PRIMEDEX HEALTH SYSTEMS INC Files SEC form 10-K, Annual Report

Form 10-K for PRIMEDEX HEALTH SYSTEMS INC
31-Jan-2005
Annual Report

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW
We operate a group of regional networks comprised of 56 fixed-site, freestanding outpatient diagnostic imaging facilities in California. We believe our group of regional networks is the largest of its kind in California. We have strategically organized our facilities into regional networks in markets, which have both high-density and expanding populations, as well as attractive payor diversity.

All of our facilities employ state-of-the-art equipment and technology in modern, patient-friendly settings. Many of our facilities within a particular region are interconnected and integrated through our advanced information technology system. Thirty three of our facilities are multi-modality sites, offering various combinations of MRI, CT, PET, nuclear medicine, ultrasound, X-ray and fluoroscopy services. Twenty three of our facilities are single-modality sites, offering either X-ray or MRI services. Consistent with our regional network strategy, we locate our single-modality sites near multi-modality sites to help accommodate overflow in targeted demographic areas.

We derive substantially all of our revenue, directly or indirectly, from fees charged for the diagnostic imaging services performed at our facilities. For the year ended October 31, 2004, we derived 63% of our net revenue from MRI and CT scans. Over the past three fiscal years, we have increased net revenue primarily through acquisitions, expansions of existing facilities, upgrades in equipment and development of new facilities.

The fees charged for diagnostic imaging services performed at our facilities are paid by a diverse mix of payors, as illustrated for the year ended October 31, 2004 by the following table:

PAYOR TYPE - % OFNET REVENUE

Insurance(1) - 40%
Managed Care Capitated Payors - 25%
Medicare/Medi-Cal - 16%
Other(2) - 14%
Workers Compensation/Personal Injury - 5%

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(1) Includes Blue Cross/Blue Shield, which represented 13% of our net revenue for the year ended October 31, 2004.
(2) Includes co-payments, direct patient payments and payments through contracts with physician groups and other non-insurance company payors.

Our eligibility to provide service in response to a referral often depends on the existence of a contractual arrangement between the radiologists providing the professional medical services or us and the referred patient's insurance carrier or managed care organization. These contracts typically describe the negotiated fees to be paid by each payor for the diagnostic imaging services we provide. With the exception of Blue Cross/Blue Shield and government payors, no single payor accounted for more than 5% of our net revenue for the year ended October 31, 2004. Under our capitation agreements, we receive from the payor a pre-determined amount per member, per month. If we do not successfully manage the utilization of our services under these agreements, we could incur unanticipated costs not offset by additional revenue, which would reduce our operating margins.

The principal components of our fixed operating expenses, excluding depreciation, include professional fees paid to radiologists, except for those radiologists who are paid based on a percentage of revenue, compensation paid to technologists and other facility employees, and expenses related to equipment rental and purchases, real estate leases and insurance, including errors and omissions, malpractice, general liability, workers' compensation and employee medical. The principal components of our variable operating expenses include expenses related to equipment maintenance, medical supplies, marketing, business development and corporate overhead. Because a majority of our expenses are fixed, increased revenue as a result of higher scan volumes per system can significantly improve our margins, while lower scan volumes can result in significantly lower margins.

BRMG strives to maintain qualified radiologists and technologists while minimizing turnover and salary increases and avoiding the use of outside staffing agencies, which are considerably more expensive and less efficient. In recent years, there has been a shortage of qualified radiologists and technologists in some of the regional markets we serve. As turnover occurs, competition in recruiting radiologists and technologists may make it difficult for our contracted radiology practices to maintain adequate levels of radiologists and technologists without the use of outside staffing agencies. At times, this has resulted in increased costs for us.

For a discussion of other factors that may have an impact on our business and our future results of operations, see "Risks Related to our Business."

