UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ----------- FORM 10-K/A (Amendment No. 1) (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003 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) (203) 596-2236 Registrant's Telephone Number, Including Area Code: Securities registered pursuant to Section 12(b) of the Act: Title of Each Class Name of Each Exchange on Which Registered Common Stock, $.001 par value American Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None. 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K/A or any amendment to this Form 10-K/A. [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). [ ] Yes [X] No The aggregate market value of the registrant's Common Stock held by non-affiliates of the registrant (without admitting that any person whose shares are not included in such calculation is an affiliate) computed by reference to the closing market price as reported on the American Stock Exchange on June 30, 2003, the last business day of the registrant's most recently completed second fiscal quarter, was $4,920,389. The number of shares outstanding of the registrant's Common Stock, par value $.001 per share, as of March 1, 2004, was 30,386,061 shares. DOCUMENTS INCORPORATED BY REFERENCE Certain information required in Part III of this Annual Report on Form 10-K/A is incorporated herein by reference to the registrant's Proxy Statement for the 2004 Annual Meeting of Stockholders. EXPLANATORY NOTE THE PURPOSE OF THIS AMENDMENT NO. 1 (THE "AMENDMENT") TO THE ANNUAL REPORT ON FORM 10-K OF OPTICARE HEALTH SYSTEMS, INC. (THE "REGISTRANT") FOR THE YEAR ENDED DECEMBER 31, 2003 (THE "ORIGINAL FORM 10-K") IS TO REFLECT THE RESTATEMENT OF THE REGISTRANT'S CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2003 AND DECEMBER 31, 2002, AND TO REFILE ITEMS 6, 7 AND 9A OF PART II AND ITEM 15 OF PART IV INCORPORATING REVISED DISCLOSURE RELATED TO THE RESTATEMENT. THE RESTATEMENT IS DESCRIBED IN NOTE 2 TO THE RESTATED CONSOLIDATED FINANCIAL STATEMENTS ACCOMPANYING THIS AMENDMENT. EXCEPT FOR ITEMS 6, 7 AND 9A OF PART II AND ITEM 15 OF PART IV, NO OTHER INFORMATION INCLUDED IN THE ORIGINAL FORM 10-K IS AMENDED BY THIS AMENDMENT. OPTICARE HEALTH SYSTEMS, INC. FORM 10-K/A TABLE OF CONTENTS [FIX PAGE NUMBERS TO MATCH FINAL VERSION] PAGE PART II ITEM 6. SELECTED FINANCIAL DATA ..................................... 4 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS................ 5 ITEM 9A. CONTROLS AND PROCEDURES...................................... 23 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K ................. 24 SIGNATURES.............................................................. 31 3 ITEM 6. SELECTED FINANCIAL DATA The following selected historical consolidated financial data has been derived from audited historical financial statements and should be read in conjunction with our consolidated financial statements and the notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations. OptiCare in its present form is the result of mergers completed on August 13, 1999 among Saratoga Resources, Inc., PrimeVision Health, Inc. and OptiCare Eye Health Centers, Inc. For accounting purposes, PrimeVision was treated as the accounting acquirer and, therefore, the predecessor business for historical financial statement reporting purposes. During 2002, we sold the net assets of our retail optometry operations in North Carolina and accounted for the sale as a discontinued operation. Accordingly, historical amounts presented below have been restated to reflect discontinued operations treatment. FOR THE YEARS ENDED DECEMBER 31, ------------------------------------------------------------------ (in thousands, except per share data) 2003(1) 2002 2001 2000 1999(2) -------- ---- ---- ---- ----- STATEMENT OF OPERATIONS DATA: Total net revenues $125,702 $ 91,531 $ 94,082 $109,346 $ 66,944 Income (loss)(3)(5) $(12,353) $ 745 $ 2,980 $(14,171) $ (1,966) Weighted average shares outstanding (4): Basic 30,067 12,552 12,795 12,354 4,776 Diluted 30,067 51,172 13,214 12,354 4,776 Income (loss) from continuing operations per share available to common stockholders: Basic $(0.43) $ 0.35 $ 0.21 $(1.19) $ (0.12) Diluted $(0.43) $ 0.10 $ 0.21 $(1.19) $ (0.12) BALANCE SHEET DATA: Net assets of discontinued operations $ - $ - $ 9,494 $ 10,051 $ 10,647 Total current assets 17,654 12,904 20,583 14,913 21,345 Goodwill and other intangibles, net 20,374 21,869 22,050 23,161 25,207 Total assets 45,855 45,105 59,742 55,513 66,740 Total current liabilities as restated (6) 23,521 12,225 17,128 49,454 20,654 Total debt (including current portion) 12,603 19,486 34,393 34,058 42,956 Redeemable preferred stock 5,635 5,018 - - - Total stockholders' equity $ 14,412 $ 10,652 $ 6,982 $ 3,877 $ 5,274 (1) We acquired Wise Optical on February 7, 2003, which was accounted for as a purchase. Accordingly, the results of operations of Wise Optical are included in the historical results of operations since February 1, 2003, the deemed effective date of the acquisition for accounting purposes. (2) We acquired OptiCare Eye Health Centers, Inc. on August 13, 1999 and Cohen Systems, Inc. (now doing business as "CC Systems") on October 1, 1999, which were accounted for as purchases. Accordingly, the results of operations of OptiCare Eye Health Centers, Inc. and Cohen Systems, Inc. are included in the historical results of operations since September 1, 1999 and October 1, 1999, respectively, the deemed effective dates of the acquisitions for accounting purposes. (3) Includes the effect of goodwill amortization of $943, $943 and $605 in 2001, 2000 and 1999, respectively. The amortization of goodwill was discontinued in 2002 pursuant to Statement of Financial Accounting Standards (SFAS) No. 142. Also includes preferred stock dividends of $618, $531, and $600 in 2003, 2002 and 1999, respectively. 4 (4) The weighted averages of common shares outstanding in 1999 have been adjusted to reflect the conversion associated with the reverse merger with Saratoga in August 1999. (5) As a result of the Company's adoption of SFAS No. 145, the Company reclassified its previously reported gain from extinguishment of debt of approximately $8.8 million and related income tax expense of approximately $3.5 million in 2002 from an extraordinary item to continuing operations. (6) As restated, see Note 2 to the condensed consolidated financial statements included in Item 15. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and notes thereto which are included elsewhere in this Annual Report on Form 10-K/A. (See "Index to Financial Statements" beginning at page F-1.) 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. On February 7, 2003, we 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 deemed effective date of the acquisition for accounting purposes. The Company incurred a substantial net loss and experienced negative cash flows in 2003 that have continued into 2004, primarily due to substantial operating losses at Wise Optical. 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 from an operating structure that was built to support a higher sales volume. In late 2003, the Company 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. The Company reduced ongoing costs to better match the operations and has engaged consultants, who we believe will assist us in increasing sales and improving product margins at Wise Optical. However, if the losses at Wise Optical continue it could have a material adverse effect on our profitability and/or liquidity. On May 12, 2003, Palisade Concentrated Equity Partnership, L.P., our majority shareholder, and Linda Yimoyines, wife of Dean J. Yimoyines, M.D., our Chairman of the Board and Chief Executive Officer, each exchanged the entire amount of principal and interest due to them under our senior subordinated secured notes payable, totaling an aggregate of $16.2 million, for a total of 406,158 shares of Series C Preferred Stock. In the third and fourth quarters of 2003 and the first and second quarters of 2004, we failed our fixed charges ratio covenant under our revolving credit facility with CapitalSource Financial, LLC, ("Capital Source") but received waivers from CapitalSource for any non-compliance with this covenant through June 30, 2004. Due to our covenant failure in the third quarter of 2003 and anticipated cash constraints in December 2003 through February 2004, both of which are mainly due to operating losses at Wise Optical and seasonality in our business, on November 14, 2003, we amended our term loan and revolving credit facility. As part of the amendment, we received (i) an additional $0.3 million term loan, (ii) an extension of the maturity dates of our term loan and revolving credit facility to January 25, 2006, (iii) a waiver for non-compliance with the minimum fixed charge ratio covenant through March 31, 2004 and (iv) a $0.7 million temporary over-advance on our 5 revolving credit facility, which was fully repaid by March 1, 2004. We obtained a waiver and amendment to the term loan and revolving credit facility with CapitalSource on August 16, 2004. In connection with this waiver and amendment, we received a waiver from CapitalSource for any non-compliance with the minimum fixed charge ratio covenant as of March 31, 2004, April 30, 2004, May 31, 2004 and June 30, 2004. This 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, which is guaranteed by our largest stockholder, Palisade Concentrated Equity Partnership, L.P, (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 for the period October 31, 2004 to February 28, 2005 . 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%. On August 17, 2004, we paid CapitalSource $25 in financing fees in connection with this waiver and amendment.. Management believes it will comply with its future financial covenants beyond the date of the current waiver, however, if operating losses continue and we fail to comply with financial covenants in the future or otherwise default on our debt, our creditors could foreclose on our assets. 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. Our business is comprised of three reportable operating segments: (1) Managed Vision, (2) Consumer Vision, and (3) Distribution and Technology. The Distribution and Technology, was renamed the Distribution segment in May 2004 in connection with our decision to dispose of its Technology business. Our Managed Vision segment contracts with insurers, managed care plans and other third party payers to manage claims payment administration of eye health benefits for those contracting parties. Our Consumer Vision segment sells retail optical products to consumers and operates integrated eye health centers and surgical facilities in Connecticut where comprehensive eye care services are provided to patients. The Distribution segment provides products and services to eye care professionals (ophthalmologists, optometrists and opticians) through (i) Wise Optical, a distributor of contact and ophthalmic lenses and other eye care accessories and supplies and (ii) a Buying Group program, which provides group purchasing arrangements for optical and ophthalmic goods and supplies. In addition to these segments, we receive income from other non-core operations and transactions, including our health service organization (HSO) operation which receives fee income for providing certain support services to individual ophthalmology and optometry practices. While we continue to provide the required services to these practices, we are in the process of generally disengaging from a number of these operations. (See "Legal Proceedings --Health Services Organization Lawsuits") CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. Estimates are adjusted as new information becomes available. Actual results may differ from these estimates under different assumptions or conditions. For a detailed discussion on the application of these and other accounting policies, see Note 4 to the consolidated 6 financial statements. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. Services Revenue Through our affiliated professional corporation, OptiCare P.C., our Consumer Vision Division provides to consumers comprehensive eye care services, including medical and surgical treatment of eye diseases and disorders by ophthalmologists, and vision measuring and non-surgical treatments and correction services by optometrists. We charge a fee for providing the use of our ambulatory surgery center to professionals for surgical procedures. Our ophthalmic, optometric and ambulatory surgery center services are recorded at established rates, reduced by an estimate for contractual allowances. Contractual allowances arise due to the terms of certain reimbursement contracts with third-party payers that provide for payments to us at amounts different from our established rates. The contractual allowance represents the difference between the charges at established rates and estimated recoverable amounts and is recognized in the period the services are rendered. The contractual allowance recorded is estimated based on an analysis of historical collection experience in relation to amounts billed and other relevant information. Any differences between estimated contractual adjustments and actual final settlements under reimbursement contracts are recognized as adjustments to revenue in the period of final settlements. Historically, we have not had significant adjustments to this estimate. Medical Claims Expense Claims expense is recorded as provider services are rendered and includes an estimate for claims incurred but not reported. Reserves for estimated insurance losses are determined on a case by case basis for reported claims, and on estimates based on our experience for loss adjustment expenses and incurred but not reported claims. These liabilities give effect to trends in claims severity and other factors which may vary as the losses are ultimately settled. We believe that our estimates of the reserves for losses and loss adjustment expenses are reasonable; however, there is considerable variability inherent in the reserve estimates. These estimates are continually reviewed and, as adjustments to these liabilities become necessary, such adjustments are reflected in current operations in the period of the adjustment. Historically, we have not had significant adjustments to this estimate. Goodwill Goodwill, which arises from the purchase price exceeding the assigned value of net assets of acquired businesses, represents the value attributable to unidentifiable intangible elements being acquired. Of the total goodwill included on our consolidated balance sheet, approximately 61% is recorded in our Managed Vision segment, 25% in our Consumer Vision segment and 14% in our Distribution & Technology segment. On an annual basis, or as circumstances dictate, management reviews goodwill and evaluates events or other developments that may indicate impairment in the carrying value. The evaluation methodology for potential impairment is inherently complex, and involves significant management judgment in the use of estimates and assumptions. We use multiples of revenue and earnings before interest, taxes, depreciation and amortization of comparable entities to value the reporting unit being evaluated for goodwill impairment. We evaluate impairment using a two-step process. First, we compare the aggregate fair value of the reporting unit to its carrying amount, including goodwill. If the fair value exceeds the carrying amount, no impairment exists. If the carrying amount of the reporting unit exceeds the fair value, then we compare the implied fair value of the reporting unit's goodwill with its carrying amount. The implied fair value is determined by allocating the fair value of the reporting unit to all the assets and liabilities of that unit, as if the unit had been acquired in a business combination and the fair value of the unit was the purchase price. If the carrying amount of the goodwill exceeds the implied fair value, then goodwill impairment is recognized by writing the goodwill down to the implied fair value. In the third and fourth quarters of 2003, we recorded an impairment charge to goodwill as a result of a loss of a major customer in our Buying Group and poor operating performance in our Wise Optical reporting unit. Adverse changes in our business climate, revenues or profitability could require further reductions to the carrying value of our goodwill in future periods. 7 Events that may indicate goodwill impairment include significant or adverse changes in business or economic climate, an adverse action or assessment by a regulator, unanticipated competition, loss of key personnel, and the sale or expected sale/disposal of a reporting unit. Due to uncertain market conditions it is possible the financial information used to support our goodwill may change in the future, which could result in non-cash charges that would adversely affect our results of operations and financial condition. See note 11 to consolidated financial statements. Income Taxes We account for income taxes in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" which requires an asset and liability method of accounting for deferred income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis using enacted tax rates expected to apply to taxable income in the years the temporary differences are expected to reverse. Our determination of the likelihood that deferred tax assets can be realized is based on our examination of available evidence, which involves estimates and assumptions. We consider future market growth, forecasted earnings, future taxable income and known future events in determining the need for a valuation allowance. In the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to earnings in the period such determination is made. In the third quarter of 2003, we recorded a valuation reserve against our entire deferred tax assets due to historical operating losses. As we experience future profitability, we expect to reduce or eliminate the valuation reserve. See note 20 to consolidated financial statements. RESULTS OF OPERATIONS Year Ended December 31, 2003 Compared to Year Ended December 31, 2002 Managed Vision revenue. Managed Vision revenue represents fees received under our managed care contracts. Managed Vision revenue decreased to approximately $28.1 million for the year ended December 31, 2003, from approximately $29.4 million for the year ended December 31, 2002, a decrease of approximately $1.3 million or 4.5%. During the second quarter of 2003 the Texas state legislature made changes to its Medicaid program and as a result HMO Blue, with whom we maintained a Medicaid contract, withdrew from Texas' Medicaid program effective September 1, 2003. Therefore, our contract with HMO Blue terminated on September 1, 2003. This contract generated revenue of approximately $1.7 million in 2003 compared to approximately $2.5 million in 2002. In addition and also effective September 1, 2003, the Texas state legislature decided to no longer fund a vision benefit in its Children's Health Insurance Program or provide vision hardware benefits to those over the age of 21. We maintained a number of contracts through this program that reduced benefits and/or terminated on September 1, 2003 and these contracts generated revenues of approximately $2.0 million in 2003 and approximately $2.2 million in 2002. While this could become a trend in other states, we do not expect it to have a material impact on future revenue since we do not have a significant number of similar contracts in other states. Other decreased revenue of approximately $2.0 million was primarily from contracts not renewed in 2003, and was partially offset by increased revenue of approximately $1.5 million from new contracts and growth in existing contracts. CIGNA experienced a decline in membership in January 2004, which translates into an approximate $2.0 million decline in our annual revenue, however, new contracts with different payors became effective March 1, 2004, which will offset this decrease in revenue. We expect future revenue to increase due to new contracts related to our to direct-to-employer initiative. Product sales revenue. Product sales primarily include the sale of optical products through Wise Optical, our Buying Group and our Consumer Vision segment. Product sales revenue increased to approximately $72.8 million for the year ended December 31, 2003, from approximately $39.4 million for the year ended December 31, 2002, an increase of approximately $33.4 million or 84.8%. This increase is primarily due to our acquisition of Wise Optical on February 7, 2003, which generated product sales revenue of approximately $41.9 million and an approximate $0.5 million increase in consumer vision product sales, primarily from an increase in purchasing volume as a result of sales incentives. This increase in revenue is partially offset by an approximate $9.0 million decrease in Buying Group 8 revenue, due to a decrease in sales volume. The decrease in Buying Group sales volume is primarily due to the loss of the business of Optometric Eye Care Centers, P.A. and its franchise affiliates and, to a lesser extent, consolidation in the eye care industry whereby smaller independent eye care businesses are being replaced by larger eye care chains that purchase directly from vendors. We expect consolidation in this market to continue and potentially further reduce the Buying Group's market share revenue, however, we do not expect this trend to have a material impact on our overall profitability due to the low margins inherent in this business. Other services revenue. Other services revenue includes revenue earned from providing eye care services in our Consumer Vision segment, software services in our Distribution and Technology segment and HSO services. Services revenue increased to approximately $22.0 million for the year ended December 31, 2003, from approximately $20.4 million for the year ended December 31, 2002, an increase of approximately $1.6 million or 8.3%. This increase includes an approximate $1.5 million increase in Consumer Vision services revenue due to increased services volume in the optometry and surgical areas due to increased doctor coverage and an approximate $0.9 million increase in software services revenue due to an increase in sales volume due to improved management focus. Product revenue for the Technology division is immaterial and therefore included in service revenue. These increases were offset by an approximate $0.8 million decrease in fees collected under our HSO agreements primarily due to disputes with certain physician practices, which are parties to these agreements, and due to HSO settlements which cancelled these agreements for the future. We continue to be in litigation with several of these practices and intend to continue to pursue settlement of these matters in the future. While we expect future HSO revenue to decline, we believe this will be more than off set by growth in Consumer Vision. Other income. Other income represents non-recurring settlements on health service organization contracts. Other income increased to approximately $2.7 million for the year ended December 31, 2003 from approximately $2.3 million for the year ended December 31, 2002. Medical claims expense. Medical claims expense decreased to $22.0 million for the year ended December 31, 2003, from approximately $22.3 million for the year ended December 31, 2002, a decrease of approximately $0.3 million. The medical claims expense loss ratio (MLR) representing medical claims expense as a percentage of Managed Vision revenue increased to 78.3% in 2003 from 75.9% in 2002. The MLR was lower in 2002 primarily due to a favorable adjustment to the reserve of approximately $0.6 million in 2002 from a contract settlement. Excluding this adjustment, MLR for 2002 would have been 77.9% compared to 78.3% in 2003. In addition, the MLR in 2003 was negatively impacted by the recent change in the Texas