 31, 2005, (iii) change the fixed charge ratio covenant from between 1.5 to 1 to not less than 1 and to extend the next test period for this covenant to March 31, 2005, (iv) decrease the minimum tangible net worth financial covenant from $(2.0) million to $(3.0) million and (v) add a debt service coverage ratio covenant of between 0.7 to 1.0. In addition, the waiver and amendment increased the termination fee payable if we terminate the revolving credit facility by 2% and increased the yield maintenance amount payable, in lieu of the termination fee, if we terminate the revolving credit facility pursuant to a refinancing with another commercial financial institution, by 2%. The yield maintenance amount was also changed to mean an amount equal to the difference between (i) the all-in effective yield which could be earned on the revolving balance through January 25, 2007 and (ii) the total interest and fees actually paid to CapitalSource on the revolving credit facility prior to the termination or repayment date. We agreed to pay CapitalSource $25,000 in financing fees in connection with this waiver and amendment. In addition, on August 27, 2004, the Company amended its loan agreement with CapitalSource to eliminate a material adverse change as an event of default or to prevent further advances under the loan agreement. This amendment eliminates the lender's ability to declare a default based upon subjective criteria as described in consensus 95-22 issued by the Financial Accounting Standards Board Emerging Issues Task Force. Palisade Concentrated Equity Partnership, L.P., provided a $1,000 guarantee against the loan balance due to CapitalSource related to this amendment. The term loan and revolving credit facility with CapitalSource are subject to a second amended and restated revolving credit, term loan and security agreement, as amended August 16, 2004. The revolving cedit, term loan and security agreement contains certain restrictions on the conduct of our business, including, among other things, restrictions on incurring debt, purchasing or investing in the securities of, or acquiring any other interest in, all or substantially all of the assets of any person or joint venture, declaring or paying any cash dividends or making any other payment or distribution on our capital stock, and creating or suffering liens on our assets. We are required to maintain certain financial covenants, including a minimum fixed charge ratio, as discussed above and to maintain a minimum net worth. Upon the occurrence of certain events or conditions described in the Loan and Security Agreement (subject to grace periods in certain cases), including our failure to meet the financial covenants, the entire outstanding balance of principal and interest would become immediately due and payable. As discussed above, we have not complied with our fixed charge ratio covenant in the past. Pursuant to the revolving credit, term loan and security agreement, as amended on August 16, 2004, our term loan with CapitalSource matures on January 25, 2006 and our revolving credit facility matures on January 25, 2007. We are required to make monthly principal payments of $25,000 on the term loan with the balance due at maturity. Although we may borrow up to $15 million under the revolving credit facility, the maximum amount that may be advanced is limited to the value derived from applying advance rates to eligible accounts receivable and inventory. The advance rate under our revolving credit facility is 85% of all eligible accounts receivable and 50 to 55% of all eligible inventory. As of June 30, 2004, the net advances to the Company were $7,297,000. The interest rate applicable to the term loan equals the prime rate plus 3.5% (but not less than 9%) and the interest rate applicable to the revolving credit facility is prime rate plus 1.5% (but not less than 6.0%). If we terminate the revolving credit facility prior to December 31, 2005, we must pay CapitalSource a termination fee of $600,000. If we terminate the revolving credit facility after December 31, 2005 but prior to the expiration of the revolving credit facility the termination fee is $450,000. Additionally, if we terminate the revolving credit facility pursuant to a refinancing with another commercial financial institution, we must pay CapitalSource, in lieu of the termination fee, a yield maintenance amount equal to the difference between (i) the all-in effective yield which could be earned on the revolving balance through January 25, 2007, and (ii) the total interest and fees actually paid to CapitalSource on the revolving credit facility prior to the termination date or date of prepayment. Our subsidiaries guarantee payments and other obligations under the revolving credit facility and we (including certain subsidiaries) have granted a first-priority security interest in substantially all our assets to CapitalSource. We also pledged the capital stock of certain of our subsidiaries to CapitalSource. In addition, the loan agreement with CapitalSource requires us to maintain a lock-box arrangement with our banks whereby amounts received into the lock-boxes are applied to reduce the revolving credit facility outstanding. The agreement also contains certain subjective acceleration clauses in the event of a material adverse event. EITF Issue 95-22, "Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements That Include both a Subjective Acceleration Clause and a Lock-Box Arrangement" requires us to classify outstanding borrowings under the revolving credit note as short-term obligations due to the existence of both a lock-box arrangement and subjective acceleration clauses. In conjunction with this pronouncement, we classify our revolving credit facility as a current liability in the amount of $7,297,000, $9,694,000 and $10,334,000 at June 30, 2004, December 31, 2003 and June 30, 2003, respectively. 