OUR RELATIONSHIP WITH BRMG
Howard G. Berger, M.D. is our President and Chief Executive, a member of our Board of Directors, and owns approximately 30% of Primedex's outstanding common stock. Dr. Berger also owns, indirectly, 99% of the equity interests in BRMG. BRMG provides all of the professional medical services at 42 of our facilities under a management agreement with us, and contracts with various other independent physicians and physician groups to provide all of the professional medical services at most of our other facilities. We obtain professional medical services from BRMG, rather than providing such services directly or through subsidiaries, in order to comply with California's prohibition against the corporate practice of medicine. However, as a result of our close relationship with Dr. Berger and BRMG, we believe that we are able to better ensure that professional medical services are provided at our facilities in a manner consistent with our needs and expectations and those of our referring physicians, patients and payors than if we obtained these services from unaffiliated practice groups.

Under our management agreement with BRMG, which expires on January 1, 2014, BRMG pays us, as compensation for the use of our facilities and equipment and for our services, a percentage of the gross amounts collected for the professional services it renders. The percentage, which was 79% at October 31, 2004, is adjusted annually, if necessary, to ensure that the parties receive fair value for the services they render. In operation and historically, the annual revenue of BRMG from all sources closely approximates its expenses, including Dr. Berger's compensation, fees payable to us and amounts payable to third parties. For administrative convenience and in order to avoid inconveniencing and confusing our payors, a single bill is prepared for both the professional medical services provided by the radiologists and our non-medical, or technical, services, generating a receivable for BRMG. BRMG finances these receivables under a working capital facility with Wells Fargo Foothill and regularly advances to us the funds that it draws under this working capital facility, which we use for our own working capital purposes. We repay or offset these advances with periodic payments from BRMG to us under the management agreement. We guarantee BRMG's obligations under this working capital facility.

As a result of our contractual and operational relationship with BRMG and Dr. Berger, we are required to include BRMG as a consolidated entity in our consolidated financial statements. See "Selected Consolidated Financial Data."

FINANCIAL CONDITION

LIQUIDITY AND CAPITAL RESOURCES
We had a working capital deficit of $32.2 million at October 31, 2004 and had losses from continuing operations of $5.5 million and $14.6 million during fiscal 2003 and 2004, respectively. The loss in fiscal 2004 includes a $5.2 million expense resulting from the increase in the valuation allowance for deferred income taxes. We also had a stockholders' deficit of $67.6 million at October 31, 2004. We operate in a capital intensive, high fixed-cost industry that requires significant amounts of capital to fund operations. In addition to operations, we require significant amounts of capital for the initial start-up and development expense of new diagnostic imaging facilities, the acquisition of additional facilities and new diagnostic imaging equipment, and to service our existing debt and contractual obligations. Because our cash flows from operations are insufficient to fund all of these capital requirements, we depend on the availability of financing under credit arrangements with third parties. Historically, our principal sources of liquidity have been funds available for borrowing under our existing lines of credit, now with Wells Fargo Foothill. Even though the line of credit matures in 2008, we classify the line of credit as a current liability primarily because is is collateralized by accounts receivable and the eligible borrowing base is classified as a current asset. We finance the acquisition of equipment mainly through capital and operating leases.

During fiscal 2004, we took the actions described below to continue to fund our obligations. In addition, some of our plans to provide the necessary working capital in the future are summarized below.

BRMG and Wells Fargo Foothill are parties to a credit facility under which BRMG may borrow the lesser of 85% of the net collectible value eligible accounts receivable plus one month of average capitation receipts for the prior six months, two times the trailing month cash collections, or $20,000,000. Eligible accounts receivable shall exclude those accounts older than 150 days from invoice date and will be net of customary reserves. In addition, Wells Fargo Foothill set up a term loan where they can advance up to the lesser of $3,000,000 or 80% of the liquidation value of the equipment value servicing the loan. The five-year term loan must be drawn prior to December 31, 2004 with interest only payments through February 28, 2005 with the first quarterly principal payments due on March 1, 2005. As of December 31, 2004, we had not borrowed under the term loan.

Under the $20,000,000 revolving loan, an overadvance subline will be available not to exceed $2,000,000, or one month of the average capitation receipts for the prior six months, until September 30, 2005. Beginning the earlier of October 1, 2005 or when the term loan funds, the maximum overadvance cannot exceed the lesser of $1,000,000 or one month of the average capitation receipts for the prior six months. Also under the revolving loan, we are entitled to request that Wells Fargo Foothill issue guarantees of payment with respect to letters of credit issued by an issuing bank in an aggregate amount not to exceed $5,000,000 at any one time outstanding. At October 31, 2004, we had $7.1 million of available borrowing under the Wells Fargo Foothill revolving loan.