state legislature, which no longer funds a vision benefit in its Children's Health Insurance Program and vision hardware to Medicaid recipients over the age of 21. As a result, we experienced an increase in claims as utilization increased prior to the elimination of the benefit. Cost of product sales. Cost of product sales increased to approximately $56.3 million for the year ended December 31, 2003, from approximately $31.1 million for the year ended December 31, 2003, an increase of approximately $25.2 million or 81.1%. This increase is primarily due to a $34.0 million increase in product costs related to the increase in sales from the acquisition of Wise Optical in February 2003. The increase in product costs is partially offset by an approximate $8.5 million decrease in product costs associated with our Buying Group due to a decrease in sales volume and an approximate $0.3 million decrease in product costs in our Consumer Vision business primarily as a result of a shift in product mix to higher margin products as a result of sales incentives, a shift that we expect will continue into the future. Cost of services. Cost of services increased to approximately $9.0 million for the year ended December 31, 2002, compared to approximately $8.2 million for the year ended December 31, 2002, an increase of approximately $0.8 million or 10.7%. Of this increase approximately $0.5 million is due to the increase in software sales volume and $0.3 million is due to the increase in Consumer Vision services. Selling, general and administrative expenses. Selling, general and administrative expenses increased to approximately $38.2 million for the year ended December 31, 2003, from approximately $26.3 million for the year ended December 31, 2002, an increase of approximately $11.9 million. Of this increase, approximately $10.9 million represents operating expenses of Wise Optical and includes approximately $1.0 million of Wise Optical integration related costs consisting primarily of severance, stay bonuses, legal, consulting and other professional fees. The remaining increase is primarily attributed to costs we incurred as part of our direct-to-employer initiative in the Managed Vision segment, including legal, consulting, compensation costs for a new sales force and other 9 professional fees. While we expect most of these cost to continue into the future, they will be offset by direct-to-employer sales revenue. Goodwill impairment charge. For the year ended December 31, 2003, we recorded a non-cash goodwill impairment loss of approximately $1.6 million in our Distribution and Technology segment due to decreases in Buying Group sales and significant operating losses at Wise Optical. Interest expense. Interest expense decreased to approximately $2.1 million for the year ended December 31, 2003 from approximately $3.0 million for the year ended December 31, 2002, a decrease of $0.9 million. This decrease in interest expense is primarily due to the decrease in the average outstanding debt balance, primarily due to the conversion of debt to preferred stock in May 2003. Gain (loss) from early extinguishment of debt. The approximate $1.9 million loss from early extinguishment of debt for the year ended December 31, 2003, primarily represents the write-off of deferred debt issuance costs and debt discount associated with the exchange of approximately $16.2 million of debt for Series C Preferred Stock, which occurred on May 12, 2003 and the amendment of our term loan with CapitalSource Finance, LLC ("CapitalSource")on November 13, 2003. The approximate $8.8 million gain on extinguishment of debt for the year ended December 31, 2002 was the result of our capital restructuring in January 2002. The 2002 gain is comprised of approximately $10.0 million of forgiveness of principal and interest by Bank Austria, our former senior secured lender, and was partially offset by the write-off of $1.2 million of related unamortized deferred financing fees and debt discount. Income tax expense (benefit). For the year ended December 31, 2003, we recorded approximately $4.9 million of income tax expense, which includes approximately $7.6 million of tax expense to establish a full valuation allowance against our deferred tax assets and is partially offset by an approximate $2.7 million income tax benefit on our loss from continuing operations. The valuation allowance was established based on the weight of historic available evidence, that it is more likely than not that the deferred tax assets will not be realized. The tax expense for the year ended December 31, 2002 of approximately $2.5 million was primarily due to approximately $3.5 million of tax expense associated with the approximate $8.8 million gain on extinguishment of debt, partially offset by an approximate $1.0 million of tax benefit on other operating losses. Discontinued operations. In May 2002, our Board of Directors approved our plan to dispose of the net assets used in the retail optical and optometry practice locations we operated in North Carolina. On August 12, 2002, we consummated the sale of those assets, which resulted in a $4.4 million loss on disposal in 2002, including income tax expense of $0.3 million. We reported $0.3 million of income from discontinued operations, net of tax, for the year ended December 31, 2002, representing income from this operation prior to disposal. Year Ended December 31, 2002 Compared to Year Ended December 31, 2001 Managed Vision revenue. Managed Vision revenue represents fees received under our managed care contracts. Managed Vision revenue increased to approximately $29.4 million for the year ended December 31, 2002, from approximately $29.0 million for the year ended December 31, 2001, an increase of approximately $0.4 million or 1.5%. Managed Vision revenue increased due to new contracts and growth within existing contracts, partially offset by a decrease in revenue largely due to the non-renewal of three contracts. Product sales revenue. Product sales primarily include the retail sale of optical products in our Consumer Vision segment and the sale of optical products through our Buying Group. Product sales revenue decreased to approximately $39.4 million for the year ended December 31, 2002, from approximately $44.4 million for the year ended December 31, 2001, a decrease of approximately $5.0 million or 11.1%. Of this decrease, approximately $4.5 million represents a decrease in Buying Group revenue and approximately $0.5 million represents a decrease in retail optical revenue resulting from a decrease in purchasing volume. The decrease in Buying Group volume is primarily due to consolidation in the eye care industry whereby smaller independent eye care businesses are being replaced by larger eye care chains that purchase directly from vendors. 10 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. Services revenue decreased to approximately $20.4 million for the year ended December 31, 2002, from approximately $20.7 million for the year ended December 31, 2001, a decrease of approximately $0.3 million or 1.9%. This decrease includes an approximate $1.6 million decrease in health service organization revenue, which was offset by an approximate $0.8 million increase in Consumer Vision services revenue and a $0.5 million increase in software services revenue. The approximate $0.8 million increase in Consumer Vision services was due to increased services volume in the optometry and ophthalmology areas. The $0.5 million increase in software services revenue was primarily due to an increase in sales volume. Other income. Other income for the year ended December 31, 2002 of approximately $2.3 million represents non-recurring settlements on health service organization contracts. We had no other income in 2001. Medical claims expense. Medical claims expense decreased to approximately $22.3 million for the year ended December 31, 2002, from approximately $23.0 million for the year ended December 31, 2001, a decrease of approximately $0.7 million. This decrease was primarily due to an approximate $0.6 million favorable adjustment to the reserve in 2002. The MLR improved to 75.9% in 2002, from 79.2% in 2001, primarily due to the favorable adjustment of approximately $0.6 million in 2002. Excluding this adjustment, MLR for 2002 would have been 77.9% compared to 79.2% for 2001. Cost of product sales. Cost of product sales decreased to approximately $31.1 million for the year ended December 31, 2002, from approximately $35.5 million for the year ended December 31, 2001, a decrease of approximately $4.4 million or 12.6%. This decrease in cost of sales is due to decreases in sales volume in our Buying Group and retail optometry operations. Cost of services. Cost of services decreased to approximately $8.2 million for the year ended December 31, 2002, compared to approximately $8.8 million for the year ended December 31, 2001, a decrease of approximately $0.6 million or 7.7%. This decrease was comprised of an approximate $0.9 million decrease in cost of services associated with Consumer Vision services as a result of cost containment initiatives, partially offset by an approximate $0.3 million increase in technology services expense associated with an increase in sales. Selling, general and administrative expenses. Selling, general and administrative expenses increased to approximately $26.3 million for the year ended December 31, 2002, from approximately $26.2 million for the year ended December 31, 2001, an increase of $0.1 million. This increase includes approximately $1.0 million of increased professional fees, principally legal and consulting, and $0.2 million of increased corporate overhead, which primarily relates to increased compensation expense associated with the addition of executive and managerial personnel. These increases were partially offset by a $1.0 million of non-recurring costs, primarily legal and workout costs, in 2001 associated with our capital restructuring. (Gain) loss from early extinguishment of debt. The approximate $8.8 million gain on extinguishment of debt for the year ended December 31, 2002 was the result of our capital restructuring in January 2002. The 2002 gain is comprised of approximately $10.0 million of forgiveness of principal and interest by Bank Austria, our former senior secured lender, and was partially offset by the write-off of $1.2 million of related unamortized deferred financing fees and debt discount. Depreciation. Depreciation expense was approximately $1.9 million for the year ended December 31, 2002 compared to approximately $1.8 million for the year ended December 31, 2001. The approximate $0.1 million increase represents depreciation expense on new fixed assets purchased during the year. Amortization. Amortization expense decreased to approximately $0.2 million for the year ended December 31, 2002 from approximately $1.1 million for the year ended December 31, 2001 due to the discontinuation of the amortization of goodwill effective January 1, 2002 in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets." Interest expense. Interest expense remained unchanged at approximately $3.0 million for each of the years ended December 31, 2002 and 2001. Although we reduced our outstanding indebtedness during 2002, interest expense associated with the decrease in debt was offset by an increase in the interest rate charged on our restructured debt. Income tax benefit. We reported income tax expense of $2.6 million for the year ended December 31, 2002 and approximately $8.0 million for the year ended December 31, 2001. The 2002 tax expense was primarily due to approximately $3.5 million of tax expense associated with the approximately $8.8 million gain on extinguishment of 11 debt, partially offset by approximately $0.9 million of tax benefit on other operating losses. The tax benefit in 2001 was primarily due to the reversal of the valuation allowance against our deferred tax assets based on our expected ability to utilize our net operating loss carryforwards in the future. Discontinued operations. In May 2002, our Board of Directors approved our plan to dispose of the net assets used in the retail optical and optometry practice locations we operated in North Carolina. On August 12, 2002, we consummated the sale of those assets, which resulted in an approximate $4.4 million loss on disposal in 2002, including income tax expense of approximately $0.3 million. We reported approximately $0.3 million of income from discontinued operations, net of tax, for each of the years ended December 31, 2002 and 2001, representing income from this operation prior to disposal. LIQUIDITY AND CAPITAL RESOURCES Uses of Liquidity. The following table summarizes our significant contractual obligations (in thousands) at December 31, 2003 that impact our liquidity. 12 CONTRACTUAL OBLIGATIONS 2004 2005 2006 2007 2008 THERE-AFTER TOTAL -------------------- --------- ----------- ----------- ----------- ----------- ----------- ------------ Debt (1) $10,818 $ 300 $ 1,475 $ $ - $ - $ 12,593 Operating leases 2,620 2,505 2,277 2,067 1,853 3,248 14,570 Capital leases 10 - - - - - 10 --------- ----------- ----------- ----------- ----------- ----------- ------------ Total $13,448 $ 2,805 $ 3,752 $ 2,067 $1,853 $3,248 $ 27,173 ========= =========== =========== =========== =========== =========== ============ (1) Interest expense on CapitalSource debt, excluding amortization of deferred finance charges, was $1,027 and $891 for the years ended December 31, 2003 and 2002, respectively. Our debt is explained in detail in Note 11 to the consolidated financial statements. Operating leases and capital leases are explained in detail in Note 14 to the consolidated financial statements. Throughout 2004, we plan to continue making substantial investments in our business. In that regard, we foresee the following as significant uses of liquidity in 2004: personnel costs, interest and principal payments of approximately $1.6 million to be made our principal lender, CapitalSource and capital expenditures of approximately $1.0 million. We also may make investments in future acquisitions of complementary businesses or technologies. The amounts and timing of our actual expenditures will depend upon numerous factors, including our investments in technology, the amount of cash generated by our operations and the amount and extent of our acquisitions. Actual expenditures may vary substantially from our estimates. Sources of Liquidity. Our primary sources of liquidity have been cash flows generated from operations in our Managed Vision and Consumer Vision segments and borrowings under our term loan and revolving credit facility with CapitalSource. We believe the combination of the above and the Company's management initiatives, as discussed in Note 3 to the consolidated financial statements, will provide sufficient liquidity to meet the Company's capital needs. As discussed below, we have failed to comply with the minimum fixed charge ratio covenant under our term loan and revolving credit facility with CapitalSource during 2003 and the first and second quarters of 2004, for which we have received waivers from CapitalSource. If we fail to comply with our financial covenants with CapitalSource we may not be able to obtain additional funds from CapitalSource and the term loan and revolving credit facility could become immediately due and payable, which could have a material adverse effect on our fiancial position. The following table sets forth a year-over-year comparison of the components of our liquidity and capital resources for the years ended December 31, 2003 and 2002: (In millions) 2003 2002 $ CHANGE ---- ---- -------- Cash and cash equivalents $ 1.7 $ 3.1 $ 1.4 Cash (used in) provided by: Operating activities (2.6) (0.2) (2.4) Investing activities (6.7) 2.4 (9.1) Financing activities 8.0 (1.7) 9.7 Net cash used in operating activities in 2003 included a net loss from continuing operations of approximately $12.4 million, which was offset by approximately $11.5 million of non-cash charges. The remaining $1.7 million of cash used in operating activities was a net decrease in working capital, primarily due to a reduction in accounts payable. Net cash used in operating activities for the year ended December 31, 2002 primarily included income from continuing operations and cash provided by discontinued operations, which were offset by a reduction in accounts payable and accrued expenses as a result of our improved liquidity after our debt restructuring in January 2002. 13 Net cash used in investing activities was approximately $6.9 million for the year ended December 31, 2003 and included approximately $6.2 million of cash used to purchase the assets of Wise Optical in February 2003 and approximately $0.9 million of capital expenditures. Net cash provided by investing activities in 2002 consisted principally of approximately $3.9 million in net cash received from the sale of discontinued operations and approximately $0.7 million received from notes receivable payments, which were partially offset by approximately $1.4 million paid to reacquire certain notes receivable and contractual rights as part of our debt restructuring in 2002 and approximately $0.8 million paid for the purchase of fixed assets. Net cash provided by financing activities was approximately $8.0 million for the year ended December 31, 2003 and was primarily the result of an approximate $8.8 million net increase in borrowings under our revolving credit facility, which was primarily used to fund the purchase of Wise Optical and offset Wise Optical's operating losses during the year. Net cash used in financing activities in 2002 of approximately $1.7 million resulted primarily from our debt and equity restructure in January 2002 and included principal payments on long-term debt of approximately $25.1 million, a net decrease in our revolving credit facility of approximately $4.9 million and financing costs of approximately $1.5 million, which were partially offset by approximately $27.5 million from the issuance of debt and preferred stock and approximately $2.5 million in proceeds from the exercise of stock warrants. The CapitalSource Loan and Security Agreement As of December 31, 2003, we had borrowings of $2.1 million outstanding under our term loan with CapitalSource, $10.4 million of advances outstanding under our revolving credit facility (including a $0.7 million temporary over-advance) with CapitalSource and $0.5 million of additional availability under our revolving credit facility. As of February 29, 2004, we had repaid the $0.7 million over-advance and had $9.6 million of advances outstanding under our revolving credit facility with CapitalSource and $1.3 million of additional availability. In January 2002, as part of a debt and equity restructuring, we entered into a credit facility with CapitalSource consisting of a $3.0 million term loan and a $10.0 million revolving credit facility. In February 2003, in connection with our acquisition of Wise Optical, the revolving credit facility was amended to $15.0 million. 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. We did not meet our minimum fixed charge ratio covenant in the third and fourth quarter of 2003, primarily due to operating losses incurred at Wise Optical. However, on November 14, 2003 we entered into an amendment of the terms of our term loan and credit facility with CapitalSource which, among other things, (i) increased our term loan by $0.3 million and extended the maturity date of the term loan from January 25, 2004 to January 25, 2006, (ii) extended the maturity date of our revolving credit facility from January 25, 2005 to January 25, 2006, (iii) permanently increased the advance rate on eligible receivables of Wise Optical from 80% to 85%, (iv) temporarily increased the advance rate on eligible inventory of Wise Optical from 50% to 55% through March 31, 2004, (v) provided access to a $0.7 million temporary over-advance bearing interest at prime plus 5 1/2%, which was repaid by March 1, 2004, and was guaranteed by Palisade Concentrated Equity Partnership, L.P., (vi) through March 31, 2004, waived our non-compliance with the minimum fixed charge ratio covenant, and (vii) changed our net worth covenant from ($27) million to tangible net worth of ($10) million. In connection with the foregoing amendment, we paid CapitalSource $80,000 in financing fees. The amendment also included an additional $150,000 termination fee if we terminate the revolving credit facility prior to December 31, 2004. Additionally, if we terminate the revolving credit facility pursuant to a refinancing with another commercial financial institution, we must pay CapitalSource, in lieu of the termination fee, a yield maintenance amount equal to the difference between (i) the all-in effective yield which could be earned on the revolving balance through January 25, 2006, 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. 14 We did not meet our fixed charge ratio covenant in January and February 2004, however we expected to meet all covenants in March 2004. Accordingly, on March 29, 2004 we entered into the Second Amended and Restated Revolving Credit, Term Loan and Security Agreement which incorporates all of the changes embodied in the above amendments and: (i) confirmed that the temporary over-advance was repaid as of February 29, 2004 (ii) changed the expiration date of the waiver of our fixed ratio covenant from March 31, 2004 to February 29, 2004 and (iii) reduced the tangible net worth covenant from $(10) million to $(2) million. In connection with the third amendment, we paid $25,000 to CapitalSource in financing fees. As of March 1, 2004, the advance rate under our revolving credit facility was 85% of all eligible accounts receivable and 55% of all eligible inventory. We are required to make monthly principal payments of $25,000 on the term loan with the balance due at maturity. 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 5.75%). 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. 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, which is guaranteed by our largest stockholder, Palisade Concentrated Equity Partnership, L.P, (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 for the period October 31, 2004 to February 28, 2005. 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. On August 17, 2004, we paid 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 the 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. 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, 15 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 the mathematical and fundamental errors in accounting and reconciliation for inventory 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 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 note outstanding. The agreement also contains certain subjective acceleration clauses. Emerging Issues Task Force 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 current liabilities. In accordance with this pronouncement, we classified our revolving credit facility as a current liability in the amount of $9,694,000 and $1,557,000 at December 31, 2003 and December 31, 2002, respectively. 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 September 2003, we began implementing strategies and operational changes designed to improve the operations of Wise Optical. These efforts include developing our sales force, improving customer service, enhancing productivity, eliminating positions and streamlining our warehouse and distribution processes. We expect these changes will lead to increased sales, improved gross margins and reduced operating costs at Wise Optical. In addition, in 2003 in our Managed Vision segment, we 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 type accounts. During 2003 we developed the sales force and infrastructure necessary to build our direct-to-employer business and expect increased and profitability as a result of this product shift. We experienced significant improvements in revenue and profitability in our Consumer Vision segment during 2003, largely from growth in existing store sales and enhanced margins as a result of sales incentives, which we expect to continue in 2004. In May 2004, management made the decision to dispose of our Technology operations, CC Systems. In June 2004 we recorded a loss on disposal of $580. 