19 The Series B Preferred Stock As of June 30, 2004, we had 3,204,959 shares of Series B Preferred Stock issued and outstanding. Subject to the senior liquidation preference of the Series C Preferred Stock described below, the Series B Preferred Stock ranks senior to all other currently issued and outstanding classes or series of our stock with respect to dividends, redemption rights and rights on liquidation, winding up, corporate reorganization and dissolution. Each share of Series B Preferred Stock is convertible into a number of shares of common stock equal to such share's current liquidation value, divided by a conversion price of $0.14, subject to adjustment for dilutive issuances. The number of shares of common stock into which each share of Series B Preferred Stock is convertible will increase over time because the liquidation value of the Series B Preferred Stock, which was $1.87 per share as of June 30, 2004, increases at a rate of 12.5% per year, compounded annually. The Series C Preferred Stock As of June 30, 2004, we had 406,158 shares of Series C Preferred Stock issued and outstanding. The Series C Preferred Stock has an aggregate liquidation preference of approximately $16.2 million and ranks senior to all other currently issued and outstanding classes or series of our stock with respect to liquidation rights. Each share of Series C Preferred Stock is convertible into 50 shares of common stock and has the same dividend rights, on an as converted basis, as our common stock. Recent Accounting Pronouncements In March 2004, the Financial Accounting Standards Board approved Emerging Issues Task Force Issue 03-6 "Participating Securities and the Two-Class Method under FAS 128." The EITF supersedes the guidance in Topic No. D-95, Effect of Participating Convertible Securities on the Computation of Basic Earnings per Share, and requires the use of the two-class method of participating securities. The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. In addition, the EITF addresses other forms of participating securities, including options, warrants, forwards and other contracts to issue an entity's common stock, with the exception of stock-based compensation. The EITF is effective for the reporting periods beginning after March 31, 2004 and should be applied by restating previously reported earnings per share. The adoption of the EITF is not expected to have a material impact on our condensed consolidated financial statements. Seasonality Our revenues are generally affected by seasonal fluctuations in the Consumer Vision and Distribution segments. During the winter and summer months, we generally experience a decrease in patient visits and product sales. As a result, our cash, accounts receivable, and revenues decline during these periods and, because we retain certain fixed costs related to staffing and facilities, our cash flows can be negatively affected. Impact of Reimbursement Rates Our revenue is subject to pre-determined Medicare reimbursement rates which, for certain products and services, have decreased over the past three years. A decrease in Medicare reimbursement rates could have an adverse effect on our results of operations if we cannot manage these reductions through increases in revenues or decreases in operating costs. To some degree, prices for health care are driven by Medicare reimbursement rates, so that our non-Medicare business is also affected by changes in Medicare reimbursement rates. FORWARD-LOOKING INFORMATION AND RISK FACTORS The statements in this Form 10-Q and elsewhere (such as in other filings by us with the Securities and Exchange Commission, press releases, presentations by us or our management and oral statements) that relate to matters that are not historical facts are "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. When used in this document and elsewhere, words such as "anticipate," "believe," "expect," "plan," "intend," "estimate," "project," "will," "could," "may," "predict" and similar expressions are intended to identify forward-looking statements. Such forward-looking statements include, but are not limited to, those relating to: o Our expectation of future revenue, sales and expense levels; o Our opinion that the outcome of lawsuits will not have a material adverse impact on our consolidated financial position or results of operations; o Our expectation of improvement in operating results of Wise Optical in the future; o Our expectation of increased profitability in our Managed Vision segment; o Our expectation of continued improvements in our Consumer Vision segment; o Our expectation that we will dispose of our Technology operations, CC Systems, and that such sale will generate cash