UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q/A (AMENDMENT NO. 1) (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 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 number of shares outstanding of the registrant's Common Stock, par value $.001 per share, at July 31, 2004 was 30,686,800 shares. 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 March 31, 2004, the last business day of the registrant's most recently completed first quarter was $6,664,203. EXPLANATORY NOTE THE PURPOSE OF THIS AMENDMENT NO. 1 (THE "AMENDMENT") TO THE QUARTERLY REPORT ON FORM 10-Q OF OPTICARE HEALTH SYSTEMS, INC. (THE "REGISTRANT") FOR THE QUARTER ENDED MARCH 31, 2004 (THE "ORIGINAL FORM 10-Q") IS TO REFLECT THE RESTATEMENT OF THE REGISTRANT'S CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE QUARTER ENDED MARCH 31, 2004 AND MARCH 31 2003, AND TO REVISE RELATED DISCLOSURE IN THE ORIGINAL FORM 10-Q. THE RESTATEMENT IS DESCRIBED IN NOTE 2 TO THE RESTATED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS ACCOMPANYING THIS AMENDMENT. EXCEPT FOR ITEMS 1, 2 AND 4 OF PART I AND ITEM 6 OF PART II, NO OTHER INFORMATION INCLUDED IN THE ORIGINAL FORM 10-Q IS AMENDED BY THIS AMENDMENT. 2 INDEX TO FORM 10-Q/A Page No. PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets at March 31, 2004, as restated December 31, 2003, and March 31, 2003, as restated (unaudited) 4 Condensed Consolidated Statements of Operations for the three months ended March 31, 2004, as restated and 2003 (unaudited) 5 Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2004, as restated and 2003 (unaudited) 6 Notes to Condensed Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 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 6. Exhibits and Reports on Form 8-K 23 SIGNATURE 24 3 PART I FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (AMOUNTS IN THOUSANDS) (UNAUDITED) MARCH 31, DECEMBER 31, MARCH 31, 2004 2003 2003 ----------- ------------ ----------- AS RESTATED AS RESTATED See Note 2 See Note 2 ASSETS CURRENT ASSETS: Cash and cash equivalents $ 1,925 $ 1,695 $ 3,937 Accounts receivable, net 10,795 9,369 12,144 Inventories 5,579 5,918 9,231 Deferred income taxes, current -- -- 1,660 Other current assets 1,110 567 762 -------- -------- -------- TOTAL CURRENT ASSETS 19,409 17,549 27,734 Property and equipment, net 4,312 4,683 5,572 Goodwill, net 19,195 19,195 20,516 Intangible assets, net 1,151 1,179 1,309 Deferred income taxes, non-current -- -- 3,140 Other assets 3,251 3,249 4,599 -------- -------- -------- TOTAL ASSETS $ 47,318 $ 45,855 $ 62,870 ======== ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 9,620 $ 5,644 $ 12,090 Accrued expenses 5,720 5,507 5,940 Current portion of long-term debt 10,554 10,828 11,697 Other current liabilities 1,646 1,542 1,258 -------- -------- -------- TOTAL CURRENT LIABILITIES 27,540 23,521 30,985 -------- -------- -------- Long-term debt--related party -- -- 14,821 Other long-term debt, less current portion -- 1,775 80 Other liabilities 519 512 678 -------- -------- -------- TOTAL NON-CURRENT LIABILITIES 519 2,287 15,579 -------- -------- -------- Series B 12.5% mandatorily redeemable, convertible preferred stock--related party 5,809 5,635 5,158 STOCKHOLDERS' EQUITY: Series C preferred stock--related party 1 1 -- Common stock 31 30 30 Additional paid-in-capital 79,701 79,700 63,924 Accumulated deficit (66,283) (65,319) (52,806) -------- -------- -------- TOTAL STOCKHOLDERS' EQUITY 13,450 14,412 11,148 -------- -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 47,318 $ 45,855 $ 62,870 ======== ======== ======== See notes to condensed consolidated financial statements. 4 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA) (UNAUDITED) THREE MONTHS ENDED MARCH 31, ------------------------ AS RESTATED ** -------- -------- 2004 2003 -------- -------- NET REVENUES: Managed vision $ 6,051 $ 7,408 Product sales 17,957 17,722 Other services 5,573 5,028 Other income 620 1,838 -------- -------- Total net revenues 30,201 31,996 -------- -------- OPERATING EXPENSES: Medical claims expense 4,644 5,744 Cost of product sales 14,202 13,901 Cost of services 2,279 2,126 Selling, general and administrative 9,282 8,808 Depreciation 403 355 Amortization 28 44 Interest 321 751 -------- -------- Total operating expenses 31,159 31,729 -------- -------- Income (loss) before income taxes (958) 267 Income tax expense 6 107 -------- -------- Net income (loss) (964) 160 Preferred stock dividends (174) (140) -------- -------- Net income (loss) available to common stockholders $ (1,138) $ 20 ======== ======== EARNINGS (LOSS) PER SHARE: Net income (loss) per common share: Basic $ (0.04) $ 0.00 Diluted $ (0.04) $ 0.00 ** See Note 2 See notes to condensed consolidated financial statements. 