UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005 OR | | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from______________ to _____________ COMMISSION FILE NUMBER 001-15223 OPTICARE HEALTH SYSTEMS, INC. (Exact Name of Registrant as Specified in Its Charter) DELAWARE 76-0453392 (State or Other Jurisdiction of Incorporation or Organization) (I.R.S. Employer Identification No.) 87 GRANDVIEW AVENUE, WATERBURY, CONNECTICUT 06708 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (203) 596-2236 Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ___ Yes X No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). ___ Yes X No Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ___ Yes X No The number of shares outstanding of the registrant's Common Stock, par value $.001 per share, at October 31, 2005 was 30,664,991 shares. INDEX TO FORM 10-Q Page No. PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets at September 30, 2005 and December 31, 2004, (unaudited) 3 Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and 2004, (unaudited) 4 Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004, (unaudited) 5 Notes to Condensed Consolidated Financial Statements, (unaudited) 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Item 3. Quantitative and Qualitative Disclosures about Market Risk 24 Item 4. Controls and Procedures 25 PART II. OTHER INFORMATION Item 1. Legal Proceedings 25 Item 5. Other Information 25 Item 6. Exhibits 25 SIGNATURE 27 2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (AMOUNTS IN THOUSANDS) (UNAUDITED) SEPTEMBER 30, DECEMBER 31, 2005 2004 ---------------- ----------------- ASSETS CURRENT ASSETS: Cash and cash equivalents $ 2,142 $ 2,228 Accounts receivable, net 2,122 2,164 Inventory 1,808 1,851 Assets held for sale - 7,894 Other current assets 750 681 ---------------- ----------------- TOTAL CURRENT ASSETS 6,822 14,818 ---------------- ----------------- Property and equipment, net 2,084 2,628 Goodwill 16,888 16,663 Intangible assets, net 985 1,068 Assets held for sale, non-current - 1,150 Other assets 3,385 3,487 ---------------- ----------------- TOTAL ASSETS $ 30,164 $ 39,814 ================ ================= LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 1,028 $ 2,727 Accrued expenses 6,030 6,514 Current portion of long-term debt 1,519 332 Current portion of long-term debt - related party 1,000 - Current portion of capital lease obligations 54 11 Liabilities of held for sale business - 5,683 Other current liabilities 897 1,119 ---------------- ----------------- TOTAL CURRENT LIABILITIES 10,528 16,386 ---------------- ----------------- Long-term debt, less current portion 898 10,024 Capital lease obligations, less current portion 115 19 Other liabilities 352 1,476 ---------------- ----------------- TOTAL NON-CURRENT LIABILITIES 1,365 11,519 ---------------- ----------------- Series B 12.5% mandatorily redeemable, convertible preferred stock--related party 6,929 6,344 STOCKHOLDERS' EQUITY: Series C & D preferred stock--related party 1 1 Common stock 31 31 Additional paid-in-capital 83,051 79,192 Accumulated deficit (71,741) (73,659) ---------------- ----------------- TOTAL STOCKHOLDERS' EQUITY 11,342 5,565 ---------------- ----------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $30,164 $39,814 ================ ================= See notes to condensed consolidated financial statements. 3 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA) (UNAUDITED) THREE MONTHS NINE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, --------------------------- ---------------------------- 2005 2004 2005 2004 ------------ ----------- ------------ ------------ NET REVENUES: Managed vision $ 6,653 $ 6,547 $19,439 $ 18,864 Product sales 2,871 2,860 8,837 8,931 Other services 5,317 4,771 15,088 15,271 Other income 75 - 848 1,458 ------------ ----------- ------------ ------------ Total net revenues 14,916 14,178 44,212 44,524 ------------ ----------- ------------ ------------ OPERATING EXPENSES: Medical claims expense 4,779 4,913 14,216 14,274 Cost of product sales 1,022 1,092 3,108 3,200 Cost of services 2,088 1,865 5,730 6,374 Selling, general and administrative 6,300 6,617 18,724 19,275 Depreciation 254 232 750 645 Amortization 28 31 83 86 Interest 175 298 553 886 ------------ ----------- ------------ ------------ Total operating expenses 14,646 15,048 43,164 44,740 ------------ ----------- ------------ ------------ Income (loss) from continuing operations before income tax 270 (870) 1,048 (216) Income tax expense (benefit) - (20) 50 32 ------------ ----------- ------------ ------------ Income (loss) from continuing operations 270 (850) 998 (248) Discontinued operations: Income (loss) from discontinued operations 920 (1,324) 920 (3,846) Income tax expense (benefit) - - - - ------------ ----------- ------------ ------------ Income (loss) from discontinued operations 920 (1,324) 920 (3,846) Net income (loss) 1,190 (2,174) 1,918 (4,094) Preferred stock dividends (199) (177) (585) (528) ------------ ----------- ------------ ------------ Net income (loss) available to common stockholders $991 $ (2,351) $1,333 $ (4,622) ============ =========== ============ ============ EARNINGS (LOSS) PER SHARE: Earnings Per Share - Basic: Income (loss) from continuing operations applicable to common stockholders $0.00 $(0.01) $0.00 $(0.01) Income (loss) from continuing operations applicable to participating securities $0.00 $ (0.02) $0.01 $(0.02) Discontinued operations $0.03 $ (0.05) $0.03 $(0.12) ------------ ----------- ------------ ------------ Net income (loss) per common share $0.03 $ (0.08) $0.04 $(0.15) ============ =========== ============ ============ Earnings Per Share - Diluted: Income (loss) from continuing operations $0.00 $ (0.03) $0.00 $ (0.03) Discontinued operations $0.01 $ (0.05) $0.01 $ (0.12) ------------ ----------- ------------ ------------ Net income (loss) per common share $0.01 $ (0.08) $0.01 $ (0.15) ============ =========== ============ ============ See notes to condensed consolidated financial statements. 4 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (AMOUNTS IN THOUSANDS) (UNAUDITED) FOR THE NINE MONTHS ENDED SEPTEMBER 30, ---------------------------------- 2005 2004 --------------- -------------- OPERATING ACTIVITIES: Net income (loss) $ 1,918 $ (4,094) (Income) loss on discontinued operations (920) 3,846 --------------- -------------- Income (loss) from continuing operations 998 (248) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation 750 645 Amortization 83 86 Non-cash interest expense 105 115 Non-cash gain on contract settlements (153) - Changes in operating assets and liabilities: Accounts receivable 42 (107) Inventory 43 (76) Other assets 95 (426) Accounts payable and accrued expenses (2,203) 3,101 Other liabilities (184) 271 Cash (used in) provided by discontinued operations (157) 68 --------------- -------------- Net cash (used in) provided by operating activities (581) 3,429 --------------- -------------- INVESTING ACTIVITIES: Cash received on notes receivable 110 111 Purchase of fixed assets, net of disposals (206) (292) Investment in acquisition (225) (25) Net proceeds from the sale of discontinued operations 3,361 700 Purchase of restricted certificates of deposit (204) (260) --------------- -------------- Net cash provided by investing activities 2,836 234 --------------- -------------- FINANCING ACTIVITIES: Net decrease in revolving credit facility (7,528) (2,184) Principal payments on long-term debt (275) (278) Proceeds from subordinated debt 1,000 - Principal payments on capital lease obligations (39) (13) Payment of financing costs (14) (5) Proceeds from issuance of Series D preferred stock 4,445 - Equipment financing 55 117 Payment of bank financing fees (13) (65) Proceeds from issuance of common stock 28 20 --------------- -------------- Net cash used in financing activities (2,341) (2,408) --------------- -------------- Increase (decrease) in cash and cash equivalents (86) 1,255 Cash and cash equivalents at beginning of period 2,228 1,695 --------------- -------------- Cash and cash equivalents at end of period $ 2,142 $ 2,950 =============== ============== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest $474 $ 765 Cash paid for income taxes, net of refunds $57 $ 59 See notes to condensed consolidated financial statements. 5 OPTICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA) (UNAUDITED) 1. BASIS OF PRESENTATION The accompanying condensed consolidated financial statements of OptiCare Health Systems, Inc., a Delaware corporation, and its subsidiaries (collectively the "Company") for the three and nine months ended September 30, 2005 and 2004 have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934, as amended, and are unaudited. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of only normal recurring accruals) necessary for a fair presentation of the condensed consolidated financial statements have been included. The results of operations for the three and nine months ended September 30, 2005 are not necessarily indicative of the results to be expected for the full year. The condensed consolidated balance sheet as of December 31, 2004 was derived from the Company's audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. In September 2004, the Company sold its Technology business, CC Systems, Inc., and in January 2005, sold its Distribution business, which was comprised of Wise Optical and the Buying Group. The effective date of the Distribution transaction was December 31, 2004. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets," both sales were accounted for as discontinued operations. Amounts in the financial statements and related notes for the 2004 period have been reclassified to reflect treatment of these businesses as held for sale. 2. MANAGEMENT'S PLAN The Company incurred operating losses in 2004 due primarily to significant operating losses at Wise Optical. In January 2005, the Company sold its Distribution business, which included the Wise Optical operation. In September 2004, the Company also sold its Technology business, CC Systems, Inc. The sale of these operations generated cash proceeds and reduced demands on working capital and corporate personnel. In addition, in January 2005, the Company sold 280,618 shares of newly created Series D preferred stock for an aggregate price of $4,445. In 2003 the Managed Vision segment began shifting away from the lower margin and long sales cycle of our third party administrator ("TPA") style business to the higher margin and shortened sales cycle of a direct-to-employer business. This new direct-to-employer business also removes some of the volatility that is often experienced in the Company's TPA-based revenues. The Company continues to grow its direct-to-employer business, however; the direct-to-employer business continues to be relatively small in comparison to the overall Managed Vision business. 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. In the nine month period ended September 30, 2005, revenue and profitability in the Consumer Vision segment have remained relatively constant with the comparable period of 2004. The Company believes the combination of these initiatives executed in the operating segments will continue to improve the Company's liquidity and should ensure compliance with covenants in the loan agreement with CapitalSource Finance LLC ("CapitalSource") in the future. On August 22, 2005, the Company announced that it had entered into an agreement and plan of merger with Refac, the details of which are included in Note 10 - Merger Proposal. 3. NEW ACCOUNTING PRONOUNCEMENTS In March 2004, the Financial Accounting Standards Board ("FASB") approved Emerging Issues Task Force ("EITF") Issue 03-6 "Participating Securities and the Two-Class Method under SFAS 128." EITF 03-6 supersedes 6 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 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 Accounting Principles Board ("APB") Opinion No. 25 "Accounting for Stock Issued to Employees" ("Opinion 25") and FASB's Statement 123R "Share-Based Payments" ("Statement 123R"), EITF 03-6 is effective for the reporting periods beginning after March 31, 2004 and should be applied by restating previously reported earnings per share. The adoption of EITF 03-6 did not have a material impact on the Company's condensed consolidated financial statements. In December 2004, the FASB issued Statement 123R. Statement 123R eliminates the option to apply the intrinsic value measurement provisions of Opinion 25. Rather Statement 123R requires companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award, (usually the vesting period). Statement 123R will also require companies to measure the cost of employee services received in exchange for Employee Stock Purchase Plan ("ESPP") awards and the Company will be required to expense the grant date fair value of the Company's ESPP awards. Statement 123R became effective for the Company's fiscal quarter beginning July 1, 2005. Based on the number of stock options outstanding as of December 31, 2004, the effect of the adoption of Statement 123R would be to increase annual compensation expense by approximately $0.2 million commencing in the Company's fiscal quarter beginning July 1, 2005. However, based on Securities and Exchange Commission Release 2005-57, we have elected to defer the adoption of Statement 123R until January 1, 2006. As a result, the Company will not incur any compensation expense in 2005 related to stock options. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections" which supersedes APB Opinion No. 20, "Accounting Changes" and FAS No. 3, "Reporting Accounting Changes in Interim Financial Statements." SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It established, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. The reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retroactively. Therefore, the reporting of a correction of an error by restating previously issued financial statements is also addressed by SFAS 154, which is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of SFAS 154 to have a material impact on its consolidated financial statements. 