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. We believe that our cash flow from operations, borrowings under our amended credit facility with CapitalSource and operating and capital lease financing will provide us with sufficient funds to finance our operations for the next 12 months Moreover, we believe that we will be able to comply with our financial covenants under our amended credit facility with CapitalSource. However, if we incur additional operating losses and we continue to fail to comply 16 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. Working Capital Constraint and Contingencies Our Managed Vision segment maintains $1,150,000 of restricted investments in the form of certificates of deposit, primarily related to the operation of our South Carolina Captive Insurance Company and our Texas HMO, thereby resulting in a restriction upon working capital. Of this amount, $900,000 is held as collateral for letters of credit. In November 2003, the Texas Commissioner of Insurance reduced the required minimum net worth for our Texas HMO subsidiary from $1,000,000 to $500,000, which has a positive impact on our liquidity. Seasonality Our revenues are generally affected by seasonal fluctuations in the Consumer Vision and Distribution and Technology segments, which is now known as the Distribution segment. 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, since we retain certain fixed costs related to staffing and facilities during these periods, our cash flows can be negatively affected. IMPACT OF INFLATION AND CHANGING PRICES Our revenue is subject to pre-determined Medicare reimbursement rates that, for certain products and services, have decreased over the past three years. Decreases in Medicare reimbursement rates could have an adverse effect on our results of operations if we cannot offset these reductions through increases in revenues or decreases in operating costs. To some degree, prices for health care services and products are set based upon Medicare reimbursement rates, so that our non-Medicare business is also affected by changes in Medicare reimbursement rates. We believe that inflation has not had a material effect on our revenues during 2003, 2002 or 2001. The Conversion of Our Senior Subordinated Secured Loans Into Series C Preferred Stock In January 2002, Palisade Concentrated Equity Partnership, L.P. and Linda Yimoyines, wife of Dean Yimoyines, our Chairman and Chief Executive Officer made subordinated secured loans to us in the amount of $13.9 million and $0.1 million, respectively. The subordinated secured loans were evidenced by senior subordinated secured notes that ranked pari passu with each other. The notes were subordinated to our indebtedness to CapitalSource and were secured by second-priority security interests in substantially all of our assets. Principal was due on January 25, 2012 and interest was payable quarterly at the rate of 11.5%. In the first and second years, we had the right to defer 100% and 50% respectively, of interest to maturity by increasing the principal amount of the note by the amount of interest so deferred. On May 12, 2003, Palisade and Ms. Yimoyines exchanged the entire amount of principal and interest due to them under the senior secured loans, totaling an aggregate of approximately $16.2 million, for a total of 406,158 shares of Series C Preferred Stock, of which 403,256 shares were issued to Palisade and 2,902 shares were issued to Linda Yimoyines. The aggregate principal and interest was exchanged at a rate equal to $.80 per share, the agreed upon value of our common stock on May 12, 2003, divided by 50 (or $40.00 per share). The Series C 17 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, at the holder's option, convertible into 50 shares of common stock and has the same dividend rights, on an as converted basis, as our common stock. The Series B Preferred Stock As of December 31, 2003, 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, 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, at the holder's option, immediately 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 increases at a rate of 12.5% per year compounded annually. Each share of Series B Preferred Stock must be redeemed in full by the Company on December 31, 2008, at a price equal to the greater of (i) the aggregate adjusted redemption value of the Series B Preferred Stock ($1.40 per share) plus accrued but unpaid dividends or (ii) the amount the preferred stockholders would be entitled to receive if the Series B Preferred Stock plus accrued dividends were converted at that time into common stock and the Company were to liquidate and distribute all of its assets to its common stockholders. The Series B Preferred Stock accrues dividends at an annual rate of 12.5%. As of December 31, 2003, cumulative accrued and unpaid dividends on the Series B Preferred Stock totaled $1.2 million. If our assets are insufficient to pay the full amount payable to the holders of the Series B Preferred Stock with respect to dividends, redemption rights or liquidation preferences, then such holders will share ratably in the distribution of assets. SIGNIFICANT RELATED PARTY TRANSACTIONS We maintain a substantial number of real estate leases with various terms with related parties for properties located in Connecticut and Florida. Generally, the leases are for property that is used for executive offices and for the practice of ophthalmology, optometry, sale of eyeglasses or other operating and administrative functions. We believe that these leases reflect the fair market value and contain customary terms for leased commercial real estate in the geographic area where they are located. In January 2002, we entered into a $14 million loan agreement with Palisade and Linda Yimoyines and issued 3.2 million shares of Series B Preferred Stock and warrants to purchase 17.5 million shares of our common stock to them as part of our debt restructure. (See "--Liquidity and Capital Resources -- The Conversion of our Senior Subordinated Secured Loans into Series C Preferred Stock") On May 12, 2003, Palisade and Ms. Yimoyines exchanged the entire amount of principal and interest due to them under the aforementioned loan agreement, totaling an aggregate of approximately $16.2 million, for a total of 406,158 shares of Series C Preferred Stock. (See "--Liquidity and Capital Resources -- The Conversion of our Senior Subordinated Secured Loans into Series C Preferred Stock") We have an unsecured promissory note payable to a former officer of the Company related to an amount owed in connection with our purchase of Cohen Systems (now "CC Systems") in 1999. The note, which accrues interest at 7.50% and matures on December 1, 2004 had an outstanding balance of approximately $106,000 and $204,000 at December 31, 2003 and 2002, respectively. RECENT ACCOUNTING PRONOUNCEMENTS In November 2002, Financial Accounting Standards Board ("FASB") Interpretation ("FIN") No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" was issued. The interpretation provides guidance on the guarantor's accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others. The Company adopted the disclosure requirements of the interpretation as of December 31, 2002. Effective January 1, 2003, additional provisions of FIN No. 45 became effective and were adopted by the Company. The accounting guidelines are applicable to guarantees issued after December 31, 2002 and require that the Company record a liability for the fair value of such guarantees in the balance sheet. The adoption of FIN No. 45 did not have a material impact on the Company's financial position or results of operations. Effective January 1, 2003, the Company adopted SFAS No. 143, "Accounting For Asset Retirement Obligations". This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The adoption of this statement did not have a material impact on the Company's financial position or results of operations. Effective January 1, 2003, the Company adopted SFAS No. 145, "Rescission of FASB Statements 4, 44 and 64, Amendment of FASB Statement 13, and Technical Corrections". SFAS No. 145 rescinds the provisions of SFAS No. 4 that requires companies to classify certain gains and losses from debt extinguishments as extraordinary items, eliminates the provisions of SFAS No. 44 regarding transition to the Motor Carrier Act of 1980 and amends the provisions of SFAS No. 13 to require that certain lease modifications be treated as sale leaseback transactions. The provisions of SFAS No. 145 related to classification of debt extinguishment are effective for fiscal years beginning after May 15, 2002. As a result of the Company's adoption of SFAS No. 145, the Company reclassified its previously reported gain from extinguishment of debt of approximately $8.8 million and related income tax expense of approximately $3.5 million in 2002 from an extraordinary item to continuing operations. Effective January 1, 2003, the Company adopted SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" and nullified EITF Issue No. 94-3. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, whereas EITF No 94-3 had recognized the liability at the commitment date of an exit plan. There was no effect on the Company's financial statements as a result of such adoption. Effective January 1, 2003, the Company adopted SFAS No. 148, "Accounting for Stock-Based Compensation--Transition and Disclosure--an amendment of FASB Statement No. 123." This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. This statement also amends the disclosure requirements of SFAS No. 123 and Accounting Principles Board Opinion ("APB") No. 28, "Interim Financial Reporting," to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company elected to adopt the disclosure only provisions of SFAS No. 148 and will continue to follow APB Opinion No. 25 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. For disclosure regarding stock options had compensation cost been determined in accordance with SFAS No. 123, see Stock Based Compensation above. In January 2003, the FASB issued Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities." FIN 46 requires an investor with a majority of the variable interests in a variable interest entity to consolidate the entity and also requires majority and significant variable interest investors to provide certain disclosures. A variable interest entity is an entity in which the equity investors do not have a controlling interest or the equity investment at risk is insufficient to finance the entity's activities without receiving additional subordinated financial support from the other parties. The consolidation provisions of this interpretation are required immediately for all variable interest entities created after January 31, 2003, and the Company's adoption of these provisions did not have a material effect on its financial position or results of operations. For variable interest entities in existence prior to January 31, 2003, the consolidation provisions of FIN 46 are effective December 31, 2003 and did not have a material effect on the Company's financial position or results of operations. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments. This statement is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of this statement did not have a material impact on the Company's financial position or results of operations. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Most of the guidance in SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of SFAS No. 150 did not have a material impact on the Company's financial position or results of operations. 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 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, EITF Issue 03-6 addresses other forms of participating securities, including options, warrants, forwards and other contracts to issue an entity's common stock, with the exception of stock-based compensation (unvested options and restricted stock) subject to the provisions of Opinion 25 and SFAS No. 123, EITF Issues 03-6 is effective for reporting periods beginning after March 31, 2004 and should be be applied by restating previously reported earnings per share. The adoption of EITF Issue 03-6 is not expected to have a material impact on the Company's consolidated financial statements. 18 FORWARD-LOOKING INFORMATION AND RISK FACTORS The statements in this Annual Report on Form 10-K/A 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 27A of the Securities Exchange Act of 1934. 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 those relating to: o Our opinion that with respect to lawsuits incidental to our current and former operations, 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 our financial position or results of operations; o Our belief that recent strategies implemented at Wise Optical will lead to increased sales, improved gross margins and reduced operating costs. o Our belief that our new direct-to-employer product will lead to increased revenue and gross margins in our Managed Vision segment. o The expectation that the consolidation in the eye care industry will continue and could further reduce our Buying Group's market share and revenue, and that we do not expect this trend to have a material impact on our overall profitability; and o Our belief that cash from operations, borrowings under our amended credit facility, and operating and capital lease financings will provide sufficient funds to finance operations for the next 12 months. 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: WE MAY FAIL FINANCIAL COVENANTS IN THE FUTURE In the third and fourth quarters of 2003 and the first and second quarters of 2004, we failed our fixed charges ratio covenant under our revolving credit facility with CapitalSource, but received waivers from CapitalSource for any non-compliance with the minimum fixed charge ratio covenant through June 30, 2004. If we fail a financial covenant in the future (beyond the date of our current waiver) or otherwise default on our debt, our creditors could foreclose on our assets. IF WE DEFAULT ON OUR DEBT TO CAPITALSOURCE FINANCE, LLC, IT COULD FORECLOSE ON OUR ASSETS. Our outstanding indebtedness to CapitalSource under its term loan and revolving credit facility as of June 1, 2004 was approximately $9.2 million. Substantially all of OptiCare's assets are pledged to secure this indebtedness. If OptiCare defaults on the financial covenants in its credit facility, CapitalSource could foreclose on its security interest in our assets, which would have a material adverse effect on our business, financial condition and results of operations. CHANGES IN THE REGULATORY ENVIRONMENT APPLICABLE TO OUR BUSINESS, INCLUDING HEALTH-CARE COST CONTAINMENT EFFORTS BY MEDICARE, MEDICAID AND OTHER THIRD-PARTY PAYERS MAY ADVERSELY AFFECT OUR PROFITS. The health care industry has experienced a trend toward cost containment as government and private third-party payors seek to impose lower reimbursement and utilization rates and negotiate reduced payment schedules with service providers. Our revenue is subject to pre-determined Medicare reimbursement rates for certain products and services, and decreases in Medicare reimbursement rates could have an adverse effect on our results of operations if we cannot offset these reductions through increases in revenues or decreases in operating costs. To some degree, prices for health care services and products are driven by Medicare reimbursement rates, so that 19 our non-Medicare business is also affected by changes in Medicare reimbursement rates. In addition, federal and state governments are currently considering various types of health care initiatives and comprehensive revisions to the health care and health insurance systems. Some of the proposals under consideration, or others that may be introduced, could, if adopted, have a material adverse effect on our business, financial condition and results of operations. RISKS RELATED TO THE EYE CARE INDUSTRY, INCLUDING THE COST AND AVAILABILITY OF MEDICAL MALPRACTICE INSURANCE, AND POSSIBLE ADVERSE LONG-TERM EXPERIENCE WITH LASER AND OTHER SURGICAL VISION CORRECTION COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The provision of eye care services entails the potentially significant risk of physical injury to patients and an inherent risk of potential malpractice, product liability and other similar claims. Our insurance may not be adequate to satisfy claims or protect us and our affiliated eye care providers, and this coverage may not continue to be available at acceptable costs. A partially or completely uninsured claim against us could have a material adverse effect on our business, financial condition and results of operations. MANAGED CARE COMPANIES FACE INCREASING THREATS OF PRIVATE-PARTY LITIGATION, INCLUDING CLASS ACTIONS, OVER THE SCOPE OF CARE FOR WHICH MANAGED CARE COMPANIES MUST PAY. Several large national managed care companies have been the target of class action lawsuits alleging fraudulent practices in the determination of health care coverage policies for their beneficiaries. Such lawsuits have, thus far, been aimed solely at full service managed care plans and not companies that specialize in specific segments, such as eye care. We cannot assure you that private party litigation, including class action suits, will not target it in the future, or that we will not otherwise be affected by such litigation. LOSS OF THE SERVICES OF KEY MANAGEMENT PERSONNEL COULD ADVERSELY AFFECT OUR BUSINESS. Our success, in part, depends upon the continued services of Dean J. Yimoyines, M.D., who is our chairman and chief executive officer. We believe that the loss of the services of Dr. Yimoyines could have a material adverse effect on our business, financial condition and results of operations. In addition, we have employment agreements with Dean J. Yimoyines and other officers that require lump sum payments to be made upon the event of a change in control. These change in control payments could deter takeover bids even if those bids are in our stockholders' best interests. IF WE FAIL TO EXECUTE OUR GROWTH STRATEGY, WE MAY NOT BECOME PROFITABLE Our growth strategy depends in part on its ability to expand and successfully implement our integrated business model. Our growth strategy also requires successful sales results and operational execution in our managed care business. Our growth strategy has resulted in, and will continue to result in, new and increased responsibilities for management and additional demands on management, operating and financial systems and resources. Our ability to continue to expand will also depend upon our ability to hire and train new staff and managerial personnel, and adapt our structure to comply with present or future legal requirements affecting our arrangements with ophthalmologists and optometrists. If we are unable to implement these and other requirements, our business, financial condition, results of operations and ability to achieve and sustain profitability could be materially adversely affected. IF WE ARE UNABLE TO OBTAIN ADDITIONAL CAPITAL, OUR GROWTH COULD BE LIMITED. If we do not generate sufficient cash from its operations, we may need to obtain additional capital in order to successfully implement our growth strategy and to finance our continued operations. We believe that our cash flow from operations, borrowings under our credit facility, and operating and capital lease financing will provide us with sufficient funds to finance our operations for the next 12 months. If however, 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 20 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. WE HAVE A HISTORY OF LOSSES AND MAY INCUR FURTHER LOSSES IN THE FUTURE. We have historically incurred substantial operating losses due to our sizeable outstanding indebtedness and costs relating to the integration of newly acquired businesses. We cannot assure that it will not incur further losses in the future. WE MAY NOT BE ABLE TO MAINTAIN THE LISTING OF ITS COMMON STOCK ON THE AMERICAN STOCK EXCHANGE, WHICH MAY MAKE IT MORE DIFFICULT FOR STOCKHOLDERS TO DISPOSE OF OUR COMMON STOCK. Our common stock is listed on the American Stock Exchange. The exchange's rules for continued listing include stockholders' equity requirements, which we may not meet if we experience further losses; and market value requirements, which we may not meet if the price of our common stock does not increase. If our common stock is delisted from the American Stock Exchange, trading in our common stock would be conducted, if at all, in the over-the-counter market. This would make it more difficult for stockholders to dispose of their common stock and more difficult to obtain accurate quotations on our common stock. This could have an adverse effect on the price of the common stock. WE MAY NOT BE ABLE TO COMPETE EFFECTIVELY WITH OTHER EYE CARE SERVICES COMPANIES WHICH HAVE MORE RESOURCES AND EXPERIENCE THAN US, AND WITH OTHER EYE CARE DISTRIBUTORS. Some of our competitors have substantially greater financial, technical, managerial, marketing and other resources and experience than we do and, as a result, may compete more effectively than we can. We compete with other businesses, including other eye care services companies, hospitals, individual ophthalmology and optometry practices, other ambulatory surgery and laser vision correction centers, managed care companies, eye care clinics, providers of retail optical products and distributors of wholesale and retail optical products. Companies in other health care industry segments, including managers of hospital-based medical specialties or large group medical practices, may become competitors in providing surgery and laser centers as well as competitive eye care-related services. Our failure to compete effectively with these and other competitors, could have a material adverse effect on our business, financial condition and results of operations. IF WE FAIL TO NEGOTIATE PROFITABLE CAPITATED FEE ARRANGEMENTS, IT COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION. Under some managed care contracts, known as "capitation" contracts, health care providers accept a fixed payment per member per month, whether or not a person covered by a managed care plan receives any services, and the health care provider is obligated to provide all necessary covered services to the patients covered under the agreement. Many of these contracts pass part of the financial risk of providing care from the payor, i.e., an HMO, health insurer, employee welfare plan or self-insured employer, to the provider. The growth of capitation contracts in markets which we serve could result in less certainty with respect to profitability and require a higher level of actuarial acumen in evaluating such contracts. We do not know whether we will be able to continue to negotiate arrangements on a capitated or other risk-sharing basis that prove to be profitable, or to pass the financial risks of providing care to other parties, or to accurately predict utilization or the costs of rendering services. In addition, changes in federal or state regulations of these contracts may limit our ability to transfer financial risks away from us. Any such developments could have a material adverse effect on our business, financial condition and results of operations. 