5 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (AMOUNTS IN THOUSANDS) (UNAUDITED) FOR THE THREE MONTHS ENDED MARCH 31, -------------------------- AS RESTATED ** ------------- ------- 2004 2003 ------------- ------- OPERATING ACTIVITIES: Net income (loss) $ (964) $ 160 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation 403 355 Amortization 28 44 Non-cash interest expense 38 558 Changes in operating assets and liabilities: Accounts receivable (1,426) 55 Inventory 339 (1,499) Other assets (602) (13) Accounts payable and accrued expenses 4,364 905 Other liabilities 101 30 ------- ------- Net cash provided by operating activities 2,281 595 ------- ------- INVESTING ACTIVITIES: Cash received on notes receivable 46 265 Purchase of fixed assets (32) (174) Acquisition of business, net of cash acquired -- (5,863) Purchase of restricted certificates of deposit -- (600) ------- ------- Net cash provided by (used in) investing activities 14 (6,372) ------- ------- FINANCING ACTIVITIES: Net increase (decrease) in revolving credit facility (1,920) 7,377 Principal payments on long-term debt (119) (684) Principal payments on capital lease obligations (1) (14) Payment of financing costs (25) (81) Proceeds from issuance of common stock -- 30 ------- ------- Net cash (used in) provided by financing activities (2,065) 6,628 ------- ------- Increase in cash and cash equivalents 230 851 Cash and cash equivalents at beginning of period 1,695 3,086 ------- ------- Cash and cash equivalents at end of period $ 1,925 $ 3,937 ======= ======= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest $ 286 $ 165 Cash paid for income taxes $ 38 $ 76 ** See Note 2 See notes to condensed consolidated financial statements. 6 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 months ended March 31, 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 months ended March 31, 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. 2. RESTATEMENT Inventory Restatement: In June 2004, subsequent to the filing of the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2004, the Company discovered an error in the accounting for its inventory at Wise Optical (see Note 6 for a discussion of the Company's acquisition of Wise Optical) during the quarter ended March 31, 2004. The error related to the accounting for inventory and was primarily due to mathematical and fundamental errors in the reconciliation process. The Company's management reported its findings to the Company's Audit Committee. After a review conducted by management at the direction of the Audit Committee, the Company determined that at March 31, 2004 its inventory was overstated by $713 and an inventory liability was understated by $255. The effect of these changes resulted in a $171K reduction of revenue and $797K increase to cost of goods sold, which resulted in a net income reduction of $968 for the quarter ended March 31, 2004. As a result, the restated condensed consolidated financial statements report a net loss for the quarter ended March 31, 2004 of $(964) opposed to net income of $4 as originally reported and net loss per common share for the quarter ended March 31, 2004 of $0.04 opposed to $0.01 as originally reported. The Company was not in compliance with its minimum fixed charge ratio covenant under its loan agreement with its senior lender, Capital Source Finance, LLC ("CapitalSource") as of March 31, 2004. In addition, the Company was not in compliance with this covenant as of April 30, 2004 or May 31, 2004. On August 16, 2004, the Company and CapitalSource amended the loan 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 10 for a discussion of the amendment and waiver). Debt 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. Subsequent to the issuance of the Company's consolidated financial statements for the year ended 12/31/03, 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 sheet as of March 31, 2003 has been restated to reflect the reclassification of the amounts outstanding pursuant to this credit facility as current liabilities. 7 A summary of the significant effects of the restatement is as follows: AS OF MARCH 31, 2004 --------------------------- AS PREVIOUSLY REPORTED AS RESTATED ------------- ----------- AT MARCH 31: Inventory $ 6,292 $ 5,579 Total Assets 48,031 47,318 Current Liabilities 17,111 27,540 Non-current Liabilities 10,693 519 Accumulated Deficit (65,315) (66,283) Stockholder's Equity 14,418 13,450 FOR THE QUARTER ENDED MARCH 31: Revenue 18,128 17,957 Cost of Goods Sold 13,365 14,162 Income (loss) before income taxes 10 (958) Net income (loss) 4 (964) Net loss per share Basic and Diluted (0.01) (0.04) AS OF MARCH 31, 2003 --------------------------- AS PREVIOUSLY REPORTED AS RESTATED ------------- ----------- AT MARCH 31: Current Portion of Long Term Debt 2,763 11,697 Long Term Debt less Current Portion 7,799 80 Total Current Liabilities 22,051 30,985 Total Non-current Liabilities 24,513 15,579 3. 