4. STOCK BASED COMPENSATION The Company accounts for its stock-based compensation plans under Opinion 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. SFAS No. 123 "Accounting for Stock-Based Compensation," as amended by SFAS No. 148 "Accounting for Stock-Based Compensation--Transition and Disclosure an amendment of Statement of Financial Accounting Standards No. 123" requires that companies which do not elect to account for stock-based compensation as prescribed by this statement, disclose the pro forma effects on earnings and earnings per share as if SFAS No. 123 had been adopted. If the Company applied the recognition provisions of SFAS No. 123, the Company's reported net income (loss) and earnings (loss) per share available to common stockholders, using the Black-Scholes option pricing model, would have been adjusted to the pro forma amounts indicated below. 7 THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, --------------------------- -------------------------- 2005 2004 2005 2004 ----------- ------------ ----------- ----------- Net income (loss) available to common stockholders, as reported $ 991 $ (2,351) $ 1,333 $ (4,622) Less: Total stock-based employee compensation expense, net of related tax effects, determined under the fair value method for all awards (47) (45) (127) (104) ----------- ------------ ----------- ----------- Pro forma net income (loss) $ 944 $ (2,396) $ 1,206 $ (4,726) =========== ============ =========== =========== Earnings (loss) per share - basic: As reported $ 0.03 $ (0.08) $ 0.04 $ (0.15) Pro forma $ 0.03 $ (0.08) $ 0.04 $ (0.15) Earnings (loss) per share - diluted: As reported $ 0.01 $ (0.08) $ 0.01 $ (0.15) Pro forma $ 0.01 $ (0.08) $ 0.01 $ (0.15) 5. DISCONTINUED OPERATIONS In May 2004, the Company's Board of Directors approved management's plan to exit the technology business, which was comprised of CC Systems, Inc. (formerly reported in the Company's Distribution and Technology segment). The Company completed the sale of the net assets of CC Systems, Inc. on September 10, 2004. In accordance with SFAS No. 144 the disposal of CC Systems, Inc. is accounted for as a discontinued operation. In connection with the sale, the Company received $700 in cash. Additional consideration provided by the buyer included the surrender of 82,500 shares of the Company's common stock which had a fair market value of approximately $21 and the forgiveness of an unsecured promissory note payable by the Company which had an outstanding balance of $71 at the time of the sale. In the third quarter of 2004, the Company recorded a $1,005 loss on the disposal of discontinued operations based on the fair value of the net assets held for sale. The results of operations of CC Systems, Inc. are included in the condensed consolidated financial statements as part of discontinued operations for the period ended September 30, 2004. In December 2004, the Company's Board of Directors approved management's plan to exit the Distribution business which experienced substantial operating losses in 2003 and 2004, which was comprised of the distribution business the Company purchased from Wise Optical Vision Group, Inc. ("Wise Optical"), a New York corporation, in February, 2003 and the Buying Group, (formerly reported in the Company's Distribution segment) and to dispose of the Company's Distribution business. The Company completed the sale of the net assets of the Distribution business on January 12, 2005 to entities formed by the Company's Chairman and former Chief Executive Officer. The effective date of the transaction was December 31, 2004. In accordance with SFAS No. 144 the disposal of the Distribution business is accounted for as a discontinued operation. The aggregate gross consideration from the sale was $4,150, less a working capital adjustment of $575 and estimated closing costs and other direct costs of $349. The Company recorded a $3,400 loss on the disposal of discontinued operations based on the fair value of the net assets held for sale. The results of operations of Wise Optical are included in the condensed consolidated financial statements as part of discontinued operations for the period ended September 30, 2004. In connection with the sale of the Distribution business, the Company entered into a supply agreement with the buyers of the Distribution business. The supply agreement is a four year commitment to purchase, on a non-exclusive basis, $4,200 of optical products per year from certain designated manufacturers and suppliers. This annual commitment includes the purchase of $1,275 of contact lenses a year. In addition, the Company is also obligated to pay an annual fee based on the total of all purchases it makes under the supply agreement. The supply agreement also contains certain buyout provisions depending on when the supply agreement is terminated. During the nine months ended September 30, 2005, the Company had approximately $2,966 in product purchases