proceeds while reducing demands on working capital and corporate personnel; 20 o Our expected impact of future interest rates and cash flows; and o Our belief that cash from operations, borrowings under our term loan and revolving credit facility, and operating and capital lease financings will provide sufficient funds to finance operations for the next 12 months and our expectation that initiatives implemented recently or to be implemented by management will lead to improved liquidity. In addition, such forward-looking statements involve known and unknown risks, uncertainties, and other factors which may cause our actual results, performance or achievements to be materially different from any future results expressed or implied by such forward-looking statements. Also, our business could be materially adversely affected and the trading price of our common stock could decline if any of the following risks and uncertainties develop into actual events. Such risk factors, uncertainties and the other factors include: o The fact that we have failed financial covenants and may fail them in the future; o If we default on our debt to CapitalSource, it could foreclose on our assets; o Our ability to execute our strategy to improve our operations and our liquidity; o Our ability to obtain additional capital, without which our growth could be limited; o Changes in the regulatory environment applicable to our business, including health-care cost containment efforts by Medicare, Medicaid and other third-party payers; o Risks related to the eye care industry, including the cost and availability of medical malpractice insurance, and adverse long-term experience with laser and other surgical vision correction; o The fact that managed care companies face increasing threats of private-party litigation, including class actions, over the scope of care that the managed care companies must pay for; o Loss of the services of key management personnel could adversely effect our business; o The fact that we have a history of losses and may incur further losses in the future; o Our ability to maintain the listing of our common stock on the American Stock Exchange; o The possibility that we may not compete effectively with other eye care services companies which have more resources and experience than us; o Failure to negotiate profitable capitated fee arrangements could have a material adverse effect on our results of operations and financial condition; o The possibility that we may have potential conflicts of interests with respect to related party transactions which could result in certain of our officers, directors and key employees having interests that differ from us and our stockholders; o Health care regulations or health care reform initiatives, could materially adversely affect our business, financial condition and results of operations; o The fact that we are dependent upon letters of credit or other forms of third party security in connection with certain of its contractual arrangements and, thus, would be adversely affected in the event it was unable to obtain such credit as needed; o The fact that we may continue to not realize the expected benefits from our acquisition of Wise Optical; o The fact that our largest stockholder, Palisade Concentrated Equity Partnership, L.P., owns sufficient shares of our common stock and voting equivalents to significantly affect the results of any stockholder vote and control our board of directors; o The fact that conflicts of interest may arise between Palisade and OptiCare; and o Other risks and uncertainties discussed elsewhere in this Form 10-Q and detailed from time to time in our periodic earnings releases and reports filed with the Securities and Exchange Commission. 21 Except as required by law, we undertake no obligation to publicly update or revise forward-looking statements to reflect events or circumstances after the date of this Form 10-Q or to reflect the occurrence of unanticipated events. ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are subject to market risk from exposure to changes in interest rates based on our financing activities under our credit facility with CapitalSource, due to its variable interest rate. The nature and amount of our indebtedness may vary as a result of future business requirements, market conditions and other factors. The extent of our interest rate risk is not quantifiable or predictable due to the variability of future interest rates and financing needs. We do not expect changes in interest rates to have a material effect on income or cash flows in the year 2004, although there can be no assurances that interest rates will not significantly change. A 10% change in the interest rate payable by us on our variable rate debt would have increased or decreased the six-month interest expense by approximately $42,000 assuming that our borrowing level is unchanged. We did not use derivative instruments to adjust our interest rate risk profile during the six months ended June 30, 2004. ITEM 4: CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our principal executive officer and principal financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Quarterly Report on Form 10-Q, have concluded that, based on such evaluation, that deficiencies caused our disclosure controls