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 CaptialSource to demand payment in full of the credit facility. However, CapitalSource has amended the terms and covenants of our 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. 8 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 profitablility 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. 4. 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 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 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 03-6 is not expected to have a material impact on the Company's condensed consolidated financial statements. 5. 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 Accounting 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 income (loss) and earnings (loss) per share using the Black Scholes option pricing model, would have been adjusted to the pro forma amounts indicated below. THREE MONTHS ENDED MARCH 31, ---------------------- 2004 2003 ------- ------- Net income (loss), as reported $ (964) $ 160 Less: Total stock-based employee compensation expense, net of related tax effects, determined under the fair value method for all awards (23) (108) 9 ------- ------- Pro forma net income (loss) $ (987) $ 52 ======= ======= Basic and diluted earnings (loss) per share: As reported $ (0.04) $ 0.00 Pro forma $ (0.04) $ 0.00 6. 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 and net income of the Company for the three months ended March 31, 2003 would have been $38,615 and $248, respectively. On the same pro forma basis, basic and diluted income per common share for the three months ended March 31, 2003 would have been $0.00. 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. 7. 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 $507, $479 and $396 at March 31, 2004, December 31, 2003 and March 31, 2003, respectively. The non-compete agreements, which had a gross carrying amount of $265, were fully amortized at March 31, 2004 and December 31, 2003 and had accumulated amortization of $218 at March 31, 2003. Amortization expense for the three months ended March 31, 2004 and 2003 was $28 and $44, respectively. Annual amortization expense is expected to be $111 in each of the years 2004 through 2008. 8. 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 10). 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 condensed consolidated financial statements report results using the Distribution and Technology segment and do not reflect the May 2004 change in 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 10 "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 months ended March 31, 2004 and 2003 is as follows: THREE MONTHS ENDED MARCH 31, ------------------------ 2004 2003 -------- -------- REVENUES: Managed vision $ 6,051 $ 7,408 Consumer vision 8,143 7,306 Distribution and technology 17,020 16,420 -------- -------- Reportable segment totals 31,214 31,134 All other 633 1,861 Elimination of inter-segment revenues (1,646) (999) -------- -------- Total net revenue $ 30,201 $ 31,996 ======== ======== SEGMENT INCOME (LOSS): Managed vision $ 166 $ 426 Consumer vision 931 565 Distribution and technology (915) (270) -------- -------- Reportable segment totals 182 721 All other 424 1,677 Depreciation (403) (355) Amortization (28) (44) Interest expense (321) (751) Corporate (812) (981) -------- -------- Income (loss) before income taxes $ (958) $ 267 ======== ======== 9. EARNINGS (LOSS) PER COMMON SHARE The following table sets forth the computation of basic and diluted earnings (loss) per share: THREE MONTHS ENDED MARCH 31, -------------------------- 2004 2003 ---------- ------------ BASIC EARNINGS (LOSS) PER SHARE: Net income (loss) $ (964) $ 160 Preferred stock dividend (174) (140) ---------- ------------ Net income (loss) available to common Stockholders $ (1,138) $ 20 ========== ============ Average common shares outstanding (basic) 30,388,891 29,543,093 Basic earnings (loss) per share: $ (0.04) $ 0.00 ========== ============ 11 THREE MONTHS ENDED MARCH 31, -------------------------- 2004 2003 ---------- ------------ DILUTED EARNINGS (LOSS) PER SHARE: Income (loss) available to common stockholders $ (1,138) $ 20 Assumed conversions of preferred stock dividends * 140 ---------- ------------ Net income (loss) available to common $ (1,138) $ 160 Stockholders ========== ============ Average common shares outstanding (basic) 30,388,891 29,543,093 Effect of dilutive securities: Options * 4,152,500 Warrants * 1,045,000 Convertible Preferred stock * 36,845,912 ---------- ------------ Diluted shares 30,388,891 71,586,505 ========== ============ Diluted earnings (loss) per share: $ (0.04) $ 0.00 ========== ============ * Anti-dilutive The following table reflects the potential