21 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 OUR STOCKHOLDERS AND US. We have contractual agreements with entities owned or controlled by our officers, directors and key employees, which agreements could create the potential for possible conflicts of interests for such individuals. Through our subsidiaries, we lease property owned by certain of our officers and their family members. Our subsidiary, OptiCare Eye Health Centers, Inc., is party to a Professional Services and Support Agreement with OptiCare, P.C., a Connecticut professional corporation. Dr. Yimoyines, our Chairman, Chief Executive Officer, and beneficial holder of approximately 17% of our outstanding voting stock, is the sole stockholder of OptiCare, P.C. Pursuant to our agreement, OptiCare, P.C. employs medical personnel and performs all ophthalmology and optometry services at our facilities in Connecticut. We select and provide the facilities at which the services are performed and provide all administrative and support services for the facilities for which OptiCare, P.C. provides medical personnel and performs its ophthalmology and optometry services. We bill and receive payments for services rendered by the medical personnel of OptiCare, P.C. and OptiCare P.C. pays its physicians compensation for such medical services rendered. HEALTH CARE REGULATIONS OR HEALTH CARE REFORM INITIATIVES COULD MATERIALLY ADVERSELY AFFECT OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS. We are subject to extensive federal and state governmental regulation and supervision, including, but not limited to: o anti-kickback statutes; o self-referral laws; o insurance and licensor requirements associated with our managed care business; o civil false claims acts; o corporate practice of medicine restrictions; o fee-splitting laws; o facility license requirements and certificates of need; o regulation of medical devices, including laser vision correction and other refractive surgery procedures; o FDA and FTC guidelines for marketing laser vision correction; and o regulation of personally identifiable health information. We cannot assure you that these laws and regulations will not change or be interpreted in the future either to restrict or adversely affect its business activities or relationships with other eye care providers. These laws and regulations have been subject to limited judicial and regulatory interpretation. They are enforced by regulatory agencies that are vested with broad discretion in interpreting their meaning. Neither federal nor state authorities have examined our agreements and activities with respect to these laws and regulations. We cannot assure you that review of our business arrangements will not result in determinations that adversely affect our operations or that certain material agreements between us and eye care providers or third-party payers will not be held invalid and unenforceable. Any limitation on our ability to continue operating in the manner in which we have operated in the past could have an adverse effect on our business, financial condition and results of operations. In addition, these laws and their interpretation vary from state to state. The regulatory framework of certain jurisdictions may limit our expansion into such jurisdictions if we are unable to modify our operational structure to conform to such regulatory framework. WE ARE DEPENDENT UPON LETTERS OF CREDIT OR OTHER FORMS OF THIRD PARTY SECURITY IN CONNECTION WITH CERTAIN OF OUR CONTRACTUAL ARRANGEMENTS AND, THUS, WOULD BE ADVERSELY AFFECTED IN THE EVENT WE ARE UNABLE TO OBTAIN SUCH CREDIT AS NEEDED. We have obtained letters of credit to secure its contractual commitments to certain managed care companies. If we are unable to maintain these letters of credit or secure replacement letters of credit, we may not be able to retain our 22 existing contracts or obtain new contracts with certain managed care companies. The inability to do business with these managed care companies could have an adverse effect on our business, financial condition and results of operations. WE MAY NOT REALIZE THE EXPECTED BENEFITS FROM OUR ACQUISITION OF WISE OPTICAL. We may not be able to decrease the operating losses or profitably manage the operations of Wise Optical in the future without encountering difficulties or experiencing the loss of key employees, potential customers or suppliers. If we can not profitably manage Wise Optical's operations, or if the effort requires greater time or resources than OptiCare has anticipated, we may not realize the expected benefits from the acquisition, and this could have a material adverse effect on our business, financial condition, and results of operations. 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 CONTROLS OUR BOARD OF DIRECTORS. Palisade owns approximately 83% of our voting power and therefore will determine the outcome of all corporate matters requiring stockholder approval, including the election of all of our directors and transactions such as mergers. In addition, in connection with the restructuring, we agreed that so long as Palisade owns more than 50% of the voting power of our capital stock, Palisade shall have the right to designate a majority of our board of directors. CONFLICTS OF INTEREST MAY ARISE BETWEEN PALISADE AND OPTICARE. Conflicts of interest may arise between us and Palisade and its affiliates in areas relating to past, ongoing and future relationships and other matters. These potential conflicts of interest include corporate opportunities, indemnity arrangements, potential acquisitions or financing transactions; sales or other dispositions by Palisade of our shares held by it; and the exercise by Palisade of its ability to control our management and affairs. In addition, two of our directors are officers of Palisade Capital Management, LLC, an affiliate of Palisade. There can be no assurance that any conflicts that may arise between Palisade and us will not have a material adverse effect on our business, financial condition and results of operations or our other stockholders. 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-K/A or to reflect the occurrence of unanticipated events. ITEM 9A. 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. When initially filed, we concluded that our disclosure controls and procedures were effective. Then in June 2004 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 Annual Report on Form 10-K/A, have concluded that, based on such evaluation, deficiencies caused our disclosure controls and procedures not to be effective at a reasonable assurance level due to the error discovered in the recording of March 31, 2004 inventory. 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 March 2004 erroneous reporting of actual inventory levels primarily due to mathematical and fundamental errors in the reconciliation process. 23 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, identified in connection with the evaluation of such internal control that occurred during our last fiscal year, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) LIST OF FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES AND EXHIBITS 1. FINANCIAL STATEMENTS: See the "Index to Financial Statements" beginning on page F-1. 2. FINANCIAL STATEMENT SCHEDULES: Required schedules have been omitted because they are either not applicable or the required information has been disclosed in the consolidated financial statements or notes thereto. 3. EXHIBITS: EXHIBIT DESCRIPTION ------- ----------- 3.1 Certificate of Incorporation of Registrant, incorporated herein by reference to the Registrant's Annual Report on Form 10-KSB filed February 3, 1995, Exhibit 3.1. 3.2 Certificate of Amendment of the Certificate of Incorporation, dated as of August 13, 1999, as filed with the Delaware Secretary of State on August 13, 1999, incorporated herein by reference to Registrant's Current Report on Form 8-K filed on August 30, 1999, Exhibit 3.1. 3.3 Certificate of Designation with respect to the Registrant's Series A Convertible Preferred Stock, as filed with the Delaware Secretary of State on August 13, 1999, incorporated herein by reference to Registrant's Current Report on Form 8-K filed on August 30, 1999, Exhibit 3.2. 3.4 Certificate of Amendment of the Certificate of Incorporation, as filed with the Delaware Secretary on January 21, 2002, increasing the authorized common stock of the Registrant from 50,000,000 to 75,000,000 shares, incorporated herein by reference 24 EXHIBIT DESCRIPTION ------- ----------- to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 3.1. 3.5 Certificate of Designation, Rights and Preferences of the Series B 12.5% Voting Cumulative Convertible Participating Preferred Stock of the Registrant, as filed with the Delaware Secretary of State on January 23, 2002, incorporated herein by reference to the Registrant's Current Report on Form 8-K dated filed on February 11, 2003, Exhibit 3.2. 3.6 Certificate of Designation, Rights and Preferences of the Series C Preferred Stock of the Registrant, as filed with the Delaware Secretary of State on May 12, 2003, incorporated herein by reference to the Registrant's Quarterly Report on Form 10-Q filed on August 12, 2003, Exhibit 3.6. 3.7 Certificate of Amendment of the Certificate of Incorporation, as filed with the Delaware Secretary of State on May 29, 2003, increasing the authorized common stock of the Registrant from 75,000,000 to 150,000,000 shares, incorporated herein by reference to the Registrant's Quarterly Report on Form 10-Q filed on August 12, 2003, Exhibit 3.7. 3.8 Amended and Restated By-laws of Registrant adopted March 27, 2000, incorporated herein by reference to Registrant's Annual Report on Form 10-K filed on March 30, 2000, Exhibit 3.3. 3.9 Amendment No. 1 to the Amended and Restated Bylaws of Registrant incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 3.3. 4.1 Form of Warrant to purchase 2,250,000 shares of common stock issued in connection with the Secured Promissory Note issued as of October 10, 2000, by OptiCare Eye Health Centers, Inc., PrimeVision Health, Inc. and OptiCare Eye Health Network, Inc. to Medici Investment Corp., incorporated herein by reference to the Registrant's Annual Report on Form 10-K filed on November 29, 2001, Exhibit 10.54. 4.2 Form of Warrant to purchase 300,000 shares and 2,000,000 shares of common stock issued in connection with the Amended and Restated Secured Promissory Note issued as of October 10, 2000, by OptiCare Eye Health Centers, Inc., PrimeVision Health, Inc. and OptiCare Eye Health Network, Inc. to Medici Investment Corp., incorporated herein by reference to the Registrant's Annual Report on Form 10-K filed on November 29, 2001 Exhibit 10.55. 4.3 Form of Warrant to purchase 50,000 shares of common stock issued in connection with the Amended and Restated Secured Promissory Note issued as of October 10, 2000, by OptiCare Eye Health Centers, Inc., PrimeVision Health, Inc. and OptiCare Eye Health Network, Inc. to Dean J. Yimoyines, M.D., incorporated herein by reference to the Registrant's Annual Report on Form 10-K filed on November 29, 2001, Exhibit 10.56. 4.4 Form of Warrant to purchase 400,000 shares of common stock issued in connection with the Amended and Restated Secured Promissory Note issued as of October 10, 2000, by OptiCare Eye Health Centers, Inc., PrimeVision Health, Inc. and OptiCare Eye Health Network, Inc. to Palisade Concentrated Equity Partnership, L.P., incorporated herein by reference to the Registrant's Annual Report on Form 10-K field on November 29, 2001, Exhibit 10.57. 4.5 Form of Warrant dated January 25, 2002, issued to CapitalSource Finance, LLC, for the purchase of up to 250,000 shares of common stock, incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 3.6. 25 EXHIBIT DESCRIPTION ------- ----------- 10.1 1999 Performance Stock Program, incorporated herein by reference to the Registrant's Registration Statement on Form S-4, registration no. 333-78501, first filed on May 14, 1999, as amended (the "Registration Statement 333-78501"), Exhibit 4.1. + 10.2 Amended and Restated 1999 Employee Stock Purchase Plan, incorporated herein by reference to Registrant's Annual Report on Form 10-K filed on March 30, 2000, Exhibit 4.2. + 10.3 2000 Professional Employee Stock Purchase Plan incorporated herein by reference to Registrant's Annual Report on Form 10-K filed on March 30, 2000, Exhibit 4.3. + 10.4 Amended and Restated 2002 Stock Incentive Plan incorporated herein by reference to Registrant's Quarterly Report on Form 10-Q filed August 14, 2002, Exhibit 4.4.+ 10.5 Vision Care Capitation Agreement between OptiCare Eye Health Centers, Inc. and Blue Cross & Blue Shield of Connecticut, Inc. (and its affiliates) dated October 23, 1999, incorporated herein by reference to the Registration Statement 333-78501, Exhibit 10.9. 10.6 Eye Care Services Agreement between OptiCare Eye Health Centers, Inc. and Anthem Health Plans, Inc. (d/b/a Anthem Blue Cross and Blue Shield of Connecticut), effective November 1, 1998, incorporated herein by reference to the Registration Statement 333-78501, Exhibit 10.10. 10.7 Contracting Provider Services Agreement dated April 26, 1996, and amendment thereto dated as of January 1, 1999, between Blue Cross and Blue Shield of Connecticut, Inc., and OptiCare Eye Health Centers, Inc., incorporated herein by reference to the Registration Statement 333-78501, Exhibit 10.11. 10.8 Form of Employment Agreement between the Registrant and Dean J. Yimoyines, M.D., effective August 13, 1999, incorporated herein by reference to the Registration Statement 333-78501, Exhibit 10.11.+ 10.9 Lease Agreement dated September 1, 1995 by and between French's Mill Associates, as landlord, and OptiCare Eye Health Centers, Inc. as tenant, for premises located at 87 Grandview Avenue, Waterbury, Connecticut incorporated herein by reference to the Registration Statement 333-78501, Exhibit 10.17. 10.10 Lease Agreement dated September 30, 1997 by and between French's Mill Associates II, LLP, as landlord, and OptiCare Eye Health Center, P.C., as tenant, for premises located at 160 Robbins Street, Waterbury, Connecticut (upper level), incorporated herein by reference to the Registration Statement 333-78501, Exhibit 10.18. 10.11 Lease Agreement dated September 1, 1995 and Amendment to lease dated September 30, 1997 by and between French's Mill Associates II, LLP, as Landlord, and OptiCare Eye Health Center, P.C., as tenant, for premises located at 160 Robbins Street, Waterbury, Connecticut (lower level), incorporated herein by reference to the Registration Statement 333-78501., Exhibit 10.19. 10.12 Second Amendment to Lease Agreement dated September 30, 1997 by and between French's Mill Associates II, LLP, as landlord, and OptiCare Eye Health Center, Inc., as tenant, for premises located at 160 Robbins Street, Waterbury, Connecticut, incorporated herein by reference to the Registrant's Quarterly Report on Form 10-Q filed on August 12, 2003, Exhibit 10.4. 10.13 Lease Agreement dated August 1, 2002 by and between Harrold-Barker Investment Company, as landlord, and OptiCare Health Systems, Inc., as tenant, for premises 26 EXHIBIT DESCRIPTION ------- ----------- located at 110 and 112 Zebulon Court, Rocky Mount, North Carolina incorporated herein by reference to the Registrant's Annual Report on Form 10-K filed on March 18, 2003, Exhibit 10-12. 10.14 Form of Health Services Organization Agreement between PrimeVision Health, Inc. and eye care providers, incorporated herein by reference to the Registration Statement 333-78501, Exhibit 10.21. 10.15 Professional Services and Support Agreement dated December 1, 1995 between OptiCare Eye Health Centers, Inc. and OptiCare P.C., a Connecticut professional corporation, incorporated herein by reference to the Registration Statement 333-78501, Exhibit 10.22. 10.16 Stock Purchase Agreement dated October 1, 1999, among the Registrant, Stephen Cohen, Robert Airola, Gerald Mandel and Reginald Westbrook (excluding schedules and other attachments thereto), incorporated herein by reference to the Registrant's Quarterly Report on Form 10-Q filed on November 15, 1999, Exhibit 10.10. 10.17 Employment Agreement between the Registrant as employer and Gordon A. Bishop, dated August, 13, 1999, incorporated herein by reference to the Registration Statement 333-93043, Exhbit 10.41. + 10.18 Employment Agreement between the Registrant and Jason M. Harrold, effective July 1, 2000, incorporated herein by reference to the Registrant's Quarterly Report on Form 10-Q filed on August 14, 2000, Exhibit 10.10. + 10.19 OptiCare Directors' and Officers' Trust Agreement dated November 7, 2001, between the Registrant and Norman S. Drubner, Esq., as Trustee, incorporated herein by reference to the Registrant's Annual Report on Form 10-K filed on November 29, 2001, Exhibit 10.52. + 10.20 Agreement for Consulting Services between Morris Anderson and Associates, Ltd. and the Registrant dated April 16, 2001, incorporated herein by reference to the Registrant's Annual Report on Form 10-K filed on November 19, 2001, Exhibit 10.53. 10.21 Restructure Agreement dated December 17, 2001, among Palisade Concentrated Equity Partnership, L.P., Dean J. Yimoyines, M.D. and the Registrant incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 10.1. 10.22 Amendment No. 1, dated January 5, 2002, to the Restructure Agreement dated December 17, 2001, among Palisade Concentrated Equity Partnership. L.P., Dean J. Yimoyines, M.D. and the Registrant incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 10.2. 10.23 Amendment No. 2, dated January 22, 2002, to the Restructure Agreement dated December 17, 2001, among Palisade Concentrated Equity Partnership, L.P. Dean J. Yimoyines, M.D. and the Registrant incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 10.3. 10.24 Amendment No. 3, dated May 12, 2003, to the Restructure Agreement dated December 17, 2001, among Palisade Concentrated Equity Partnership. L.P., Dean J. Yimoyines, M.D. and the Registrant, incorporated herein by reference to the Registrant's Quarterly Report on Form 10-Q filed on August 12, 2003, Exhibit 10.3. 10.25 Subordinated Pledge and Security Agreement dated as of January 25, 2002, by the Registrant (including certain of its subsidiaries) as grantor, and Palisade Concentrated Equity Partnership, L.P., as secured party and agent for the other secured party (Linda 27 EXHIBIT DESCRIPTION ------- ----------- Yimoyines), securing the senior secured subordinated notes made by the Registrant to the secured parties dated January 25, 2002, incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 10.6. 10.26 Registration Rights Agreement dated January 25, 2002, covering common stock held by Palisade, common stock issuable on conversion of the Series B Preferred Stock and exercise of the warrants issued to Palisade, Linda Yimoyines and CapitalSource Finance, L.L.C., incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 10.7. 10.27 Amendment No. 1, dated May 12, 2003, to the Registration Rights Agreement dated January 25, 2002, incorporated herein by reference to the Registrant's Quarterly Report on Form 10-Q filed on August 12, 2003, Exhibit 10.2. 10.28 Subordination Agreement dated January 25, 2002, among Palisade Concentrated Equity Partnership, L.P., Linda Yimoyines, CapitalSource Finance, L.L.C. and the Registrant, incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 10.8. 10.29 Amended and Restated Revolving Credit, Term Loan and Security Agreement dated as of January 25, 2002, between CapitalSource Finance, L.L.C. and the Registrant, including Annex I, Financial Covenants, and Appendix I, Definitions, incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 10.9. 10.30 Waiver and Second Amendment, dated as of November 14, 2003, to the Amended and Restated Revolving Credit, Term Loan and Security Agreement, originally dated as of January 25, 2003, by and between the Registrant, OptiCare Eye Health Centers, Inc., PrimeVision Health, Inc. and CapitalSource Finance LLC, incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on November 19, 2003, Exhibit 10.1. 10.31 Term Note B, dated November 14, 2003, by and between the Registrant, OptiCare Eye Health Centers, Inc., PrimeVision Health, Inc. (individually and collectively as borrower) and CapitalSource Finance LLC (as lender), incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on November 19, 2003, Exhibit 10.2. 10.32 Guaranty Agreement dated November 14, 2003 by and between Palisade Concentrated Equity Partnership, L.P., the Registrant, PrimeVision Health, Inc., OptiCare Eye Health Centers, Inc., OptiCare Acquisition Corp., and CapitalSource Finance LLC, incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on November 19, 2003, Exhibit 10.3. 10.33 Reassignment of Rights to Payments under Services Agreements, Physician Notes and Physician Security Agreements, between Bank Austria Creditanstalt Corporate Finance, Inc., and the Registrant, dated January 25, 2002, incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 10.10. 10.34 Assignment and Assumption Agreement dated January 25, 2002, between Bank Austria Creditanstalt Corporate Finance, Inc., and CapitalSource Finance, L.L.C., incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 11, 2002, Exhibit 10.11. 10.35 OptiCare Directors' & Officers' Tail Policy Trust dated January 10, 2002, between the Registrant and Norman S. Drubner, Esq.as trustee incorporated herein by reference to 28 EXHIBIT DESCRIPTION ------- ----------- the Registrant's Annual Report on Form 10-K filed on April 1, 2002, Exhibit 10.74.+ 10.36 Employment Agreement dated as of September 1, 2001, between the Registrant and William Blaskiewicz, incorporated herein by reference of the Registrant's Quarterly Report on Form 10-Q filed on December 3, 2002, Exhibit 10.21.+ 10.37 Employment Letter Agreement, dated as of February 18, 2002, between the Registrant and Christopher J. Walls, incorporated herein by reference to the Registrant's Quarterly Report on Form 10-Q filed on May 15, 2002, Exhibit 10.76.+ 10.38 Employment Letter Agreement, dated as of May 21, 2002, between the Registrant and Lance A. Wilkes, incorporated herein by reference of the Registrant's Quarterly Report on Form 10-Q filed on August 14, 2002, Exhibit 10.77.+ 10.39 Asset Purchase Agreement, dated as of August 1, 2002, by and among the Registrant, PrimeVision Health, Inc. and Optometric Eye Care Center, P.A., incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on August 27, 2002, Exhibit 2. 10.40 Asset Purchase Agreement, dated as of February 7, 2003, by and among the Wise Optical Vision Group, Inc. and OptiCare Acquisition Corp., incorporated herein by reference to the Registrant's Current Report on Form 8-K filed on February 10, 2003, Exhibit 2. 10.41 Joinder Agreement and First Amendment, dated as of February 7, 2003, to the Amended and Restated Revolving Credit, Term Loan and Security Agreement, originally dated as of January 25, 2003, by and between the Registrant, OptiCare Eye Health Centers, Inc., PrimeVision Health, Inc. and CapitalSource Finance LLC, incorporated herein by reference to Exhibit 99.2 of the Registrant's Current Report on Form 8-K filed February 10, 2003, Exhibit 99.2. 10.42 Lease Agreement dated August 7, 2000 and Amendment to Lease dated August 1, 2001, by and between Mack-Cali So. West Realty Associates L.L.C., as landlord, and Wise/Contact US Optical Corporation, as tenant, for premises located at 4 Executive Plaza, Yonkers, New York incorporated herein by reference to the Registrant's Annual Report on Form 10-K filed on March 18, 2003, Exhibit 10.39. 10.43 Letter Agreement dated May 12, 2003 by and among Palisade Concentrated Equity Partnership, L.P., the Registrant and Linda Yimoyines, incorporated herein by reference to the Registrant's Quarterly Report on Form 10-Q filed on August 12, 2003, Exhibit 10.1. 10.44 Second Amended and Restated Revolving Credit, Term Loan and Security Agreement, dated as of March 29, 2004, by and between the Registrant, OptiCare Eye Health Centers, Inc., PrimeVision Health, Inc. OptiCare Acquisition Corporation and CapitalSource Finance LLC, incorporated herein by reference to the Registrant's Annual Report on Form 10-K filed on March 30, 2004, Exhibit 10.44. 21 List of Subsidiaries of the Registrant, incorporated herein by reference to the Registrant's Annual Report on Form 10-K filed on March 30, 2004, Exhibit 21. 