related to this supply agreement which included the purchase of approximately $973 in contact lenses. Also in connection with the sale of the Distribution business, the lease obligation on the facility occupied by Wise Optical located in Yonkers, New York remained with the Company. The lease term on the facility was scheduled to expire in June 2011. At December 31, 2004, the Company estimated its potential exposure on the lease 8 to be $1,300 and recorded a provision for this amount which was included in the loss on disposal of discontinued operations for the year ended December 31, 2004. During the nine months ended September 30, 2005, the Company paid $157 in rent payments related to this lease. On October 21, 2005, the Company entered into a surrender agreement with the landlord of the Yonkers facility. The Company paid $125 to the landlord and also agreed to forego $85 in a rent deposit that it had paid at the inception of the lease in January 2003. In return, the landlord released the Company from any and all financial obligations regarding the lease of the Yonkers facility, effective September 30, 2005, and the landlord will release the Company from all other obligations under the lease agreement, effective December 31, 2005. As a result of this transaction, the Company adjusted its estimated provision to cover any potential exposure on the Yonkers lease obligation down to $125 at September 30, 2005. The offset to this adjustment was treated as income from discontinued operations in 2005 since the original provision was included in the loss on disposal of discontinued operations for the year ended December 31, 2004. Operating results of the discontinued operations for the three and nine months ended September 30, 2004 are as follows: THREE MONTHS NINE ENDED MONTHS ENDED SEPT. 30, 2004 SEPT. 30, 2004 ---------------- ----------------- External revenue $ 14,182 $45,285 ================ ================= Intercompany revenue $ 1,616 $ 4,704 ================ ================= Loss from discontinued operations before tax $(1,324) $ (3,846) Income tax expense - - ---------------- ----------------- Loss from discontinued operations $(1,324) $ (3,846) ================ ================= Loss per share from discontinued operations $(0.05) $ (0.12) ================ ================= 6. INTANGIBLE ASSETS Intangible assets subject to amortization are comprised of a service agreement and non-compete agreements. The fifteen year service agreement has a gross carrying amount of $1,658 and accumulated amortization of $673 and $590 at September 30, 2005 and December 31, 2004, respectively. The non-compete agreements, which had a gross carrying amount of $265, were fully amortized at September 30, 2005 and December 31, 2004. Amortization expense for the three months ended September 30, 2005 and 2004 was $28 and $31, respectively, and for the nine months ended September 30, 2005 and 2004 was $83 and $86, respectively. Estimated annual amortization expense is expected to be approximately $111 in each of the years 2005 through 2008. 7. DEBT 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 contained certain subjective acceleration clauses in the event of a material adverse event. EITF Issue 95-22 "Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements That Include both a Subjective Acceleration Clause and a Lock-Box Arrangement" required the Company to classify outstanding borrowings under the revolving credit note as current liabilities. 9 On August 27, 2004, the Company amended its loan agreement with CapitalSource to eliminate the lender's ability to declare a default based upon subjective criteria as described in EITF Issue 95-22. Palisade Concentrated Equity Partnership, L.P. ("Palisade"), provided a $1,000 guarantee against the loan balance due to CapitalSource related to this amendment. As a result of this amendment, the Company has classified the loan balance related to the revolving credit facility as long-term at September 30, 2005 and December 31, 2004. On January 12, 2005, we amended the term loan and revolving credit facility with CapitalSource to reduce the tangible net worth covenant for December 2004 and January 2005 from ($3,000) to ($6,500). Without this Amendment, we would have been in violation of the tangible net worth covenant at December 31, 2004. Under the term loan and revolving credit facility, as amended, we must maintain a tangible net worth of at least ($3,000) after February 1, 2005. We paid CapitalSource approximately $13 in financing fees in connection with this amendment. The Company's temporary over advance facility with CapitalSource expired on August 31, 2005. On September 1, 2005, in connection with the proposed merger between the Company and Refac (see Note 10), Refac made a subordinated loan to