common shares of the Company for the three months ended March 31, 2004 and 2003 that have been excluded from the calculation of diluted earnings per share due to anti-dilution. THREE MONTHS ENDED MARCH 31, -------------------------- 2004 2003 ---------- ---------- Options 6,160,289 2,054,566 Warrants 3,125,000 2,080,000 Convertible Preferred Stock 61,801,304 -- ---------- ---------- 71,086,593 4,134,566 ========== ========== 10. SUBSEQUENT EVENTS In May 2004, the Company's Board of Directors approved management's plan to exit the technology business 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 Statement of Financial Accounting Standard ("SFAS") No. 144, the disposal of CC Systems will be accounted for as a discontinued operation for the quarter ended June 30, 2004. 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. The carrying amount of the assets and liabilities of the disposal group at March 31, 2004, December 31, 2003 and March 31, 2003 were as follows: March 31, December 31, March 31, 2004 2003 2003 --------- ------------ --------- Assets: Accounts receivable $1,286 $1,502 $1,118 Inventory 106 148 76 Property and equipment, net 31 36 70 Intangible assets, net 1,303 1,303 1,348 12 Other assets 2 46 ------ ------ ------ Total assets $2,726 $2,991 $2,658 ====== ====== ====== Liabilities: Accounts Payable $ 40 $ 119 $ 94 Accrued Expenses 61 129 115 Other liabilities 879 993 1,182 ------ ------ ------ Total liabilities $ 980 $1,241 $1,391 ====== ====== ====== As a result of operating losses at 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 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 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. 11. 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 March 31, 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. 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. Additionally, the following discussion reflects our March 31, 2004 restatement. 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. 13 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 as of June 30, 2004. 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 their 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 March 31, 2004 Compared to the Three Months Ended March 31, 2003 Managed Vision revenue. Managed Vision revenue represents fees received under our managed care contracts. Managed Vision revenue decreased to approximately $6.0 million for the three months ended March 31, 2004 compared to approximately $7.4 million for the three months ended March 31, 2003, a decrease of approximately $1.4 million or 18.9%. Of this decrease, approximately $1.3 million is due to terminated contracts, primarily as a result of changes made by the Texas state legislature to its Medicaid and Children's Health Insurance Programs, and $0.6 million is due to a decline in membership in existing contracts with one of our large health plan customers. These decreases are partially offset by increases in revenue of approximately $0.3 million from new contracts and approximately $0.2 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 a new contract with a different payor, which became effective March 1, 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 increased to approximately $18.0 million for the three months ended March 31, 2004 compared to approximately $17.7 million for the three months ended March 31, 2003, an increase of approximately $0.3 million or 2.3%. This increase represents an approximate $0.9 million increase in revenue from Wise Optical and an approximate $0.2 million increase in revenue from Consumer Vision, which were partially offset by an approximate $0.8 million decrease in revenue from the Buying Group. Revenue of Wise Optical was approximately $0.9 higher in the first quarter of 2004 as compared to the first quarter of 2003, because 2004 revenue included a full quarter of revenue, whereas 2003 revenue only included revenue from February 1, 2003, the effective date of our acquisition of Wise Optical. The increase in Wise Optical revenue due to the additional month of revenue in 2004 is partially offset by the overall decline in sales volume we experienced immediately after we purchased Wise Optical. We began implementing strategies in September 2003 to increase 14 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 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. 