23 Consent of Deloitte & Touche regarding its report on our financial statements as of December 31, 2003 and 2002, and for each of the three years in the period ended December 31, 2003.* 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.* 32.1 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* 29 * Filed herewith. + Management or compensatory plan. (b) REPORTS ON FORM 8-K On November 19, 2003 we filed information regarding the modification of our term loan and credit facility under "Item 5. Other Events and Regulations FD Disclosure" and furnished information regarding results of our third quarter of fiscal 2003 under "Item 12. Results of Operation and Financial Condition" on the same current Report on Form 8-K. 30 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. September 2, 2004 OPTICARE HEALTH SYSTEMS, INC. By: /s/ Dean J. Yimoyines ------------------------------------- Dean J. Yimoyines, M.D. Chairman of the Board and Chief Executive Officer 31 INDEX TO FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm F-2 Consolidated Balance Sheets as of December 31, 2003, as restated and 2002, as restated F-3 Consolidated Statements of Operations for the years ended December 31, 2003, 2002 and 2001 F-4 Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001 F-5 Consolidated Statements of Stockholders' Equity for the years ended December 31, 2003, 2002 and 2001 F-6 Notes to Consolidated Financial Statements F-7 F-1 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of OptiCare Health Systems, Inc. Waterbury, Connecticut We have audited the accompanying consolidated balance sheets of OptiCare Health Systems, Inc. and subsidiaries (the "Company") as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the years in the period ended December 31, 2003. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2003 and 2002, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 4 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets to conform to Statement of Financial Accounting Standard No. 142. As discussed in Note 4 to the consolidated financial statements, the Company changed its method of accounting for extraordinary items to conform to Statement of Financial Accounting Standard No. 145. As discussed in Note 2 to the consolidated financial statements, the accompanying 2003 and 2002 financial statements have been restated. DELOITTE & TOUCHE LLP Stamford, Connecticut March 29, 2004 (August 30, 2004 as to the effects of the restatement discussed in Note 2, and as to Notes 3, 12, 23) F-2 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) DECEMBER 31, -------------------- AS RESTATED See Note 2 2003 2002 -------- -------- ASSETS CURRENT ASSETS: Cash and cash equivalents $ 1,695 $ 3,086 Accounts receivable, net 9,369 5,273 Inventories 5,918 2,000 Deferred income taxes, current -- 1,660 Notes receivable 105 516 Other current assets 462 369 -------- -------- Total Current Assets 17,549 12,904 -------- -------- Property and equipment, net 4,683 3,337 Goodwill 19,195 20,516 Intangible assets, net 1,179 1,353 Deferred income taxes, non-current -- 3,140 Deferred debt issuance costs, net 398 1,187 Notes receivable, less current portion 791 838 Restricted cash 1,158 252 Other assets 902 1,578 -------- -------- TOTAL ASSETS $ 45,855 $ 45,105 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable 5,644 2,902 Claims payable and claims incurred but not reported 1,534 2,143 Accrued salaries and related expenses 2,609 1,838 Accrued expenses 1,364 1,274 Current portion of long-term debt 10,818 2,823 Current portion of capital lease obligations 10 61 Unearned revenue 993 1,053 Other current liabilities 549 131 -------- -------- Total Current Liabilities 23,521 12,225 NON-CURRENT LIABILITIES: Long-term debt - related party -- 15,588 Other long-term debt, less current portion 1,775 1,007 Capital lease obligations, less current portion -- 7 Other liabilities 512 608 -------- -------- Total Non-Current Liabilities 2,287 17,210 -------- -------- COMMITMENTS AND CONTINGENCIES (Notes 12, 13, and 20) SERIES B 12.5% REDEEMABLE, CONVERTIBLE PREFERRED STOCK AT AGGREGATE LIQUIDATION PREFERENCE-RELATED PARTY 5,635 5,018 STOCKHOLDERS' EQUITY: Series C Preferred Stock, $.001 par value ($16,251 aggregate liquidation preference); 406,158 shares issued and outstanding at December 31, 2003; No shares authorized, issued or outstanding at December 31, 2002 1 -- Common Stock, $0.001 par value; 150,000,000 shares authorized; 30,386,061 and 28,913,990 shares issued and outstanding at December 31, 2003 and 2002, 30 29 respectively Additional paid-in-capital 79,700 63,589 Accumulated deficit (65,319) (52,966) -------- -------- TOTAL STOCKHOLDERS' EQUITY 14,412 10,652 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 45,855 $ 45,105 ======== ======== See notes to consolidated financial statements. F-3 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) YEAR ENDED DECEMBER 31, ----------------------------------- 2003 2002 2001 --------- --------- --------- NET REVENUES: Managed vision $ 28,111 $ 29,426 $ 28,988 Product sales 72,834 39,409 44,352 Other services 22,035 20,350 20,742 Other income 2,722 2,346 -- --------- --------- --------- Total net revenues 125,702 91,531 94,082 --------- --------- --------- OPERATING EXPENSES: Medical claims expense 22,000 22,326 22,966 Cost of product sales 56,253 31,064 35,545 Cost of services 9,034 8,158 8,840 Selling, general and administrative 38,174 26,298 26,151 (Gain) loss from early extinguishment of debt 1,896 (8,789) Goodwill impairment 1,639 -- -- Depreciation 1,899 1,851 1,773 Amortization 174 181 1,124 Interest 2,059 3,048 3,022 --------- --------- --------- Total operating expenses 133,128 84,137 99,421 --------- --------- --------- Income (loss) from continuing operations before income taxes (7,426) 7,394 (5,339) Income tax expense (benefit) 4,927 2,528 (8,026) --------- --------- --------- Income (loss) from continuing operations (12,353) 4,866 2,687 Income from discontinued operations, net of income taxes -- 313 293 Loss on disposal of discontinued operations, net of income tax expense of $342 -- (4,434) -- --------- --------- --------- Net income (loss) (12,353) 745 2,980 Preferred stock dividends (618) (531) -- --------- --------- --------- Income (loss) available to common stockholders $ (12,971) $ 214 $ 2,980 ========= ========= ========= EARNINGS (LOSS) PER SHARE: Income (loss) from continuing operations: Basic $ (0.43) $ 0.35 $ 0.21 Diluted $ ( 0.43) $ 0.10 $ 0.21 Income (loss) from discontinued operations: Basic -- $ (0.33) $ 0.02 Diluted -- $ (0.33) $ 0.02 Net income (loss): Basic $ (0.43) $ 0.02 $ 0.23 Diluted $ (0.43) $ 0.01 $ 0.23 See notes to consolidated financial statements. F-4 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (AMOUNTS IN THOUSANDS) YEAR ENDED DECEMBER 31, -------------------------------- 2003 2002 2001 -------- -------- -------- OPERATING ACTIVITIES: Net income (loss) $(12,353) $ 745 $ 2,980 (Income) loss on discontinued operations -- 4,121 (293) -------- -------- -------- Income (loss) from continuing operations (12,353) 4,866 2,687 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation 1,899 1,851 1,773 Amortization 174 181 1,124 Deferred income taxes 4,800 2,658 (7,800) Bad debt expense 506 323 498 Non-cash interest expense 958 258 556 Non-cash (gain) loss on early extinguishment of debt 1,867 (8,789) -- Non-cash gain on contract settlements (576) -- -- Non-cash goodwill impairment charge 1,639 -- -- Non-cash compensation charges 178 -- -- Loss on disposal of fixed assets 62 -- 73 Changes in operating assets and liabilities Accounts receivable 1,914 1,166 636 Inventories 1,814 (213) 21 Other assets (50) (168) (519) Accounts payable and accrued expenses (5,663) (3,192) (1,018) Other liabilities 201 (136) 2,401 Cash provided by discontinued operations -- 992 1,020 -------- -------- -------- Net cash (used in) provided by operating activities (2,630) (203) 1,452 -------- -------- -------- INVESTING ACTIVITIES: Purchases of property and equipment (890) (765) (317) Purchase of notes receivable -- (1,350) -- Payments received on notes receivable 458 658 -- Refund of security deposits 775 -- -- Purchase of restricted investments (900) -- -- Acquisition of business, net of cash acquired (6,192) -- -- Net proceeds from sale of discontinued operations -- 3,862 -- -------- -------- -------- Net cash (used in) provided by investing activities (6,749) 2,405 (317) -------- -------- -------- FINANCING ACTIVITIES: Proceeds from long-term debt 314 23,474 500 Net increase (decrease) in revolving credit facility 8,837 (4,917) -- Proceeds from exercise of warrants -- 2,450 -- Proceeds from issuance of stock 144 4,000 9 Principal payments on long-term debt (988) (25,143) (488) Payment of financing costs (261) (1,445) -- Principal payments on capital lease obligations (58) (71) (65) -------- -------- -------- Net cash provided by (used in) financing activities 7,988 (1,652) (44) -------- -------- -------- Increase (decrease) in cash and cash equivalents (1,391) 550 1,091 Cash and cash equivalents at beginning of year 3,086 2,536 1,445 -------- -------- -------- Cash and cash equivalents at end of year $ 1,695 $ 3,086 $ 2,536 ======== ======== ======== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest $ 1,061 $ 1,359 $ 432 Cash paid (received) for income taxes 76 45 (109) Reduction of debt in exchange for reduction of receivables 86 1,011 -- Conversion of senior subordinated debt to Series C Preferred Stock 16,251 -- -- See notes to consolidated financial statements. F-5 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA) Series A Series C Preferred Stock Preferred Stock Common Stock Additional -------------------- ---------------- ------------------- Paid-in Accumulated Shares Amount Shares Amount Shares Amount Capital Deficit Total ----------- ------ -------- ------ ----------- ------ --------- --------- --------- Balance at December 31, 2000 418,803 $ 1 -- -- 12,747,324 $ 13 $ 60,554 $ (56,691) $ 3,877 Issuance of stock under employee stock purchase plan -- -- -- -- 33,458 -- 9 -- 9 Issuance of common stock -- -- -- -- 34,310 -- 8 -- 8 Issuance of warrants -- -- -- -- -- -- 108 -- 108 Net income for 2001 -- -- -- -- -- -- -- 2,980 2,980 ----------- ---- -------- ---- ----------- ---- --------- --------- --------- Balance at December 31, 2001 418,803 1 -- -- 12,815,092 13 60,679 (53,711) 6,982 Issuance of common stock -- -- -- 17,525,000 17 2,433 -- 2,450 Cancellation of shares (418,803) (1) -- -- (1,426,102) (1) (375) -- (377) Issuance of warrants -- -- -- -- -- -- 1,383 -- 1,383 Dividends on redeemable preferred stock -- -- -- -- -- -- (531) -- (531) Net income for 2002 -- -- -- -- -- -- -- 745 745 ----------- ---- -------- ---- ----------- ---- --------- --------- --------- Balance at December 31, 2002 -- -- -- -- 28,913,990 29 63,589 (52,966) 10,652 Issuance of preferred stock -- -- 406,158 $ 1 -- -- 16,113 -- 16,114 Issuance of common stock -- -- -- -- 1,555,000 1 651 -- 652 Cancellation of shares -- -- -- -- (82,929) -- (35) -- (35) Dividends on redeemable preferred stock -- -- -- -- -- -- (618) -- (618) Net loss for 2003 -- -- -- -- -- -- -- (12,353) (12,353) ----------- ---- -------- ---- ----------- ---- --------- --------- --------- Balance at December 31, 2003 -- $-- 406,158 $ 1 30,386,061 $ 30 $ 79,700 $ (65,319) $ 14,412 =========== ==== ======== ==== =========== ==== ========= ========= ========= See notes to consolidated financial statements. F-6 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except share and per share data) 1. ORGANIZATION AND BASIS OF PRESENTATION OptiCare Health Systems, Inc. and subsidiaries (the "Company") is an integrated eye care services company focused on vision benefits management (managed vision), the distribution of products and software services to eye care professionals, and consumer vision services, including medical, surgical and optometric services and optical retail. The Company contracts with OptiCare, P.C.--a professional corporation--which employs ophthalmologists and optometrists to provide the surgical, medical, optometric and other professional services to patients. The Company acquired Wise Optical on February 7, 2003 and was accounted for as a purchase. Accordingly, the results of operations of Wise Optical are included in the Company's results of operations since February 1, 2003, the deemed effective date of the acquisition for accounting purposes. 2. RESTATEMENT The loan agreement with CapitalSource requires the Company to maintain a lock-box arrangement with banks whereby amounts received into the lock-boxes are applied to reduce the revolving credit facility outstanding. The agreement also contains certain subjective acceleration clauses in the event of a material adverse event. Subsequent to the issuance of the Company's consolidated financial statements for the year ended December 31, 2003, the Company's management determined that the amounts outstanding pursuant to certain provisions contained in its credit facility with CapitalSource (see Note 12) should have been classified as current liabilities rather than long-term debt, pursuant to the provisions of consensus 95-22 issued by the Financial Accounting Standards Board Emerging Issues Task Force. Accordingly, the accompanying balance sheets have been restated to reflect the classification of the amounts outstanding pursuant to this credit facility as current liabilities. A summary of the significant effects of the restatement is as follows: ------------------------------------------------------------------------------------------------------------ December 31, 2003 December 31, 2002 ------------------------------------------------------------------------------------------------------------ As Previously As Restated As Previously As Restated Reported Reported ------------------------------------------------------------------------------------------------------------ Current portion of long-term debt $ 1,124 $10,818 $1,266 $ 2.823 ------------------------------------------------------------------------------------------------------------ Total current liabilities 13,827 23,521 10,668 12,225 ------------------------------------------------------------------------------------------------------------ Other long, term debt, less current 11,469 1,775 2,564 1,007 portion ------------------------------------------------------------------------------------------------------------ Total non-current liabilities 11,981 2,287 18,767 17,210 ------------------------------------------------------------------------------------------------------------ 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 CapitalSource 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 us in increasing sales and improving product margins at Wise Optical. In addition, in 2003 the Managed Vision segment began shifting away from the lower margin and long sales cycle of the Company's third party administrator F-7 ("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 our direct-to-employer business and expect increased profitability as a result of this product shift that has lead to new contracts and improved gross margins. The Company experienced significant improvements in revenue and profitability in the Consumer Vision segment from 2003 to 2004, largely from growth in existing store sales and enhanced margins as a result of sales incentives that the Company expects to continue. OptiCare has also continued to settle outstanding litigation with positive results through June of 2004. Although Wise operating losses have continued into 2004, the Company has generated approximately $4.0 million of cash from operations in the six months ended June 30, 2004, which has resulted in reductions of senior debt of approximately $3.3 million and increased borrowing availability to the Company. In addition, in May 2004, management made the decision to dispose of the Technology operation, CC Systems. The Company anticipates the sale of that operation will generate cash proceeds while reducing demands on working capital and corporate personnel. The Company believes the combination of the above initiatives executed in the operating segments will continue to improve the Company's liquidity and should ensure compliance with the CapitalSource covenants in the future. 4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its affiliate OptiCare P.C.. All significant intercompany accounts and transactions have been eliminated in consolidation. CASH AND CASH EQUIVALENTS The Company considers investments purchased with an original maturity of three months or less when purchased to be cash equivalents. RECEIVABLES Receivables are stated net of allowances for doubtful accounts. The allowance for doubtful accounts reflects the Company's best estimate of probable losses inherent in the accounts receivable balance from bad debts. We determine the allowance based on historical experience and other currently available evidence. Adjustments to the allowance are recorded to bad debt expense, which is included in operating expenses. Gross receivables are stated net of contractual allowances and insurance disallowances. (See also "Services Revenue" below) INVENTORIES Inventories primarily consist of eyeglass frames, lenses, sunglasses, contact lenses and surgical supplies. Inventories are valued at the lower of cost or market, determined on the first-in, first-out "FIFO" basis. PROPERTY AND EQUIPMENT Property and equipment are recorded at cost. Leasehold improvements are being amortized over the term of the lease or the life of the improvement, whichever is shorter. Depreciation and amortization are provided primarily using the straight-line method over the estimated useful lives of the respective assets as follows: F-8 CLASSIFICATION ESTIMATED USEFUL LIFE Furniture, ------------------------ ---------------------- fixtures and equipment 5 - 7 years Leasehold improvements 7 - 10 years Computer hardware and software 3 - 5 years DEFERRED DEBT ISSUANCE COSTS Deferred debt issuance costs are being amortized on the straight-line method, which approximates the interest method, over the term of the related debt and such amortization is included in interest expense. Amortization expense of deferred debt issuance costs totaled $248 and $258 for the years ended December 31, 2003 and 2002, respectively. GOODWILL AND OTHER INTANGIBLE ASSETS The Company accounts for goodwill and intangible assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets" (see "New Accounting Pronouncements"), which was adopted by the Company on January 1, 2002. In accordance with this standard, goodwill and other intangible assets with indefinite useful lives are no longer subject to amortization, but are reviewed by the Company for impairment on an annual basis, or more frequently if events or circumstances indicate potential impairment. The evaluation methodology for potential impairment is inherently complex, and involves significant management judgement in the use of estimates and assumptions. The Company uses multiples of revenue and earnings before interest, taxes, depreciation and amortization of comparable entities to value the reporting unit being evaluated for goodwill impairment. The Company evaluates impairment using a two-step process. First, the aggregate fair value of the reporting unit is compared to its carrying amount, including goodwill. If the fair value exceeds the carrying amount, no impairment exists. If the carrying amount of the reporting unit exceeds the fair value, then we compare the implied fair value of the reporting unit's goodwill with its carrying amount. The implied fair value is determined by allocating the fair value of the reporting unit to all the assets and liabilities of that unit, as if the unit had been acquired in a business combination and the fair value of the unit was the purchase price. If the carrying amount of the goodwill exceeds the implied fair value, then goodwill impairment is recognized by writing the goodwill down to the implied fair value. Goodwill represents the excess of the purchase price over the fair value of identifiable net assets acquired in a business combination accounted for as a purchase. During the year 2001, goodwill was amortized using the straight-line method, generally over a period of 25 years. Intangible assets, which represent purchased service and non-compete agreements, are amortized over their contract life and are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. MANAGED VISION REVENUE The Company provides vision care services, through its managed vision care business, as a preferred provider to HMOs, PPOs, third party administrators and insurance indemnity programs. The contractual arrangements with these entities operate primarily under capitated programs. Capitation payments are accrued when they are due under the related contracts at the agreed-upon per-member, per-month rates. Revenue from non-capitated services, such as fee-for-service and other preferred provider arrangements, is recognized when the services are provided and the Company's customers are obligated to pay for such services. PRODUCT SALES REVENUE The Company recognizes revenue on product sales at the time of delivery to the customer. Product sales revenue includes sales of optical products to customers through the retail optometry centers that the Company manages and to affiliated and non-affiliated ophthalmologists and optometrists through the Company's buying group. The buying group negotiates volume buying discounts with optical product suppliers. Products sold through the buying group are shipped directly to the buying group's customers from the supplier. The Company bills the customer and bears the credit risk. All sales to affiliated ophthalmologists and optometrists are eliminated in consolidation. F-9 SERVICES REVENUE The Company (through its affiliated professional corporation) provides comprehensive eye care services to consumers, including medical and surgical treatment of eye diseases and disorders by ophthalmologists, and vision measuring and non-surgical correction services by optometrists. The Company also charges a fee for providing the use of its ambulatory surgery center to professionals for surgical procedures. The Company's ophthalmic, optometric and ambulatory surgery center services are recorded at established rates reduced by an estimate for contractual allowances. Contractual allowances arise due to the terms of certain reimbursement contracts with third-party payors that provide for payments to the Company at amounts different from its established rates. The contractual allowance represents the difference between the charges at established rates and estimated recoverable amounts and is recognized in the period the services are rendered. The contractual allowance recorded is estimated based on an analysis of collection experience in relation to amounts billed and other relevant information. Any differences between estimated contractual adjustments and actual final settlements under reimbursement contracts are recognized as adjustments to revenue in the period of final settlements. The Company's Health Services Organization ("HSO") provides marketing, managed care and other administrative services to individual ophthalmology and optometry practices under agreements between the Company and each practice. HSO revenue is recognized monthly at a contractually agreed upon fee, based on a percentage of cash collections by the HSO practices. The Company sells and installs software systems that support eye health practice management to optometry practices, retail optical locations and manufacturing laboratories. Revenue associated with sales of software systems is recognized upon delivery and acceptance by the customer. OTHER INCOME Revenue from HSO settlements are recognized in other income when received. MEDICAL CLAIMS EXPENSE Claims expense is recorded as provider services are rendered and includes an estimate for