the Company of $1,000. This loan is evidenced by a subordinated secured note and is subordinate to the Company's senior indebtedness with CapitalSource. Pursuant to the terms and conditions of the loan agreement with Refac, the principal balance together with any accrued but unpaid interest shall be due and payable by the Company on January 25, 2007. However, if the merger provided for in the agreement and plan of merger, dated August 22, 2005, between Refac, OptiCare Merger Sub, Inc. and the Company is not completed on or before January 31, 2006, the maturity date shall be March 31, 2006. The Company did not incur any loan origination fees associated with the subordinated loan from Refac. The note bears interest at a rate equivalent to prime plus 5.5%. The entire amount of loan proceeds was used by the Company to repay a portion of our outstanding indebtedness under the revolving credit facility with CapitalSource. The Company had standby letters of credit outstanding at September 30, 2005 and December 31, 2004 of $1,100, respectively. There were no draw downs against these standby letters of credit in 2005 or 2004. The letters of credit outstanding at September 30, 2005 and December 31, 2004 were secured by restricted certificates of deposit and security deposits. 8. SEGMENT INFORMATION During the third quarter of 2004, the Company sold its Technology business, CC Systems, Inc., and on January 12, 2005 sold its Distribution business, which was comprised of Wise Optical and the Buying Group, with an effective date of December 31, 2004. As a result of selling these businesses, the Company has the following two reportable operating segments: (1) Managed Vision and (2) Consumer Vision. 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 Chief Executive Officer and President assesses performance and allocates resources among these two operating segments. The Managed Vision segment contracts with insurers, insurance fronting companies, employer groups, managed care plans and other third party payers 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. In addition to its reportable operating segments, the Company's "Other" category includes other non-core operations and transactions, which do not meet the quantitative thresholds for a reportable segment. Included in the "Other" category is revenue earned under the Company's health service organization ("HSO") operation, which receives fee income for providing certain support services to individual ophthalmology and optometry practices. 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 the Company's segments based on income before income taxes, interest expense, depreciation and amortization, and other corporate overhead. Summarized financial information, by segment, for the three and nine months ended September 30, 2005 and 2004 is as follows: 10 THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- 2005 2004 2005 2004 ------------ ------------ ------------ ------------- REVENUES: Managed vision $ 6,653 $ 6,547 $ 19,439 $ 18,864 Consumer vision 8,426 7,861 24,684 24,797 ------------ ------------ ------------ ------------- Reportable segment totals 15,079 14,408 44,123 43,661 Other 81 15 866 1,539 Elimination of inter-segment revenues (244) (245) (777) (676) ------------ ------------ ------------ ------------- Total net revenue $ 14,916 $ 14,178 $ 44,212 $ 44,524 ============ ============ ============ ============= SEGMENT INCOME: Managed vision $ 534 $ 251 $ 1,259 $ 657 Consumer vision 942 678 2,760 2,739 ------------ ------------ ------------ ------------- Total reportable segment totals 1,476 929 4,019 3,396 Other 83 (171) 795 1,009 Depreciation (254) (232) (750) (645) Amortization expense (28) (31) (83) (86) Interest expense (175) (298) (553) (886) Corporate (832) (1,067) (2,380) (3,004) ------------ ------------ ------------ ------------- Income from continuing operations before tax $ 270 $ (870) $ 1,048 $ (216) ============ ============ ============ ============= 9. EARNINGS (LOSS) PER COMMON SHARE The following table sets forth the computation of basic and diluted earnings (loss) per share: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------------------------- --------------------------------- 2005 2004 2005 2004 -------------- -------------- -------------- -------------- EARNINGS (LOSS) PER SHARE: Income (loss) from continuing operations $ 270 $ (850) $ 998 $ (248) Preferred stock dividend (199) (177) (585) (528) -------------- -------------- -------------- -------------- Income (loss) from continuing operations applicable to common stockholders and participating securities $ 71 $(1 ,027) $ 413 $ (776) ============== ============== ============== ============== Income (loss) from continuing operations applicable to common stockholders $ 20 $ (332) $ 117 $ (250) Income (loss) from continuing operations applicable to participating securities 51 (695) 296 (526) Discontinued operations 920 (1,324) 920 (3,846) -------------- -------------- -------------- -------------- Net income (loss) applicable to common stockholders $ 991 $ (2,351) $ 1,333 $ (4,622) ============== ============== ============== ============== Weighted average common shares--basic 30,664,991 30,685,060 30,649,686 30,579,558 Effect of dilutive securities: Options 708,727 * 938,264 * 11 Warrants 86,045 * 106,045 * Preferred Stock 76,846,234 * 76,846,234 * -------------- -------------- -------------- -------------- Weighted average common shares-- diluted 108,305,997 30,685,060 108,540,229 30,579,558 ============== ============== ============== ============== Earnings Per Share - Basic: Income (loss) from continuing operations applicable to common stockholders $ 0.00 $ (0.01) $ 0.00 $ (0.01) Income (loss) from continuing operations applicable to participating securities $ 0.00 $ (0.02) $ 0.01 $ (0.02) Discontinued operations $ 0.03 $ (0.05) $ 0.03 $ (0.12) -------------- -------------- -------------- -------------- Net income (loss) per common share $ 0.03 $ (0.08) $ 0.04 $ (0.15) ============== ============== ============== ============== Earnings Per Share - Diluted: Income (loss) from continuing operations $ 0.00 $ (0.03) $ 0.00 $ (0.03) Discontinued operations $ 0.01 $ (0.05) $ 0.01 $ (0.12) -------------- -------------- -------------- -------------- Net income (loss) per common share $ 0.01 $ (0.08) $ 0.01 $ (0.15) ============== ============== ============== ============== * Anti-dilutive The following table reflects the potential common shares of the Company for the nine months ended September 30, 2005 and 2004 that are not included in the dilutive securities for purposes of computing weighted average common shares - diluted. The amounts reflected for the three and nine months ended September 30, 2004 have been excluded from the calculation of diluted earnings per share due to anti-dilution. 2005 2004 ---------------- -------------- Options 4,806,179 6,195,943 Warrants 3,168,955 3,275,000 Convertible Preferred Stock - 64,343,513 ---------------- -------------- 7,975,134 73,814,456 ================ ============== 10. MERGER PROPOSAL On April 8, 2005, the Company announced that Refac, an affiliated company, expressed interest in exploring an acquisition of the Company in a stock transaction and that the Company and Refac had entered into discussions regarding the same. On August 22, 2005, the Company announced that it had entered into an agreement and plan of merger with Refac. The Company originally expected the merger to close before the end of 2005. The Company now expects that the merger will be consummated on or before April 30, 2006. Under the terms of the merger agreement, as amended on November 11, 2005, (i) each of the Company's preferred stockholders will receive 0.04029244 shares of Refac common stock for each share of the Company's common stock underlying the Company's preferred stock they hold, (ii) Palisade will receive 0.04029244 shares of Refac common stock for each share of the Company's common stock it holds and (iii) each other of the Company's stockholders will receive 0.0472 shares of Refac common stock for each share of the Company's common stock they hold and the Company will become a wholly-owned subsidiary of Refac. As a condition to the merger, the Company's preferred stockholders have agreed to convert all of their preferred stock into the Company's common stock prior to the merger. The merger requires the approval of the holders of at least 55% of the outstanding shares of Refac common stock. Palisade, as the Company's majority stockholder, has executed a written consent approving the merger, which consent shall be effective within 20 days after the Company mails an information statement to its stockholders. Refac also announced that it has entered into a definitive agreement with U.S. Vision, Inc., another affiliated company, which is privately-held and operates the 6th largest retail optical chain in the United States, under which Refac will acquire U.S. Vision, Inc. 12 The Company, Refac and U.S. Vision are all controlled by Palisade which beneficially owns approximately 89% of the Company's outstanding common stock (on a fully diluted basis), 90% of Refac's outstanding common stock and 88% of U.S. Vision's outstanding common stock. Refac was incorporated in 1952 and for most of its history, was engaged in intellectual property licensing activities. During the period from 1997 to 2002, it was also engaged in the business of product development and graphic design and had invested these creative resources, together with its licensing skills, in certain product development ventures. In