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. We expect product sales of the Buying Group to remain at current levels for the remainder of the year, adjusted for seasonality. Other services revenue. Other services revenue includes revenue earned from providing eye care services in our Consumer Vision segment, software services in our Distribution & Technology segment and HSO services. Other services revenue increased to approximately $5.6 million for the three months ended March 31, 2004 compared to approximately $5.0 million for the three months ended March 31, 2003, an increase of approximately $0.6 million or 12.0%. This increase is primarily due to increased services volume in the medical, optometry and surgical areas 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 HSO contracts. Other income for the three months ended March 31, 2004 was approximately $0.6 million compared to approximately $1.8 million for the three months ended March 31, 2003, representing a decrease of approximately $1.2 million or 66.7%, as a result of a decrease in the number of settlements in the current quarter. Medical claims expense. Medical claims expense decreased to approximately $4.6 million for the three months ended March 31, 2004, from approximately $5.7 million for the three months ended March 31, 2003, a decrease of approximately $1.1 million or 19.3%. The medical claims expense loss ratio (MLR) representing medical claims expense as a percentage of Managed Vision revenue decreased to 76.8% in 2004 from 77.5% in 2003. The favorable change in MLR is a result of changes to existing contracts and increased revenue from certain contracts which do not generate claims expense. 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 as restated, increased to approximately $14.2 million for the three months ended March 31, 2004 compared to approximately $13.9 million for the three months ended March 31, 2003, an increase of approximately $0.3 million or 3.1%. This increase is primarily due to an approximate $0.9 million increase in product costs associated with Wise Optical, and a $0.2 million increase in product costs associated with increased sales in our Consumer Vision division, which were partially offset by an approximate $0.8 million decrease in product costs associated with the decrease in Buying Group sales. The increase in Wise Optical product costs is because 2004 product costs included a full quarter of Wise Optical costs, whereas 2003 product costs only included costs from February 1, 2003, the effective date of our acquisition of Wise Optical. This increase in Wise Optical product costs in 2004 is partially offset by a decrease in its product costs as a result of a decrease in sales volume. Overall, we expect total product costs to increase slightly in the future due to an expected increase in product sales. Cost of services. Cost of services increased to approximately $2.3 million for the three months ended March 31, 2004 compared to approximately $2.1 million for the three months ended March 31, 2003, an increase of approximately $0.2 million or 9.5%. 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 increased to approximately $9.3 million for the three months ended March 31, 2004 compared to approximately $8.8 million for the three months ended March 31, 2003, an increase of approximately $0.5 million or 5.7%. The increase in 2004 is primarily due to expenses associated with Wise Optical's operations being included in our results for a full quarter, whereas 2003 expenses only included Wise Optical from February 1, 2003, the effective date of our acquisition of Wise Optical. Interest expense. Interest expense decreased to approximately $0.3 million for the three months ended March 31, 2004 from approximately $0.8 million for the three months ended March 31, 2003, a decrease of approximately $0.5 million or 62.5%. This decrease in interest expense is primarily due to a decrease in the average outstanding debt balance as a result of the conversion of approximately $16.2 million of debt to preferred stock in May 2003. 15 Income tax expense. Income tax expense recorded for the three months ended March 31, 2004 primarily represents minimum state tax expense. We recorded income tax expense of approximately $0.1 million for the three months ended March 31, 2003, representing tax expense on income from operations of approximately $0.3 million, at an effective rate of 40%. Net income/loss available to common stockholders. Net loss available to common stockholders for the three months ended March 31, 2004 was approximately $1.1 million compared to net income available to common stockholders of approximately $0.02 million for the three months ended March 31, 2003. The loss in 2004 is primarily due to losses incurred in our Wise Optical business. We expect reduced operating losses at Wise Optical in the future as we continue to implement improvement strategies. 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. 