Advances outstanding under the revolving loan bear interest at the base rate plus 1.5%, or the LIBOR rate plus 3.0%. Advances under the overadvance subline and term loan bear interest at the base rate plus 4.75%. Letter of credit fees bear interest of 3.0% per annum times the undrawn amount of all outstanding lines of credit. The base rate refers to the rate of interest announced within Wells Fargo Bank at its principal office in San Francisco as it prime rate. The line is collateralized by substantially all of the Company's assets and requires the Company to meet certain financial covenants including minimum levels if EBITDA, net worth, fixed charge coverage ratios and maximum senior debt/EBITDA ratios as well as limitations on annual capital expenditures.

We also had a line of credit with an affiliate of DVI. At October 31, 2004, the Company had $3.4 million outstanding under this line. Interest on the outstanding balance was payable monthly at our lender's prime rate plus 1.0%. Future borrowings under this line of credit were no longer available and the balance was being paid down by collections on historical accounts receivable and variable monthly installment payments in the future. Subsequent to year-end, we and Post Advisory Group, LLC, a Los Angeles-based investment advisor, issued $4.0 million in principal amount of notes to repurchase the DVI affiliate's line of credit facility with the residual funds utilized by us as working capital. The new note payable has monthly interest only payments at 12% per annum until its maturity in July 2008.

On December 19, 2003, we issued a $1.0 million convertible subordinate note payable at a stated rate of 11% per annum with interest payable quarterly. The note payable is convertible at the holder's option anytime after June 19, 2005 at $0.50 per share. As additional consideration for the financing we issued a warrant for the purchase of 500,000 shares at an exercise price of $.50 per share. We have allocated $0.1 million to the value of the warrants and believe the value of the conversion feature is nominal.

In July 2004, we renegotiated our existing notes and capital lease obligations with our three primary lenders, General Electric ("GE"), DVI Financial Services and U.S. Bank extending terms and reducing monthly payments on approximately $135 million of combined outstanding debt.

At the time of the debt restructuring, outstanding principal balances for DVI and GE were $15.2 million and $54.3 million respectively.

DVI's restructured note payable is six payments of interest only from July to December 2004 at 9%, 41 payments of principal and interest of $273,988, and a final balloon payment of $7.6 million on June 1, 2008 if and only if the Company's subordinated bond debentures, then due, are not extended and paid in full. If the bond debenture payment is deferred, the Company would make monthly payments of $290,785 to DVI for the next 29 months. Effective November 30, 2004, Post Advisory Group, LLC, ("Post"), acquired the DVI note payable and the indebtedness was restructured by Post and the Company. The new note payable has monthly interest only payments at 11% per annum until its maturity in June 2008. The assignment of the note payable to Post will not result in any actual total dollar savings to the Company over the term of the new obligation, but it will defer cash outlays of approximately $1.3 million per year until its maturity.

GE's restructured note payable is six payments of interest only at 9%, or $407,210, beginning on August 1, 2004, 40 payments of principal and interest at $1,127,067 beginning on February 1, 2005, and a final balloon payment of $21 million due on June 1, 2008 if and only if our subordinated bond debentures, then due, are not extended and paid in full. If the bond debenture payment is deferred, we will continue to make monthly payments of $1,127,067 to GE for the next 20 months.

At the time of the debt restructuring, the outstanding principal balance, including accrued interest, due U.S. Bank was $65.6 million. U.S. Bank's restructured note payable is six payments of interest only at 9%, or $491,933, beginning on August 1, 2004, 40 payments of principal and interest of $1,055,301 beginning on February 1, 2005, and a final balloon payment of $39.7 million due on June 1, 2008 if and only if our subordinated bond debentures, then due, are not extended and paid in full. If the bond debenture payment is deferred, we will continue to make monthly payments of $1,055,301 to U.S. Bank for the next 44 months.