and procedures not to be effective at a reasonable assurance level. Our principal executive officer and principal financial officer, along with our Audit Committee, determined that there was a "material weakness," or a reportable condition in which the design or operation of one or more of the specific internal control components does not reduce to a relatively low level the risk that errors or fraud in amounts that would be material in relation to the consolidated financial statements may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions, in our internal controls relating to our accounting for inventory that did not prevent the erroneous reporting of actual inventory levels primarily due to mathematical and fundamental errors in the reconciliation process. Our management discussed the areas of weakness described above with our Audit Committee and agreed to implement remedial measures to identify and rectify past accounting errors and to prevent the situation that resulted in the need to restate prior period financial statements from reoccurring. To this end, we have initially enhanced the inventory reconciliation process to provide more detail, mathematical checks and a detailed comparison to prior periods. We are continuing to monitor these processes to further enhance our procedures as may be necessary. This reconciliation process is also supported by additional levels of management and senior management review. Management believes the new controls and procedures address the conditions identified by its review. We are continuing to monitor the effectiveness of our internal controls and procedures on an ongoing basis and will take further action, as appropriate. (b) Changes in Internal Controls. There were no changes in our internal control over financial reporting, except as noted above identified in connection with the evaluation of such internal control that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. However, we believe the measures we have implemented and currently are implementing to improve our internal controls are reasonably likely to have a material impact on our internal controls over financial reporting in future periods. 22 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS HEALTH SERVICE ORGANIZATION LAWSUITS In June 2004, we reached settlement with Eye Surgeons of Indiana and Eye Associates of Southern Indiana respectively, two HSO practices which we were in litigation in the matter of In re Prime Vision Health, Inc. Contract Litigation, MDL 1466, which was previously reported in our Annual Report on Form 10-K for the year ended December 31, 2003. These settlements resulted in cash payments to us and mutual termination of the HSO service agreements. ITEM 3. DEFAULTS UPON SENIOR SECURITIES We were not in compliance with the minimum fixed charge ratio covenant under our term loan and revolving credit facility with CapitalSource as of March 31, 2004, April 30, 2004 and May 31, 2004. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" above for a complete discussion of our term loan and revolving credit facility with CapitalSource and our compliance with the terms thereof. ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS. The Annual Meeting of Stockholders of OptiCare Health Systems, Inc. was held on May 7, 2004. There were represented, in person or by proxy, 27,264,328 shares of common stock entitled to vote at the meeting, constituting a quorum. The only matter voted upon and approved by our stockholders at the meeting was the election of directors by the following votes: NUMBER OF SHARES NUMBER OF SHARES VOTED FOR: WITHHELD: -------------------- -------------------- Dean J. Yimoyines, M.D 27,227,018 37,310 Eric J. Bertrand 27,232,018 32,310 Norman S. Drubner 27,231,018 33,310 Mark S. Hoffman 27,232,018 32,310 Richard L. Huber 27,234,018 30,310 Clark A. Johnson 27,234,118 30,210 Melvin Meskin 27,232,018 32,310 Mark S. Newman 27,234,018 30,310 There were no [broker non-votes, votes cast against or abstentions] in connection with this matter. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K a. Exhibits The following Exhibits are filed as part of this Quarterly Report on Form 10-Q: EXHIBIT DESCRIPTION ------- ----------- 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 23 b. Reports on Form 8-K On May 14, 2004, we furnished information regarding results of our quarter ended March 31, 2004 under Item 12 (Results of Operations and Financial Condition) on a Current Report on Form 8-K. On July 1, 2004, we filed information regarding the review of our inventory and the expected restatement of our financial statements for the quarter ended March 31, 2004 under Item 5 (Other Events and Regulation FD Disclosure) and Item 12 (Results of Operations and Financial Condition) on a Current Report on Form 8-K. SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be filed on its behalf by the undersigned, hereunto duly authorized. Date: September 2, 2004 OPTICARE HEALTH SYSTEMS, INC. By: /s/ William A. Blaskiewicz ----------------------------------- William A. Blaskiewicz Vice President and Chief Financial Officer (Principal Financial and Accounting Officer and duly authorized officer) 24 EXHIBIT INDEX EXHIBIT DESCRIPTION ------- ----------- 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 25