claims incurred but not reported ("IBNR"). Reserves for estimated insurance losses are determined on a case by case basis for reported claims, and on estimates based on company experience for loss adjustment expenses and incurred but not reported claims. These liabilities give effect to trends in claims severity and other factors which may vary as the losses are ultimately settled. The Company's management believes that the estimates of the reserves for losses and loss adjustment expenses are reasonable; however, there is considerable variability inherent in the reserve estimates. These estimates are continually reviewed and, as adjustments to these liabilities become necessary, such adjustments are reflected in current operations in the period of the adjustment. COST OF PRODUCT SALES Cost of product sales is comprised of optical products including eyeglasses, contact lenses and other optical goods. COST OF SERVICES Cost of services represents the direct costs associated with services revenue. These costs are primarily comprised of medical and other service provider wages, as well as medical and other supplies and costs incidental to other services revenue. MALPRACTICE CLAIMS The Company purchases insurance to cover medical malpractice claims. There are known claims and incidents as well as potential claims from unknown incidents that may be asserted from past services provided. Management believes that these claims, if asserted, would be settled within the limits of insurance coverage. F-10 INSURANCE OPERATIONS The Company's managed vision care business includes a wholly-owned subsidiary which is a licensed single service HMO in Texas (the "Texas HMO") and a licensed captive insurance company domiciled in South Carolina, OptiCare Vision Insurance Company ("OVIC"). The Texas HMO is subject to regulation and supervision by the Texas Department of Insurance, which has broad administrative powers relating to standards of solvency, minimum capital and surplus requirements, maintenance of required reserves, payments of dividends, statutory accounting and reporting practices, and other financial and operational matters. The Texas Department of Insurance requires that stipulated amounts of paid-in-capital and surplus be maintained at all times. Dividends payable by the Texas HMO to the Company are generally limited to the lesser of 10% of statutory-basis capital and surplus or net income of the preceding year excluding realized capital gains. OVIC is subject to the regulation and supervision by the South Carolina Department of Insurance and requires minimum capital and surplus levels. Under the Company's agreements with the Texas and South Carolina Departments of Insurance, the Company was required to pledge investments of $250 and $500, respectively, at December 31, 2003. INCOME TAXES The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes" which requires an asset and liability method of accounting for deferred income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis using enacted tax rates expected to apply to taxable income in the years the temporary differences are expected to reverse. A valuation allowance against deferred tax assets is recorded if, based on the weight of historic available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. REDEEMABLE CONVERTIBLE PREFERRED STOCK In January 2002 the Company issued 3,204,959 shares of Series B 12.5% Voting Cumulative Convertible Participating Preferred Stock. Each share of Series B Preferred Stock is, at the holder's option, immediately convertible into a number of shares of common stock based on such share's current liquidation value. Each share of Series B Preferred Stock must be redeemed in full by the Company on December 31, 2008. (See also Note 16) SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" requires an issuer to classify a mandatorily redeemable instrument as a liability if it represents an unconditional obligation requiring the Company to redeem the instrument by transferring its assets at a specified or determinable date or upon an event that is certain to occur. The Company's convertible redeemable preferred stock is not classified as a liability due to its conversion feature. STOCK-BASED COMPENSATION SFAS No. 123, "Accounting for Stock-Based Compensation," encourages, but does not require companies to record compensation cost for stock-based employee compensation plans at fair value. As permitted under SFAS No. 123 and as amended by SFAS No. 148, "Accounting for Stock-Based Compensation--Transition and Disclosure--an Amendment of FASB Statement No. 123", the Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion (APB) No. 25 "Accounting for Stock Issued to Employees" and related interpretations, and provides the pro forma disclosure. Accordingly, compensation cost for the stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the measurement date over the amount an employee must pay to acquire the stock. Pro forma information regarding net income (loss) and income (loss) per share is required by SFAS No. 123, and has been determined as if the Company accounted for its employee stock options granted subsequent to December 31, 1995, under the fair value method of SFAS No. 123. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions for 2003 and 2002 (there were no options granted in 2001): 2003 2002 --------------- ------------- Risk free interest rate 3.0% 3.0% Dividends -- -- Volatility factor .60 .60 Expected Life 5 years 5 years F-11 For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows: YEAR ENDED DECEMBER 31, -------------------------------------- 2003 2002 2001 ---------- ---------- ---------- Net income (loss) $ (12,353) $ 745 $ 2,980 Less: Total stock-based employee compensation expense determined under Black-Scholes option pricing model, net of related tax effects determined under the fair value method for all awards (357) (519) (321) ---------- ---------- ---------- Pro forma net income (loss) $ (12,710) $ 226 $ 2,659 ========== ========== ========== Earnings (loss) per share - As reported: Basic $ (0.43) $ 0.02 $ 0.23 Diluted $ (0.43) $ 0.01 $ 0.23 Earnings (loss) per share - Pro forma: Basic $ (0.44) $ (0.02) $ 0.21 Diluted $ (0.44) $ (0.02) $ 0.20 FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, as amended, "Disclosures about Fair Value of Financial Instruments," requires the disclosure of fair value information for certain assets and liabilities for which it is practicable to estimate that value. The Company's financial instruments include cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, long-term debt and redeemable preferred stock. The Company considers the carrying amount of cash and cash equivalents, accounts receivable, notes receivable, accounts payable and accrued liabilities to approximate their fair values because of the short period of time between the origination of such instruments and their expected realization or their current market rate of interest. The carrying amount of long term debt approximates fair value due to the variable interest rate. Using available market information, the Company determined that the fair value at December 31, 2003 of the redeemable preferred stock was $30,602 compared to a carrying value of $5,635. CONCENTRATIONS The Company's principal financial instrument subject to potential concentration of credit risk is accounts receivable which are unsecured. The Company records receivables from patients and third party payors related to eye health services rendered. The Company does not believe that there are any substantial credit risks associated with receivables due from governmental agencies and any concentration of credit risk from other third party payors is limited by the number of patients and payors. The Company does not believe that there are any substantial credit risks associated with other receivables due from buying group members or other customers. The Company has six managed vision contracts with two insurers, CIGNA and United St. Louis, which account for 14 % of the Company's consolidated revenue in 2003. ESTIMATES In preparing financial statements, management is required to make estimates and assumptions, particularly in determining the adequacy of the allowance for doubtful accounts, insurance disallowances, managed care claims accrual, deferred taxes and in evaluating goodwill and intangibles for impairment, that affect the reported amounts of assets and liabilities as of the balance sheet date and results of operations for the year. Actual results could differ from those estimates. RECLASSIFICATIONS Certain prior year amounts have been reclassified in order to conform to the current year presentation. F-12 RECENT ACCOUNTING PRONOUNCEMENTS In November 2002, Financial Accounting Standards Board ("FASB") Interpretation ("FIN") No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" was issued. The interpretation provides guidance on the guarantor's accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others. The Company adopted the disclosure requirements of the interpretation as of December 31, 2002. Effective January 1, 2003, additional provisions of FIN No. 45 became effective and were adopted by the Company. The accounting guidelines are applicable to guarantees issued after December 31, 2002 and require that the Company record a liability for the fair value of such guarantees in the balance sheet. The adoption of FIN No. 45 did not have a material impact on the Company's financial position or results of operations. Effective January 1, 2003, the Company adopted SFAS No. 143, "Accounting For Asset Retirement Obligations". This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The adoption of this statement did not have a material impact on the Company's financial position or results of operations. Effective January 1, 2003, the Company adopted SFAS No. 145, "Rescission of FASB Statements 4, 44 and 64, Amendment of FASB Statement 13, and Technical Corrections". SFAS No. 145 rescinds the provisions of SFAS No. 4 that requires companies to classify certain gains and losses from debt extinguishments as extraordinary items, eliminates the provisions of SFAS No. 44 regarding transition to the Motor Carrier Act of 1980 and amends the provisions of SFAS No. 13 to require that certain lease modifications be treated as sale leaseback transactions. The provisions of SFAS No. 145 related to classification of debt extinguishment are effective for fiscal years beginning after May 15, 2002. As a result of the Company's adoption of SFAS No. 145, the Company reclassified its previously reported gain from extinguishment of debt of approximately $8.8 million and related income tax expense of approximately $3.5 million in 2002 from an extraordinary item to continuing operations. Effective January 1, 2003, the Company adopted SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" and nullified EITF Issue No. 94-3. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, whereas EITF No 94-3 had recognized the liability at the commitment date of an exit plan. There was no effect on the Company's financial statements as a result of such adoption. Effective January 1, 2003, the Company adopted SFAS No. 148, "Accounting for Stock-Based Compensation--Transition and Disclosure--an amendment of FASB Statement No. 123." This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. This statement also amends the disclosure requirements of SFAS No. 123 and Accounting Principles Board Opinion ("APB") No. 28, "Interim Financial Reporting," to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company elected to adopt the disclosure only provisions of SFAS No. 148 and will continue to follow APB Opinion No. 25 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. For disclosure regarding stock options had compensation cost been determined in accordance with SFAS No. 123, see Stock Based Compensation above. In January 2003, the FASB issued Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities." FIN 46 requires an investor with a majority of the variable interests in a variable interest entity to consolidate the entity and also requires majority and significant variable interest investors to provide certain disclosures. A variable interest entity is an entity in which the equity investors do not have a controlling interest or the equity investment at risk is insufficient to finance the entity's activities without receiving additional subordinated financial support from the other parties. The consolidation provisions of this interpretation are required immediately for all variable interest entities created after January 31, 2003, and the Company's adoption of these provisions did not have a material effect on its financial position or results of operations. For variable interest entities in existence prior to January 31, 2003, the consolidation provisions of FIN 46 are effective December 31, 2003 and did not have a material effect on the Company's financial position or results of operations. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and F-13 Hedging Activities". SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments. This statement is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of this statement did not have a material impact on the Company's financial position or results of operations. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Most of the guidance in SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of SFAS No. 150 did not have a material impact on the Company's financial position or results of operations. 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 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, EITF Issue 03-6 addresses other forms of participating securities, including options, warrants, forwards and other contracts to issue an entity's common stock, with the exception of stock-based compensation (unvested options and restricted stock) subject to the provisions of Opinion 25 and SFAS No. 123, EITF Issues 03-6 is effective for reporting periods beginning after March 31, 2004 and should be be applied by restating previously reported earnings per share. The adoption of EITF Issue 03-6 is not expected to have a material impact on the Company's consolidated financial statements. 5. 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 Company acquired Wise Optical to become a leading optical product distributor. Wise Optical has experienced substantial operating losses in 2003. These losses are largely attributable to significant expenses incurred by Wise Optical, including integration costs (primarily severance and stay bonuses and legal and professional fees), weakness in gross margins and an operating structure built to support a higher sales volume. In September 2003, the Company began implementing strategies and operational changes designed to improve the operations of Wise Optical. These efforts include developing our sales force, improving customer service, enhancing productivity, eliminating positions and streamlining our warehouse and distribution processes. In addition, effective September 3, 2003, Gordon Bishop, President of the Company's Consumer Vision division, has replaced the former President of the Distribution sector of the Distribution division, formerly the Distribution and Technology division. Gordon brings industry expertise and a strong optical background to Wise Optical, along with a focus on operating expenses. The Company believes these changes will lead to increased sales, improved gross margins and reduced operating costs. The results of operations of Wise Optical are included in the consolidated financial statements from February 1, 2003, the deemed effective date of the acquisition for accounting purposes. The following is a summary of the unaudited pro forma results of operations of the Company as if the Wise Acquisition had closed effective January 1, of the respective periods below: YEAR ENDED DECEMBER 31, ------------------------------------ 2003 2002 2001 -------- -------- -------- Net Revenues $132,380 $157,413 $154,215 Loss from continuing operations (12,206) (6,641) 2,135 Net income (loss) (12,206) (10,762) 2,428 Income (loss) per common share from continuing operations (1): Basic $ (0.43) $ (0.53) $ 0.16 Diluted $ (0.43) $ (0.53) $ 0.15 Net income (loss)(1) F-14 Basic $ (0.43) $ (0.83) $ 0.18 Diluted $ (0.43) $ (0.83) $ 0.17 (1) Includes effect of preferred stock dividends. The unaudited pro forma information presented above 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. The aggregate purchase price of Wise Optical of $7,949 consisted of approximately $7,290 of cash, 750,000 shares of the Company's common stock with an estimated fair market value of $330, and transaction costs of approximately $329. Funds for the acquisition were obtained via the Company's revolving credit note with CapitalSource Finance, LLC ("CapitalSource"), which was increased from $10,000 to $15,000 in connection with the acquisition of Wise Optical. The aggregate purchase price of $7,949 was allocated to the estimated fair value of the assets acquired and liabilities assumed with the excess identified as goodwill. Fair values were based on valuations and other studies. The goodwill resulting from this transaction, of $318, was assigned to the Company's Distribution and Technology operating segment, which is now the Distribution Segment, and is expected to be amortizable for tax purposes. The goodwill from this acquisition was written-off in September 2003 due to impairment, primarily resulting from the unexpected losses at Wise Optical. See Note 11. The following table sets forth the allocation of purchase price consideration to the assets acquired and liabilities assumed at the date of acquisition. Assets: Cash and cash equivalents $ 1,427 Accounts receivable 6,626 Inventory 5,732 Property and equipment, net 2,416 Other assets 148 Goodwill 318 -------- Total assets $16,667 ======== Liabilities: Accounts payable and accrued expenses $ 8,657 Other liabilities 61 -------- Total liabilities $ 8,718 ======== 6. DISCONTINUED OPERATIONS In May 2002, the Company's Board of Directors approved management's plan to dispose of substantially all of the net assets relating to the retail optical business and professional optometry practice locations it operated in North Carolina ("NCOP"). Accordingly, during the quarter ended June 30, 2002 the Company recorded a $3,940 loss on disposal of discontinued operations based on the estimated fair value of the net assets held for sale. On August 12, 2002 the Company consummated the sale of the NCOP net assets to Optometric Eye Care Center, P.A. ("OECC"), an independent professional association owned by two former officers of the Company and recorded an additional loss on disposal of $494, including income tax expense of $342. In connection with the sale, the Company received $4,200 in cash and a $1,000 promissory note. Additional consideration included OECC's surrender of 1,321,010 shares of the Company's common stock (for retirement) with an estimated fair market value of $357 and OECC's assumption of $135 of certain other liabilities. The aggregate gross consideration from the sale of approximately $5,692 was offset by approximately $477 of closing and other direct costs associated with the sale. The Company paid $3,074 to its bank from the proceeds it received from the sale, of which $500 was applied as a payment on the term loan and $2,574 was applied as a payment on the outstanding credit facility. This sale was accounted for as a disposal group under SFAS No. 144. Accordingly, amounts in the financial F-15 statements and related notes for all periods presented have been reclassified to reflect SFAS No. 144 treatment. Operating results of the discontinued operations are as follows: 2002 2001 -------- -------- External revenue $ 16,771 $ 17,985 ======== ======== Intercompany revenue $ 4,875 $ 9,602 ======== ======== Income from discontinued operations before taxes $ 523 $ 489 Income tax expense 210 196 -------- -------- Income from discontinued operations 313 293 Loss on disposal of discontinued operations, net of income taxes of $342 (4,434) -- -------- -------- Total income (loss) from discontinued operations $ (4,121) $ 293 ======== ======== Income (loss) per share from discontinued operations $ (0.33) $ 0.02 ======== ======== 7. SEGMENT INFORMATION During the third quarter of 2002, the Company sold its retail optometry division in North Carolina and modified the Company's strategic vision. Accordingly, the Company realigned its business into the following three reportable operating segments: (1) Managed Vision, (2) Consumer Vision, and (3) Distribution and Technology. These operating segments are managed separately, offer separate and distinct products and services, and serve different customers and markets, although there is some cross-marketing and selling between the segments. Discrete financial information is available for each of these segments and the Company's President assesses performance and allocates resources among these three operating segments. The Managed Vision segment contracts with insurers, insurance fronting companies, employer groups, managed care plans and other third party payors to manage claims payment administration of eye health benefits for those contracting parties. The Consumer Vision segment sells retail optical products to consumers and operates integrated eye health centers and surgical facilities where comprehensive eye care services are provided to patients. The Distribution and Technology 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; (ii) a Buying Group program, which provides group purchasing arrangements for optical and ophthalmic goods and supplies and (iii) CC Systems, which provides systems and software solutions to eye care professionals. In addition to its reportable operating segments, the Company's "All Other" category includes other non-core operations and transactions, which do not meet the quantitative thresholds for a reportable segment. Included in the "All Other" category is revenue earned under the Company's HSO operation, which receives fee income for providing certain support services to individual ophthalmology and optometry practices. While the Company continues to meet its contractual obligations by providing the requisite services under its HSO agreements, the Company is in the process of disengaging from a number of these 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 years ended December 31, 2003, 2002 and 2001 is as follows: F-16 YEAR ENDED DECEMBER 31, ----------------------------------- 2003 2002 2001 --------- --------- --------- REVENUES: Managed vision $ 28,111 $ 29,426 $ 28,988 Consumer vision 30,871 28,834 28,606 Distribution and technology 69,038 35,029 38,721 --------- --------- --------- Reportable segment totals 128,020 93,289 96,315 All other 2,869 3,283 2,568 Elimination of inter-segment revenues (5,187) (5,041) (4,801) --------- --------- --------- Total net revenue $ 125,702 $ 91,531 $ 94,082 ========= ========= ========= SEGMENT INCOME (LOSS): Managed vision $ 1,271 $ 2,630(1) $ 2,018 Consumer vision 2,856 1,463 385 Distribution and technology (2,695) 267 (71) --------- --------- --------- Total reportable segment income 1,432 4,360 2,332 All other 2,053 2,335 2,041 Depreciation (1,899) (1,851) (1,773) Amortization expense and write-off of goodwill (1,813) (181) (1,124) Interest expense (2,059) (3,048) (3,022) Corporate (3,244) (3,010) (3,793) Gain (loss) on early extinguishment of debt (1,896) 8,789 -- --------- --------- --------- Income (loss) from continuing operations before income taxes $ (7,426) $ 7,394 $ (5,339) ========= ========= ========= (1) Includes a $600 reduction in claims expense due to a favorable adjustment to the reserve. YEAR ENDED DECEMBER 31, ----------------------------------- 2003 2002 2001 --------- --------- --------- ASSETS: Managed vision $15,567 $15,133 $14,435 Consumer vision 10,229 10,200 11,767 Distribution and technology 16,246 7,456 7,652 --------- --------- --------- Segment totals 42,042 32,789 33,854 Discontinued operations -- -- 11,729 Corporate and other 3,813 12,316 14,159 --------- --------- --------- Total $45,855 $45,105 $59,742 ========= ========= ========= CAPITAL EXPENDITURES: Managed vision $ 135 $ 51 $ 25 Consumer vision 591 518 143 Distribution and technology 142 12 36 --------- --------- --------- Segment totals 868 581 204 Discontinued operations -- 379 306 Corporate and other 22 184 113 --------- --------- --------- Total $ 890 $ 1,144 $ 623 ========= ========= ========= F-17 8. RESTRUCTURING AND OTHER ONE-TIME CHARGES DEBT AND EQUITY RESTRUCTURING In the fourth quarter of 2001, the Company recorded approximately $1,017 of professional fees, primarily legal and work-out related non-deferrable costs, associated with the restructure of the Company's long-term debt that closed in January 2002. (See Note 12) OPERATIONS RESTRUCTURING In the fourth quarter of 2000, the Company recorded $2,306 of restructuring charges and $230 of charges related to the canceled sale of the Connecticut operations. The Company's restructuring plans included closing and consolidating facilities, reducing overhead and streamlining operations and was completed in 2001. During the years ended December 31, 2003, 2002 and 2001, $206, $119 and $436, respectively, was charged against the restructuring accrual, representing primarily severance and lease related payments on vacant facilities that were closed as part of the Company's restructuring activities. In 2003, the Company reduced its restructuring reserve by $140 due to a change in estimated future rent payments. The remaining restructuring liability at December 31, 2003 of $471 principally relates to lease obligations on excess office space that are not expected to be utilized over the terms of the remaining leases. 