In addition, during fiscal 2003, in order to provide us additional liquidity, Dr. Berger advanced to us $1.0 million, some of our executive officers have forgone a portion of their salary, an affiliate of GE began making short-term working capital loans in the amount of $0.2 million per month for nine months, and we sold Westchester Imaging Group for net cash proceeds of approximately $1.4 million. See "Significant Events - Sale of Joint Venture Interest - Discontinued Operation".

In October 2003, we successfully consummated a "pre-packaged" Chapter 11 plan of reorganization with the United States Bankruptcy Court, Central District of California, in order to modify the terms of our convertible subordinated debentures by extending the maturity to June 30, 2008, increasing the annual interest rate from 10.0% to 11.5%, reducing the conversion price from $12.00 to $2.50 and restricting our ability to redeem the debentures prior to July 1, 2005. The plan of reorganization did not affect any of our operations or obligations, other than the subordinated debentures.

Our business strategy with regard to operations will focus on the following:

• Maximizing performance at our existing facilities;

• Focusing on profitable contracting;

• Expanding MRI and CT applications

• Optimizing operating efficiencies; and

• Expanding our networks.

Our ability to generate sufficient cash flow from operations to make payments on our debt and other contractual obligations will depend on our future financial performance. A range of economic, competitive, regulatory, legislative and business factors, many of which are outside of our control, will affect our financial performance. Taking these factors into account, including our historical experience and our discussions with our lenders to date, although no assurance can be given, we believe that through implementing our strategic plans and continuing to restructure our financial obligations, we will obtain sufficient cash to satisfy our obligations as they become due in fiscal 2005.

SOURCES AND USES OF CASH
Cash decreased for fiscal 2004 and 2003 by $29,000 and $6,000, respectively.

Cash provided by operating activities for the year ended October 31, 2004 was $17.1 million compared to $22.0 million for the same period in 2003. The primary reason for the decrease in cash was due to reductions in accounts payable and accrued expenses in fiscal 2004 of $2.8 million compared to an increase in these same liabilities in fiscal 2003 of $3.2 million. Fiscal 2003 results include cash used by the discontinued operation of $0.8 million. In addition, imputed interest expense increased approximately $5.1 million for the year ended October 31, 2004 compared to the same period in 2003. Imputed interest is interest accrued and unpaid on outstanding notes and capital lease obligations, as well as interest on capitalized debt restructuring charges which are amortized over the term of the new note payable or capital lease obligation. During the first three quarters of fiscal 2004, we deferred payments on the majority of our notes payable with DVI while negotiating with external third parties and the existing lender.

Cash used by investing activities for fiscal 2004 was $3.8 million compared to $1.7 million for the same period in 2003. For fiscal 2004 and 2003, we purchased property and equipment for approximately $3.8 million and $3.1 million, respectively, and received proceeds from the sale of facilities of $1.4 million in fiscal 2003 and purchased additional DIS common stock for $35,000 in fiscal 2004. The cash received from the sale of facilities in fiscal 2003 was for the discontinued operation.

Cash used for financing activities for fiscal 2004 was $13.3 million compared to $20.3 million for the same period in 2003. For fiscal 2004 and 2003, we made principal payments on capital leases, notes payable and lines of credit of approximately $13.2 million and $25.7 million, respectively, reduced cash disbursements in transit by $0.3 million and $1.7 million, respectively, received proceeds from borrowings under existing lines of credit and refinancing arrangements of approximately $1.0 million and $7.4 million, respectively, purchased subordinated debentures for approximately $60,000 and $3,000, respectively, made payments to limited partners of $650,000 and $300,000 respectively, and received proceeds from the issuance of common stock of approximately $0 and $28,000, respectively.

Cash used for financing the discontinued operation, included above, for fiscal 2003 was $0.6 million. The payments were for principal payments on capital leases and joint venture distributions.