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 March 31, 2004, we had cash and cash equivalents of approximately $1.9 million. As a result of the 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 or 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 March 31, 2004 and 2003: (In millions) 2004 2003 $ CHANGE ---- ---- -------- Cash and cash equivalents $ 1.9 $ 3.9 $ (2.0) Cash provided by (used in): Operating activities 2.3 0.6 1.7 Investing activities -- (6.4) 6.4 Financing activities (2.1) 6.6 (8.7) 16 Net cash provided by operating activities was approximately $2.3 million for the three months ended March 31, 2004 compared to approximately $0.6 million of net cash used in operating activities for the three months ended March 31, 2003, an increase of approximately $1.7 million. The increase in cash provided by operating activities was primarily due to improved inventory management and an increase in accounts payable due to higher product sales and the timing of purchases and payments on payables. There were no significant sources or uses of cash related to investing activities for the three months ended March 31, 2004. Net cash used in investing activities for the three months ended March 31, 2003 was approximately $6.4 million, which was primarily used to purchase the assets of Wise Optical in February 2003. Net cash used in financing activities was approximately $2.1 million for the three months ended March 31, 2004 compared to approximately $6.6 million of net cash provided by financing activities for the three months ended March 31, 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 used 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. 17 The CapitalSource Loan and Security Agreement As of March 31, 2004, we had approximately $2.0 million of borrowings outstanding under our term loan with CapitalSource, approximately $8.5 million of advances outstanding under our revolving credit facility with CapitalSource and approximately $2.5 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 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, 2004 or May 31 2004, but we 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. 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 on August 16, 2004. The revolving credit, 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. The $0.9 million reduction in our inventory value as a result of our restatement reduced our borrowing availability under this formula from $2.5 million to $1.9 million at March 31, 2004. 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 18 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. 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 $8,474,000, $9,694,000 and $8,934,000 at March 31, 2004, December 31, 2003 and March 31, 2003, respectively. The Series B Preferred Stock As of March 31, 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 $1.81 per share as of March 31, 2004, increases at a rate of 12.5% per year, compounded annually. The Series C Preferred Stock As of March 31, 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. 0-95, Effect of Participating Convertible Securities in 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 and Technology 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. 19 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; o Our expected impact of future interest rates on income 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; 20 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/A and detailed from time to time in our periodic earnings releases and reports filed with the Securities and Exchange Commission. 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/A 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 three-month interest expense by approximately $22,000 assuming that our borrowing level is unchanged. We did not use derivative instruments to adjust our interest rate risk profile during the three months ended March 31, 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. 21 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 that the immediate enhancements to the controls and procedures adequately address the initial conditions identified by its review. We are continuing to monitor the effectiveness of our enhanced 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. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS HEALTH SERVICE ORGANIZATION LAWSUITS In January 2004 and March 2004, we reached settlement with Downing-McPeak Vision Centers, P.S.C. and John E. Downing, M.D., and Milne Eye Medical Center, P.C. and Milton J. Milne, M.D., 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 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. 22 b. Reports on Form 8-K On March 31, 2004, we furnished information regarding results of our quarter and year ended December 31, 2003 under Item 12 (Results of Operation 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) 23 EXHIBIT INDEX EXHIBIT DESCRIPTION ------- ----------- 31.1 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Section 906 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. 24