9. RECEIVABLES Activity in the allowance for doubtful accounts consisted of the following for the years ended December 31: 2003 2002 2001 ------- ------- ------- Balance at beginning of period $ 587 $ 501 $ 558 Allowance of acquired company (Wise Optical) 642 -- -- Additions charged to expense 506 323 498 Deductions (546) (237) (555) ------- ------- ------- Balance at end of period $ 1,189 $ 587 $ 501 ======= ======= ======= 10. PROPERTY AND EQUIPMENT Property and equipment consist of the following: DECEMBER 31, -------------------- 2003 2002 -------- -------- Leasehold improvements $ 3,881 $ 3,166 Furniture and equipment 5,441 5,043 Computer hardware and software 6,174 3,828 -------- -------- Total 15,496 12,037 Accumulated depreciation and amortization (10,813) (8,700) -------- -------- Property and equipment, net $ 4,683 $ 3,337 ======== ======== 11. GOODWILL AND OTHER INTANGIBLE ASSETS Effective January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets". The standard changed the accounting for goodwill and intangible assets with an indefinite life whereby such assets are no longer amortized; however the standard does require at least annually a test for impairment, and a corresponding write-down, if appropriate. The first step of the goodwill impairment test identifies potential impairment and the second step of the test is used to measure the amount of impairment loss, if any. The Company completed its transitional test for impairment in the second quarter of 2002 and its annual test for impairment during the fourth quarter of 2002. No impairment charges were required in connection with these tests and there were no changes to the carrying value of goodwill during 2002. F-18 In the third quarter of 2003, the Company performed an interim impairment test of goodwill due to decreases in Buying Group sales and significant operating losses at Wise Optical. The Company completed the first step of the impairment test, which resulted in carrying value exceeding estimated fair value, indicating impairment. The Company was unable to finalize the second step of the impairment test during the third quarter, but recorded an estimated impairment charge of $1,300 in September 2003. The Company finalized the second step of its interim impairment test during the fourth quarter of 2003 and based on the results of that test recorded an additional $339 impairment charge. The Company also performed its annual test for goodwill impairment for all of its reporting units as of December 31, 2003 and no additional impairment charge was required. Changes in the carrying amount of goodwill for the year ended December 31, 2003, by segment, are as follows: MANAGED CONSUMER DISTRIBUTION & VISION VISION TECHNOLOGY TOTAL -------- -------- ---------- -------- Balance, December 31, 2000 $ 11,820 $ 5,586 $ 4,053 $ 21,459 Goodwill from acquisition -- -- -- -- Amortization -- (840) (103) (943) -------- -------- -------- -------- Balance, December 31, 2001 11,820 4,746 3,950 20,516 Goodwill from acquisition -- -- -- -- Amortization -- -- -- -- -------- -------- -------- -------- Balance, December 31, 2002 11,820 4,746 3,950 20,516 Goodwill from acquisition -- -- 318 318 Impairment charge -- -- (1,639) (1,639) -------- -------- -------- -------- Balance, December 31, 2003 $ 11,820 $ 4,746 $ 2,629 $ 19,195 ======== ======== ======== ======== F-19 Comparative information as if goodwill had not been amortized is as follows: 2003 2002 2001 ---------- ---------- ---------- Net income (loss) as reported $ (12,353) $ 745 $ 2,980 Add back: goodwill amortization -- -- 943 ---------- ---------- ---------- Adjusted net income (loss) (12,353) 745 3,923 Preferred stock dividend (618) (531) -- ---------- ---------- ---------- Adjusted net income (loss) available to common Stockholders $ (12,971) $ 214 $ 3,923 ========== ========== ========== Earnings (loss) per common share - basic: Net income (loss) available to common stockholders $ (0.43) $ 0.02 $ 0.23 Goodwill amortization -- -- 0.07 ---------- ---------- ---------- Adjusted net income (loss) per share $ (0.43) $ 0.02 $ 0.30 ========== ========== ========== Earnings (loss) per common share - diluted: Net income (loss) available to common stockholders $ (0.43) $ 0.01 $ 0.23 Goodwill amortization -- -- 0.07 ---------- ---------- ---------- Adjusted net income (loss) per share $ (0.43) $ 0.01 $ 0.30 ========== ========== ========== Intangible assets subject to amortization are as follows as of December 31: 2003 2002 ----------------------------- ----------------------------- Gross Accumulated Net Gross Accumulated Net Amount Amortization Balance Amount Amortization Balance ------ ------ ------ ------ ------ ------ Service Agreement $1,658 $ (479) $1,179 $1,658 $ (368) $1,290 Non-compete agreements 265 (265) -- 265 (202) 63 ------ ------ ------ ------ ------ ------ Total $1,923 $ (744) $1,179 $1,923 $ (570) $1,353 ====== ====== ====== ====== ====== ====== The weighted average amortization period for service agreements and non-compete agreements are 15 years and 3.5 years, respectively. Amortization expense for the years ended December 31, 2003 and 2002 was $174 and $181, respectively. Annual amortization expense is expected to be $111 for each of the years 2004 through 2008. 12. DEBT The details of the Company's debt at December 31, 2003 and 2002 are as follows: 2003 2002 -------- -------- Term note payable to CapitalSource, due January 25, 2006. Monthly principal payments of $25 with balance due at maturity $ 2,075 $ 2,333 Revolving credit note to CapitalSource, due January 25, 2007 10,394 1,557 Senior subordinated secured notes payable due January 24, 2012. (1) -- 15,588 Subordinated notes payable due at various dates through 2004. Principal and interest payments are due monthly or annually. Interest is payable at rates ranging from 7% to 11.4% 124 1,189 Unamortized discounts -- (1,249) -------- -------- Total 12,593 19,418 Less current portion 10,818 2,823 -------- -------- $ 1,775 $ 16,595 ======== ======== (1) Converted into Series C Preferred Stock on May 12, 2003. F-20 Aggregate maturities of long-term debt by year are $1,124 in 2004, $300 in 2005 and $11,869 in 2006. The loan agreement with CapitalSource requires the Company to maintain a lock-box arrangement with its banks whereby amounts received into the lock-boxes are applied to reduce the revolving credit note outstanding. The agreement also contains certain subjective acceleration clauses in the event of a material adverse event. Emerging Issues Task Force (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 the Company to classify outstanding borrowings under the revolving credit note as current liabilities. In accordance with this pronouncement, the Company classified its revolving credit facility as a current liability in the amount of $9,694 and $1,557 at December 31, 2003 and December 31, 2002, respectively. In addition, $700 of an overadvance from CapitalSource is included in current liabilities. The Company had standby letters of credit outstanding at December 31, 2003 and 2002 for $900 and $400, respectively. The letters of credit outstanding at December 31, 2003 and 2002 were secured by restricted certificates of deposit and security deposits, respectively. THE CAPITALSOURCE LOAN AND SECURITY AGREEMENT In January 2002 the Company entered into an Amended and Restated Revolving Credit, Term Loan and Security Agreement (the "Amended Credit Facility") with CapitalSource. CapitalSource acquired this agreement from the Company's previous senior secured lender, Bank Austria, discussed below. The Amended Credit Facility made available to the Company a $3,000 term loan and up to a $10,000 revolving loan facility (the "Revolver") secured by a security interest in substantially all of the assets of the Company. The revolver agreement requires the Company to maintain a lock-box arrangement whereby amounts received into the lock-box is applied to reduce the revolver debt outstanding. On February 7, 2003, in connection with the Company's acquisition of Wise Optical, the Company's credit facility with CapitalSource was amended. The amendment primarily resulted in an increase in the Company's Revolver from $10,000 to $15,000. On November 14, 2003 the Company amended the terms of the Amended Credit Facility which, among other things, (i) increased the term loan by $314 and extend the maturity date of the term loan from January 25, 2004 to January 25, 2006, (ii) extended the maturity date of the revolver January 25, 2005 to January 25, 2006, (iii) permanently increased the advance rate on eligible receivables of Wise Optical from 80% to 85%, (iv) temporarily increased the advance rate on eligible inventory of Wise Optical from 50% to 55% through March 31, 2004, (v) provided access to a $700 temporary over-advance bearing interest at prime plus 5 1/2% due March 31, 2004 (which was prepaid in full by March 1, 2004) and was guaranteed by Palisade Concentrated Equity Partnership, L.P. ("Palisade"), (vi) waived the Company's non-compliance with the minimum fixed charge ratio financial covenant through March 31, 2004 and (vii) changed the net worth covenant from ($27,000) to tangible net worth of ($10,000). In connection with this amendment, the Company agreed to pay CapitalSource $80 in financing fees. The amendment also included an additional $150 termination fee if the Company terminates the Revolver prior to December 31, 2004. Additionally, if the Company terminates the Revolver pursuant to a refinancing with another commercial financial institution, it shall pay CapitalSource, in lieu of a termination fee, a yield maintenance amount shall 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, 2006 and (ii) the total interest and fees actually paid to CapitalSource on the Revolver prior to the termination date or date of prepayment. On March 29, 2004 we entered into the Second Amended Credit Facility with CapitalSource which incorporates all of the changes embodied in the above amendments and: (i) confirmed that the temporary over-advance was repaid as of February 29, 2004 (ii) changed the expiration date of the waiver of our fixed ratio covenant from March 31, 2004 to February 29, 2004 (iii) reduced the tangible net worth covenant from $(10) million to $(2) million. Prior to January 2002, the Company was a party to a loan agreement (the "Credit Facility") with Bank Austria. The Credit Facility made available to the Company a $21,500 term loan and up to a $12,700 revolving loan facility secured by a security interest in substantially all of the assets of the Company. On January 25, 2002 Bank Austria forgave approximately $10,000 of principal and interest and sold this loan to CapitalSource. F-21 CapitalSource, as lender, and the Company, as borrower, amended and restated the terms of the indebtedness as described above (see also Note 8). The Company did not meet its minimum fixed charge ratio covenant for the three months ended September 30, 2003 and December 31, 2003, however, the Company received a waiver for non-compliance with this covenant through February 29, 2004. 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. 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 $2,000 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, which is guaranteed by our largest stockholder, Palisade Concentrated Equity Partnership, L.P, (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 $(2,000) to $(3,000) and (v) add a debt service coverage ratio covenant of between 0.7 to 1.0 for the period October 31, 2004 to February 28, 2005. 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. On August 17, 2004, we paid 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. 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 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 F-22 fee of $600,000. If we terminate the revolving credit facility after December 31, 2005 but prior to the expiration of the revolving credit facility the termination fee is $450,000. Additionally, if we terminate the revolving credit facility pursuant to a refinancing with another commercial financial institution, we must pay CapitalSource, in lieu of the termination fee, a yield maintenance amount equal to the difference between (i) the all-in effective yield which could be earned on the revolving balance through January 25, 2007, and (ii) the total interest and fees actually paid to CapitalSource on the revolving credit facility prior to the termination date or date of prepayment. Our subsidiaries guarantee payments and other obligations under the revolving credit facility and we (including certain subsidiaries) have granted a first-priority security interest in substantially all our assets to CapitalSource. We also pledged the capital stock of certain of our subsidiaries to CapitalSource. SENIOR SUBORDINATED SECURED NOTES In January 2002, Palisade made a subordinated loan to the Company of $13,900 and Ms. Yimoyines made a subordinated loan to the Company of $100 (collectively, the "Senior Secured Loans"), which were evidenced by senior subordinated secured notes. These notes were subordinated to the Company's senior indebtedness with CapitalSource, and were secured second priority security interests in substantially all of the Company's assets. Principal was due on January 25, 2012 and interest was payable quarterly at a rate of 11.5% per annum. In the first and second years of the notes, the Company had the right to defer 100% and 50%, respectively, of interest to maturity by increasing the principal amount of the note by the amount of interest so deferred. On May 12, 2003, Palisade and Ms. Yimoyines exchanged the entire amount of principal and interest due to them under the Senior Secured Loans, totaling an aggregate of $16,246, for a total of 406,158 shares of Series C Preferred Stock, of which 403,256 shares were issued to Palisade and 2,902 shares were issued to Ms. Yimoyines. The aggregate principal and interest was exchanged at a rate equal to $.80 per share, the agreed upon value of our common stock on May 12, 2003, divided by 50 (or $40.00 per share). 13. GAIN (LOSS) ON EARLY EXTINGUISHMENT OF DEBT On January 25, 2002, the Company recorded a gain on the early extinguishment of debt of $8,789 before income tax as a result of the Company's debt restructuring. The $8,789 gain was comprised principally of approximately $10,000 of debt and interest forgiveness by Bank Austria, the Company's former senior secured lender, which was partially offset by $1,200 of unamortized deferred financing fees and debt discount. (See Note 12) On May 12, 2003, the Company recorded a $1,847 loss on the exchange of $16,246 of debt for Series C Preferred Stock. The $1,847 loss represents the write-off of the unamortized deferred debt issuance costs and debt discount associated with the extinguished debt. (See Notes 12 and 17) On November 14, 2003, the Company amended the Amended Credit Facility with CapitalSource and recorded a $49 loss on the extinguishment of debt, representing financing fees and the write-off of unamortized deferred debt issuance costs associated with the original loans under the Amended Credit facility. (See Note 12) 14. LEASES The Company leases certain furniture, machinery and equipment under capital lease agreements that expire through 2005. The Company primarily leases its facilities under cancelable and noncancelable operating leases expiring in various years through 2012, including leases with related parties (see Note 18). Several facility leases F-23 have annual rental terms comprised of base rent at the inception of the lease adjusted by an amount based, in part, upon the increase in the consumer price index. Lease expense charged to continuing operations during the years ended December 31, 2003, 2002 and 2001 was $2,438, $3,990 and $5,087, respectively. Property and equipment includes the following amounts for capital leases at December 31: 2003 2002 ----- ----- Furniture, machinery and equipment $ 248 $ 248 Less accumulated amortization (235) (181) ----- ----- $ 13 $ 67 ===== ===== Future minimum lease payments, by year and in the aggregate, under capital leases and operating leases with remaining terms of one year or more consisted of the following at December 31, 2003: CAPITAL OPERATING LEASES LEASES ------- ------- 2004 $ 10 $ 2,620 2005 -- 2,505 2006 -- 2,277 2007 -- 2,067 2008 1,853 Thereafter -- 3,248 ------- ------- Total minimum lease payments $ 10 $14,570 ======= ======= 15. 401(K) SAVINGS PLAN The Company provides a defined contribution 401(k) savings plan to substantially all employees who meet certain age and employment criteria. Eligible employees are allowed to contribute a portion of their income in accordance with specified guidelines. The Company matches a percentage of employee contributions up to certain limits. Employer contributions are made on a discretionary basis as authorized by the Board of Directors. Employer contributions for the years ended December 31, 2003, 2002, and 2001 were $243, $288 and $333, respectively. 16. REDEEMABLE CONVERTIBLE PREFERRED STOCK On January 25, 2002 the Company designated and issued 3,204,959 shares of Series B 12.5% Voting Cumulative Convertible Participating Preferred Stock (the "Series B Preferred Stock") having a liquidation preference of $1.40 per share. Subject to a senior liquidation preference of the Series C Preferred Stock (see Note 17), the Series B Preferred Stock ranks senior to all other currently issued and outstanding classes or series of the Company's 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, at the holder's option, immediately 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 increases at a rate of 12.5% per year compounded annually. Each share of Series B Preferred Stock must be redeemed in full by the Company on December 31, 2008, at a price equal to the greater of (i) the aggregate adjusted redemption value of the Series B Preferred Stock ($1.40 per share) plus accrued but unpaid dividends or (ii) the amount the preferred stockholders would be entitled to receive if the Series B Preferred Stock plus accrued dividends were converted at that time into common stock and the Company were to liquidate and distribute all of its assets to its common stockholders. As of December 31, 2003, cumulative accrued and unpaid dividends on the Series B Preferred Stock totaled $1,150 or $0.36 per preferred share. As of December 31, 2003 there were 3,204,959 shares of Series B Preferred Stock outstanding with a liquidation value of $1.76 per share. F-24 17. STOCKHOLDERS' EQUITY SERIES C PREFERRED STOCK On May 12, 2003, the Company issued 406,158 shares of Series C preferred stock to Palisade and Ms. Yimoyines, collectively, in exchange for amounts due to them by the Company under Senior Secured Loans (See Note 12.) The Series C Preferred Stock 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, at the holder's option, convertible into 50 shares of common stock and has the same dividend rights, on an as converted basis, as the Company's common stock. The Company authorized for issuance 5,000,000 shares of Series B and Series C Preferred Stock, collectively. WARRANTS As of December 31, 2003, the following warrants to purchase common stock of the Company were outstanding and exercisable with expiration dates ranging from 2005 to 2012: OUTSTANDING EXERCISE WARRANTS PRICE ----------- ------- 275,000 $ 0.14 20,000 $ 0.16 750,000 $ 0.40 2,000,000 $ 1.00 50,000 $ 3.50 30,000 $ 4.50 ----------- 3,125,000 =========== In December 2002 warrants to purchase 17,500,000 common shares of the Company were exercised at a price of $0.14 per share. These warrants were scheduled to expire in 2012. EMPLOYEE STOCK PURCHASE PLAN The Company provides an Employee Stock Purchase Plan (the "ESPP") to substantially all eligible employees who meet certain employment criteria. Under the terms of the ESPP, eligible employees may have up to 20% of eligible compensation deducted from their pay to purchase common stock. The per share purchase price is 85% of the average high and low per share trading price of common stock on the American Stock Exchange on the last trading date prior to the investment date, as defined in the ESPP. The amount that may be offered pursuant to this plan is 450,000 shares. Effective July 2001, the Company suspended the purchase of shares by employees under the ESPP. As of December 31, 2003, the purchase of shares under the ESSP remained suspended and, therefore, no shares were purchased by employees during 2003. For the year ended December 31, 2001, 33,458 shares were purchased by employees under the ESPP at a weighted average price of $0.24. STOCK PLANS The Company's stock plans provide for the grant of incentive stock options and non-qualified stock options as well as restricted stock. Stock options generally are granted with an exercise price equal to 100% of the market value of a share of common stock on the date of grant, have a 10-year term and vest within four years from the date of grant. The weighted average fair value of stock options, calculated using the Black-Scholes option pricing model, granted during 2003 and 2002 was $0.37 and $0.11 per share, respectively. There were 225,000 and 25,000 shares of restricted common stock issued in 2003 and 2002, respectively, with a weighted average fair value at the date of grant of $0.65 and $0.16, respectively. There were no stock options or restricted stock granted during the year ended December 31, 2001. As of December 31, 2003, 8,734,791 shares were reserved for issuance under the stock plans, including 3,211,329 shares available for future grant. Presented below is a summary of the status of the Company's stock options and the related transactions for the years ended December 31, 2003, 2002 and 2001. F-25 WEIGHTED AVERAGE OPTIONS EXERCISE OUTSTANDING PRICE ---------- ----- December 31, 2000 1,242,146 $5.33 Canceled (321,688) $4.51 ---------- ----- December 31, 2001 920,458 $5.62 Granted 4,732,500 $0.33 Canceled (68,892) $5.71 ---------- ----- December 31, 2002 5,584,066 $1.14 Granted 888,000 $0.66 Exercised (580,000) $0.25 Canceled (368,604) $0.66 ---------- ----- December 31, 2003 5,523,462 $1.19 ========== ===== The following table summarizes in more detail information regarding the Company's stock options outstanding at December 31, 2003. OPTIONS OUTSTANDING OPTIONS EXERCISABLE --------------------------------------- ------------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED REMAINING AVERAGE AVERAGE OUTSTANDING CONTRACTUAL EXERCISE EXERCISABLE EXERCISE Exercise Price OPTIONS LIFE (YEARS) PRICE OPTIONS PRICE --------------- ----------- ------------ -------- ----------- -------- $ 0.15 - $ 0.16 1,350,000 8.0 $ 0.15 675,000 $ 0.15 $ 0.20 745,000 8.4 $ 0.20 411,250 $ 0.20 $ 0.25 - $ 0.26 862,500 8.5 $ 0.26 412,500 $ 0.25 $ 0.31 - $ 0.36 540,000 8.9 $ 0.36 407,500 $ 0.36 $ 0.65 - $ 0.77 758,000 9.1 $ 0.66 215,000 $ 0.65 $ 1.00 - $ 1.78 245,000 8.1 $ 1.14 95,000 $ 1.37 $ 2.00 - $ 2.56 545,131 6.7 $ 2.35 395,131 $ 2.49 $ 5.85 440,000 5.6 $ 5.85 440,000 $ 5.85 $ 6.37 - $ 63.73 37,831 4.7 $30.42 37,831 $30.42 ---------- --- ------ --------- ------ Total 5,523,462 8.0 $ 1.19 3,089,212 $ 1.75 ========== === ====== ========= ====== There were 2,685,001 and 651,078 options exercisable at December 31, 2002 and 2001, respectively, with a weighted average exercise price of $1.68 and $5.74, respectively. 