CONTRACTUAL COMMITMENTS
Our future obligations for notes payable, equipment under capital leases, lines of credit, subordinated debentures, equipment and building operating leases and purchase and other contractual obligations for the next five years and thereafter include (dollars in thousands):

[See Chart Found in 10K]

We are parties to an agreement with GE Medical Systems for the maintenance and repair of the majority of our medical equipment for a fee based upon a percentage of net revenues, subject to minimum aggregate net revenue requirements. The agreement expires on October 31, 2005. The annual service fee is currently the higher of 3.74% of our net revenue (less provisions for bad debt) or approximately $4.7 million. The aggregate minimum net revenue ranges from $85.0 million to $125.0 million during the term of the agreement. For fiscal 2004 and 2005 the monthly service fees were 3.74% of net revenue with a minimum net revenue of $125.0 million. We believe this framework of basing service costs on usage is an effective and unique method for controlling our overall costs on a facility-by-facility basis.

CRITICAL ACCOUNTING ESTIMATES
Our discussion and analysis of financial condition and results of operations are based on our consolidated financial statements that were prepared in accordance with generally accepted accounting principles, or GAAP. Management makes estimates and assumptions when preparing financial statements. These estimates and assumptions affect various matters, including:

• Our reported amounts of assets and liabilities in our consolidated balance sheets at the dates of the financial statements;

• Our disclosure of contingent assets and liabilities at the dates of the financial statements; and

• Our reported amounts of net revenue and expenses in our consolidated statements of operations during the reporting periods.

These estimates involve judgments with respect to numerous factors that are difficult to predict and are beyond management's control. As a result, actual amounts could materially differ from these estimates.

The Securities and Exchange Commission, or SEC, defines critical accounting estimates as those that are both most important to the portrayal of a company's financial condition and results of operations and require management's most difficult, subjective or complex judgment, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. In Note 2 to our consolidated financial statements, we discuss our significant accounting policies, including those that do not require management to make difficult, subjective or complex judgments or estimates. The most significant areas involving management's judgments and estimates are described below.

REVENUE RECOGNITION
Revenue is recognized when diagnostic imaging services are rendered. Revenue is recorded net of contractual adjustments and other arrangements for providing services at less than established patient billing rates. We estimate contractual allowances based on the patient mix at each diagnostic imaging facility, the impact of managed care contract pricing and historical collection information. We operate 56 facilities, each of which has multiple managed care contracts and a different patient mix. We review the estimated contractual allowance rates for each diagnostic imaging facility on a monthly basis. We adjust the contractual allowance rates, as changes to the factors discussed above become known. Depending on the changes we make in the contractual allowance rates, net revenue may increase or decrease.

ACCOUNTS RECEIVABLE
Substantially all of our accounts receivable are due under fee-for-service contracts from third party payors, such as insurance companies and government-sponsored healthcare programs, or directly from patients. Services are generally provided pursuant to one-year contracts with healthcare providers or directly to patients. Receivables generally are collected within industry norms for third-party payors. We continuously monitor collections from our clients and maintain an allowance for bad debts based upon any specific payor collection issues that we have identified and our historical experience. For fiscal 2002, 2003 and 2004 our provision for bad debts as a percentage of net revenue was 5.1%, 3.6% and 2.8% respectively.

DEFERRED TAX ASSETS
We evaluate the realizability of the net deferred tax assets and assess the valuation allowance periodically. If future taxable income or other factors are not consistent with our expectations, an adjustment to our allowance for net deferred tax assets may be required. Even though we expect to utilize our net operating loss carry forwards in the future, the last three fiscal year losses and available evidence cause the valuation of our net deferred tax assets to be uncertain in the near term. As of October 31, 2004, we have fully allowed for our net deferred tax assets.

VALUATION OF GOODWILL AND LONG-LIVED ASSETS
Our net goodwill at October 31, 2004 was $23.1 million. Goodwill is recorded as a result of our acquisition of operating facilities. The operating facilities are grouped by region into reporting units. We evaluate goodwill, at a minimum, on an annual basis and whenever events and changes in circumstances suggest that the carrying amount may not be recoverable in accordance with Statement of Financial Accounting Standards, or SFAS, No. 142, "Goodwill and Other Intangible Assets." Impairment of goodwill is tested at the reporting unit level by comparing the reporting unit's carrying amount, including goodwill, to the fair value of the reporting unit. The fair values of the reporting units are estimated using a combination of the income or discounted cash flows approach and the market approach, which uses comparable market data. If the carrying . . .