18. RELATED PARTY TRANSACTIONS The Company incurred rent expense of $106 and $146 in 2002 and 2001, respectively, which was paid to certain doctors for the use of equipment. The Company incurred rent expense of $1,086, $1,780 and $2,098 in 2003, 2002 and 2001, respectively, which was paid to entities in which certain officers of the Company had an interest, for the lease of facilities. In the normal course of business, the Company contracts with OptiCare P.C. to provide medical, surgical and optometric services to patients. The Company's Chief Executive Officer is the sole stockholder of OptiCare P.C. A subsidiary of the Company remains a guarantor with respect to two leases where the lessee is an entity owned by two former officers of the Company. Aggregate annual rent under the leases is $194,392. Each of the guarantees and its underlying lease involved the professional optometry practice locations and retail optical business the Company operated in the State of North Carolina, which were sold to Optometric Eye Care Center, P.A. ("OECC") in August 2002. Although, in connection with that sale, OECC assumed from the Company any obligations the Company or its subsidiaries or affiliates may have had as lessee under those leases, OECC and the Company were unable to obtain landlord consent to the assignment of the Company's guarantees with respect to the leases, which expire in 2005. As a guarantor, performance by the Company would be required if the borrowing entity defaulted, however the Company had deemed that its performance as a guarantor is not likely to occur. In addition, if the Company were called upon to perform in the event of default by OECC, the Company would have recourse against OECC. In January 2002, the Company issued senior subordinated secured notes payable to Palisade, a significant F-26 shareholder, for $13,900 and to Ms. Yimoyines, wife of the Company's Chief Executive Officer, for $100. For the years ended December 31, 2002, interest expense on the notes to Palisade and Ms. Yimoyines was $1,577 and $11, respectively, which was paid in kind. In May 2003, Palisade and Ms. Yimoyines exchanged the entire amount of principal and interest due to them under these notes for shares of Series C Preferred Stock, of which 403,256 shares were issued to Palisade and 2,902 shares were issued to Ms. Yimoyines. Interest expense on the notes payable to Palisade and Ms. Yimoyines in 2003, prior to the exchange for Series C Preferred Stock, was $658 and $5, respectively. In January 2002, in connection with providing the Senior Secured Loans to the Company, Palisade and Ms. Yimoyines received warrants to purchase 17,375,000 and 125,000 shares, respectively, of the Company's common stock at an exercise price of $0.14. These warrants were exercised in December 2002. In January 2002, Palisade purchased 2,571,429 shares of the Company's Series B Preferred Stock for $3,600 in cash and Ms. Yimoyines purchased 285,714 shares of Series B Preferred Stock for $400 in cash. Also in January 2002, the Company issued an additional 309,170.5 shares of Series B Preferred Stock to Palisade to satisfy an outstanding loan of $400 of principal and $33 of accrued interest and issued an additional 38,646.3 shares of Series B Preferred Stock to Ms. Yimoyines to satisfy an outstanding loan of $50 of principal and $4 of accrued interest due to Ms. Yimoyines. As of December 31, 2003, accrued and unpaid dividends on these shares owned by Palisade and Ms. Yimoyines totaled $1,034 and $116, respectively. As of December 31, 2002 the Company had an unsecured promissory note payable to an officer of the Company related to an amount owed in connection with the Company's purchase of Cohen Systems in 1999. The note, which accrues interest at 7.50% and matures on December 1, 2004, had an outstanding balance of $106 at December 31, 2003 and is reflected as a current liability. For the year ended December 31, 2003 and 2002, interest expense on this note was $12 and 9, respectively. 19. EARNINGS (LOSS) PER COMMON SHARE The following table sets forth the computation of basic and diluted earnings (loss) per share: YEAR ENDED DECEMBER 31, ------------------------------------------ 2003 2002 2001 ---------- ------------ ------------ Income (loss) from continuing operations $ (12,353) $ 4,866 $ 2,687 Preferred stock dividends (618) (531) -- ---------- ------------ ------------ Income (loss) from continuing operations applicable to common stockholders (12,971) 4, 335 2,687 Discontinued operations -- (4,121) 293 ---------- ------------ ------------ Net income (loss) applicable to common shareholders $ (12,971) $ 214 $ 2,980 ========== ============ ============ Weighted average common shares - basic 30,066,835 12,552,185 12,795,433 Effect of dilutive securities: Convertible preferred stock Options * 790,102 * Warrants * 7,887,094 * Preferred Stock * 29,942,229 418,803 ---------- ------------ ------------ Weighted average common shares - dilutive 30,066,835 51,171,610 13,214,236 ========== ============ ============ Basic Earnings Per Share: Income (loss) from continuing operations $ (0.43) $ 0.35 $ 0.21 Discontinued operations -- (0.33) 0.02 ---------- ------------ ------------ Net income (loss) per common share $ (0.43) $ 0.02 $ 0.23 ========== ============ ============ Diluted Earnings Per Share: Income (loss) from continuing operations $ (0.43) $ 0.10 $ 0.21 Discontinued operations -- $ (0.33) 0.02 ---------- ------------ ------------ Net income (loss) per common share $ (0.43) $ 0.01 $ 0.23 ========== ============ ============ F-27 * Anti-dilutive The following table reflects the potential common shares of the Company at December 31, 2003, 2002 and 2001 that have been excluded from the calculation of diluted earnings per share due to anti-dilution. 2003 2002 2001 ---------- ---------- ---------- Options 5,523,462 2,111,566 920,458 Warrants 3,125,000 2,830,000 3,501,198 Convertible preferred stock 60,574,323 -- -- ---------- ---------- ---------- Total 69,222,785 4,941,566 4,421,656 ========== ========== ========== 20. INCOME TAXES Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The liability method of accounting for deferred income taxes requires a valuation allowance against deferred tax assets if, based on the weight of historic available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The Company recorded income tax expense of $4,927 for the year ended December 31, 2003, which included $7,600 of tax expense to establish a full valuation allowance against the Company's deferred tax assets. The 2003 valuation allowance is required due to the substantial operating losses at Wise Optical. The 2003 tax expense was partially offset by $2,673 of tax benefit on the Company's loss from continuing operations. Significant components of the Company's deferred tax assets and liabilities consisted of the following at December 31, 2003 and 2002: 2003 2002 ------- ------- Deferred tax assets (liabilities): Net operating loss carryforwards $ 2,956 $ 1,389 Accruals 1,438 1,451 Allowance for bad debts 412 202 Depreciation and amortization 2,395 1,480 Other 399 278 ------- ------- Total deferred tax assets 7,600 4,800 Valuation allowance (7,600) -- ------- ------- Total deferred tax assets, net $ -- $ 4,800 ======= ======= The current portion of the deferred tax asset, which is included in other current assets, was $0 and $1,660 at December 31, 2003 and 2002, respectively. As of December 31, 2003, the Company has net operating loss carryforwards available of approximately $6,800 for federal tax purposes. These NOL carryforwards expire in the years 2021 through 2023. The components of income tax expense (benefit) for the years ended December 31, 2003, 2002 and 2001 are as follows: 2003 2002 2001 ------- ------- ------- Current: Federal $ -- $ -- $ -- State 127 80 (30) ------- ------- ------- Total current 127 80 (30) ------- ------- ------- Deferred: Federal 3,980 2,030 (6,634) State 820 418 (1,362) F-28 ------- ------- ------- Total deferred 4,800 2,448 (7,996) ------- ------- ------- Total income tax expense (benefit) $ 4,927 $ 2,528 $(8,026) ======= ======= ======= A reconciliation of the tax provision (benefit) at the U.S. Statutory Rate to the effective income tax rate as reported is as follows: 2003 2002 2001 ---- ---- ---- Tax provision (benefit) at U.S. Statutory Rate (34)% 34% (34)% State income taxes, net of federal benefit 8% 5% (6)% Non-deductible expenses and other (11)% (5)% 33% Change in valuation allowance 104% -- (143)% ---- ---- ---- Effective income tax rate 67% 34% (150)% ==== ==== ==== 21. COMMITMENTS AND CONTINGENCIES HEALTH SERVICE ORGANIZATION LAWSUITS In September and October 2001, the following actions were commenced: Charles Retina Institute, P.C. and Steven T. Charles, M.D. v. OptiCare Health Systems, Inc., filed in Chancery Court of Tennessee for the Thirtieth Judicial District at Memphis; Eye Associates of Southern Indiana, P.C. and Bradley C. Black, M.D. v. PrimeVision Health, Inc., filed in United States District Court, Southern District of Indiana; and Huntington & Distler, P.S.C., John A. Distler, M.D. and Anne C. Huntington, M.D. v. PrimeVision Health, Inc., filed in United States District Court, Western District of Kentucky. Plaintiffs (ophthalmology or optometry practices) in each of these actions alleged that our subsidiary, PrimeVision Health, Inc. (referred to as "PrimeVision") defaulted under agreements effective as of April 1, 1999 entitled Services Agreement (HSO Model) (referred to as "Services Agreements") by failing to provide the services allegedly required under those agreements in exchange for annual fees (referred to as "HSO Fees") to be paid to PrimeVision. Plaintiffs also alleged that PrimeVision repudiated any duty to perform meaningful services under the Services Agreements and never intended to provide meaningful services. Plaintiffs seek declaratory relief that they are not required to make any payments of HSO Fees to PrimeVision under the Services Agreements for a variety of reasons, including that plaintiffs are discharged of any duty to make payments, there was no termination of the Services Agreements that would trigger an obligation by plaintiffs to pay PrimeVision the amounts designated in the agreements as being owed upon early termination (referred to as the "Buy-out Price"), the agreements contained an unenforceable penalty, there was lack of consideration, and there was a mutual and material misunderstanding. Plaintiffs also seek damages for non-performance and breach of duty of good faith and fair dealing, and seek to rescind the Services Agreements for fraud in the inducement, material misrepresentation, and mistake. Finally, plaintiffs seek punitive damages and attorneys' fees, interest and costs. PrimeVision also filed denials of all of the material allegations of the complaints in the Huntington & Distler and Eye Associates of Southern Indiana cases, and asserted counterclaims to recover HSO Fees and the Buy-out Price. In November 2001, PrimeVision commenced the following action: PrimeVision Health, Inc. v. Charles Retina Institute and Steven T. Charles, M.D. filed in United States District Court for the Eastern District of North Carolina, Western District. In this action, PrimeVision sued in North Carolina, which is its principal place of business, one of the practices which had, in an action cited above, sued it in Tennessee. PrimeVision alleged that the Services Agreement and a Transition Agreement, also entered into by Defendant and PrimeVision in April 1999, were part of an integrated transaction in which many practices (referred to as the "Practices") that had previously entered into a physician practice management (referred to as "PPM") arrangement with PrimeVision converted to a health service organization (referred to as "HSO") model. As part of that integrated transaction, the Practices (including Defendant) repurchased assets that they had sold to PrimeVision in or about 1996 and were able to terminate agreements entered into with PrimeVision in 1996 and the obligations thereunder. PrimeVision sought a declaratory judgment that the Services Agreement is enforceable and that Defendant must pay to PrimeVision the annual HSO Fees required under the Services Agreement or, alternatively, the Buy-out Price. The Multidistrict Litigation. On March 18, 2002, PrimeVision filed a motion with the Judicial Panel on Multidistrict Litigation in Washington, D.C. (referred to as the "Judicial Panel") to transfer the foregoing litigation to a single federal district court for consolidated or coordinated pretrial proceedings. Over the opposition of the plaintiffs, the Judicial Panel granted the motion and ordered that all of the cases be consolidated in the U.S. District F-29 Court for the Western District of Kentucky under the caption In re PrimeVision Health, Inc. Contract Litigation, MDL 1466 ("MDL 1466"). In October and November 2002, PrimeVision commenced the following actions: 1. PrimeVision Health, Inc. v. The Brinkenhoff Medical Center, Inc., Michael Brinkenhoff, M.D., Tri-County Eye Institute, and Mark E. Schneider, M.D., filed in the United States District Court for the Central District of California; 2. PrimeVision Health, Inc. v. Robert M. Thomas, Jr., M.D., a medical corporation, Robert M. Thomas, Jr., M.D., Jeffrey P. Wasserstrom, M.D., a medical corporation, Jeffrey P. Wasserstrom, M.D., Lawrence S. Rice, a medical corporation and Lawrence S. Rice, M.D., filed in the United States District Court for the Southern District of California; 3. PrimeVision Health, Inc. v. The Milne Eye Medical Center, P.C. and Milton J. Milne, M.D., filed in the United States District Court for the District of Maryland; 4. PrimeVision Health, Inc. v. Eye Surgeons of Indiana, P.C., Michael G. Orr, M.D., Kevin L. Waltz, M.D. and Surgical Care, Inc., in the United States District Court for the Southern District of Indiana, Indianapolis Division; 5. PrimeVision Health, Inc. v. Downing-McPeak Vision Centers, P.S.C. and John E. Downing, M.D., in the United States District Court for the Western District of Kentucky, Bowling Green Division; 6. Prime Vision Health, Inc. v. HCS Eye Institute, P.C., Midwest Eye Institute of Kansas City, John C. Hagan, III, M.D. and Michael Somers, M.D., filed in the United States District Court for the Western District of Missouri; and 7. PrimeVision Health, Inc. v. Delaware Eye Care Center, P.A., a professional corporation; and Gary Markowitz, M.D., filed in the Superior Court of the State of Delaware, New Castle County. PrimeVision requested the Judicial Panel to transfer all of the actions except No. 7 to Kentucky and consolidate them as part of MDL 1466. (Action 7 could not be transferred because it was filed in state court.) The Judicial Panel entered a conditional transfer order for such actions, and because there was no opposition to transfer and consolidation in Actions 4, 5 and 6, they are now part of MDL 1466. One practice defendant in Action 1, and the defendants in Actions 2 and 3 opposed transfer to MDL 1466. On April 11, 2003, the Judicial Panel denied those defendants' motions to vacate the Judicial Panel's order to conditionally transfer the actions to the Western District of Kentucky and ordered the remaining three actions transferred to the Western District of Kentucky for inclusion in the coordinated or consolidated pretrial proceedings occurring there. The actions filed by PrimeVision contain similar allegations as the action PrimeVision filed against Charles Retina Institute in North Carolina District Court as described above. Instead of declaratory relief, however, PrimeVision seeks money damages for payment of the contractual Buy-Out Price. All of the defendants have denied the material allegations of the complaints, and the defendants in Actions 3, 4, 5, 6 and 7 above have asserted counterclaims and seek relief similar to the claims asserted and relief sought by the practices in the Charles Retina, Eye Associates of Southern Indiana and Huntington & Distler cases. PrimeVision has denied all of the material allegations of the counterclaims. The parties have exchanged written discovery and have begun taking depositions. PrimeVision also is willing to discuss a potential settlement with any or all of the Practices, although there is no indication that the Practices are prepared to discuss settlement on the same general basis or terms as PrimeVision. At this stage of the actions, we are unable to form an opinion as to the likely outcome or the amount or range of potential loss, if any. During 2002 and 2003, we reached settlement with two HSO Practices with which we were in litigation and with 11 other practices with which we were not in litigation but where there was a mutual desire to disengage from the Services Agreements. While we continue to meet our contractual obligations by providing the requisite services under our Services Agreements, we are in the process of disengaging from a number of these arrangements. OTHER LITIGATION OptiVest, LLC v. OptiCare Health Systems, Inc., OptiCare Eye Health Centers, Inc. and Dean Yimoyines, filed in F-30 the Superior Court, Judicial District of Waterbury, Connecticut on January 14, 2002. Plaintiff is a Connecticut limited liability corporation that entered into an Asset Purchase Agreement for certain of our assets. We believe we properly cancelled the Asset Purchase Agreement pursuant to its terms. Plaintiff maintains that it incurred expenses in investigating a potential purchase of certain assets, that we misled it with respect to our financial condition, and, as a result, Plaintiff has suffered damages. Plaintiff seeks specific performance of the Asset Purchase Agreement and an injunction prohibiting us from interfering with concluding the transactions contemplated by the Asset Purchase Agreement. Further, Plaintiff alleges a breach of contract with regard to the Asset Purchase Agreement. Plaintiff further alleges we engaged in innocent misrepresentation, negligent misrepresentation, intentional and fraudulent misrepresentation, and unfair trade practices with respect to the Asset Purchase Agreement. The parties agreed to non-binding mediation, which began in April 2003 and will continue at a later date to be agreed by the parties. At the mediation, OptiVest, LLC agreed to withdraw its lawsuit and continue to attempt to resolve this matter through non-binding mediation. Optivest LLC has withdrawn its lawsuit however non-binding mediation has not been successful and the parties will submit this matter to binding arbitration to be scheduled in the future. THREATENED LITIGATION As previously reported, in the fourth quarter of 2002, the Company received notice from an attorney representing a physician employed by our professional affiliate regarding a possible employment claim and expressing disagreement with the computation of physicians' salaries in the professional affiliate, alleged mismanagement of our company and/or the professional affiliate, possible conflicts of interests and unlawful practice and/or compensation issues. In April 2003 the parties proceeded with non-binding mediation and believed the matter had been resolved, however, since that time the parties have been in discussion regarding the resolution reached at the mediation and no formal settlement agreement has been entered into at this time. In the normal course of business, 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 December 31, 2003 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 effect in relation to the Company's consolidated financial position or results of operations. 22. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Historical quarterly results have been restated, as presented below, to reflect the Company's adoption of SFAS No. 145, which resulted in the reclassification of the Company's previously reported gain from extinguishment of debt of $8,789 and related income taxes of $3,475 in 2002 from an extraordinary item to continuing operations. FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER -------- -------- -------- -------- 2003 ---- Net revenue $ 31,996 $ 32,897 $ 32,946 $ 27,793 Gross profit 10,225 10,484 9,022 8,692 Income (loss) from continuing operations 160 (2,173) (8,479) (1,861) Net income (loss) 160 (2,173) (8,479) (1,861) Preferred stock dividend (140) (160) (159) (159) Basic and diluted earnings (loss) per share : Loss from continuing operations 0.00 (0.08) (0.29) (0.07) Net loss 0.00 (0.08) (0.29) (0.07) 2002 ---- Net revenue $ 23,290 $ 24,046 $ 23,010 $ 21,185 Gross profit 6,612 7,478 8,193 7,700 Income (loss) from continuing operations 4,868 (125) 104 21 Discontinued operations 189 (3,945) (23) (342) F-31 Net income (loss) 5,057 (4,070) 81 (321) Preferred stock dividend (103) (142) (143) (143) Basic earnings (loss) per share : Income (loss) from continuing operations 0.37 (0.02) (0.01) (0.01) Net income (loss) 0.39 (0.33) (0.01) (0.04) Diluted earnings (loss) per share : Income (loss) from continuing operations 0.08 (0.02) (0.01) (0.01) Net income (loss) 0.08 (0.33) (0.01) (0.04) Quarterly and year-to-date computations of earnings per share amounts are made independently. Therefore, the sum of earnings per share amounts for the quarters may not agree with the per share amounts for the year. 23. SUBSEQUENT EVENTS Discontinued Operations - CC Systems: 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 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, December 31, 2003 and December 31, 2002 were as follows: December 31, December 31, 2003 2002 ------ ------ Assets: Accounts receivable $1,502 $1,410 Inventory 148 134 Property and equipment, net 36 52 Intangible assets, net 1,303 1,302 Other assets 2 73 ------ ------ Total assets $2,991 $2,971 ====== ====== Liabilities: Accounts Payable $ 119 $ 104 Accrued Expenses 129 110 Other liabilities 993 1,027 ------ ------ Total liabilities $1,241 $1,241 ====== ====== Debt Restatement: As a result of continued operating losses of Wise Optical, the Company did not meet its minimum fixed charge ratio covenant under its loan agreement with CapitalSource as of March 31, 2004, April 30, 2004 or May 31, 2004.. The Company, however, in connection with a waiver and amendment to its loan agreement with CapitalSource entered into on August 16, 2004, 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 waiver and amendment 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, which is guaranteed by our largest stockholder, Palisade Concentrated Equity Partnership, L.P, (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 $(2,000) to $(3,000) and (v) add a debt service coverage ratio covenant of between 0.7 to 1.0. for the period October 31, 2004 to February 28, 2005. In addition, the F-32 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. On August 17, 2004, the Company paid 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. F-33