March 2002, Refac announced plans to reposition itself for sale or liquidation and by the end of 2002, it had disposed of all of its operating segments with the exception of its licensing business and it has limited the operations of that segment to managing certain existing license agreements and related contracts. On February 28, 2003, Refac completed a merger with a wholly-owned subsidiary of Palisade pursuant to which Palisade acquired control of Refac and, in May 2003, Palisade increased its ownership to approximately 90% through an additional cash investment of $17,000. Palisade had indicated that it intended to use Refac as a vehicle for making acquisitions and the purpose of the stock purchase transaction was to provide Refac with additional capital for making these acquisitions. As of December 31, 2004, Refac reported a net worth of $31,197 with approximately $29,000 available for acquisitions. U.S. Vision, a privately held company, is a leading store-within-a-store retailer of optical products and services with net revenues of approximately $128,000 during its most recent fiscal year. It operates 518 locations in 47 states and Canada, consisting of 506 licensed departments and 12 freestanding stores. 11. CONTINGENCIES The Company is both a plaintiff and defendant in lawsuits incidental to its current and former operations. Such matters are subject to many uncertainties and outcomes are not predictable with assurance. Consequently, the ultimate aggregate amount of monetary liability or financial impact with respect to these matters at September 30, 2005 cannot be ascertained. Management is of the opinion that, after taking into account the merits of defenses and established reserves, the ultimate resolution of these matters will not have a material adverse impact on the Company's consolidated financial position or results of operations. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion may be understood more fully by reference to our consolidated financial statements, notes to the consolidated financial statements, and management's discussion and analysis contained in our Annual Report on Form 10-K, as amended, for the year ended December 31, 2004, as filed with the Securities and Exchange Commission. OVERVIEW We are an integrated eye care service company focused on vision benefits management (managed vision) and retail optical sales and eye care services to consumers and patients (consumer vision). Throughout 2004, we implemented cost cutting measures and programs designed to increase sales and product margins at our contact lens distributor, Wise Optical. However, we were unable to increase sales or improve product margins and operating income at Wise Optical, which negatively impacted our results of operations in 2004. As a result of the continued troubles at Wise Optical, on January 12, 2005, our wholly-owned subsidiary, OptiCare Acquisition Corp., entered into an Asset Purchase Agreement with Wise Optical, LLC and AECC/Pearlman Buying Group, LLC, both entities formed by Dean J. Yimoyines, M.D., our former Chief Executive Officer, current President and Chief Executive Officer of our medical affiliate, OptiCare P.C., and our current Chairman, pursuant to which we sold, effective as of December 31, 2004, substantially all of the assets and certain liabilities of our Distribution division, which consisted of Wise Optical, and our Optical Buying Group, for an aggregate purchase price of approximately $4.2 million less a working capital adjustment of approximately $0.6 million and estimated closing costs and other direct costs of approximately $0.3 million. In addition, in May 2004, our Board of Directors approved management's plan to exit and dispose of our Technology business, CC Systems, Inc. We completed the sale of the net assets of CC Systems on September 10, 2004. 13 As a result of selling these businesses, we now have the following two reportable operating segments: (1) Managed Vision and (2) Consumer Vision. Our Managed Vision segment contracts with insurers, managed care plans and other third party payers and employer groups to manage claims payment administration of eye health benefits for those contracting parties and to provide insurance. 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. We have financed our operations and certain acquisitions through a term loan and revolving credit facility with Capital Source Finance, LLC (CapitalSource), portions of which our majority stockholder, Palisade Concentrated Partnership, L.L.C. (Palisade), has guaranteed. In connection with the sale of certain assets of our Distribution division on January 12, 2005, we amended the terms of our term loan and revolving credit facility with CapitalSource to reduce the tangible net worth covenant for December 2004 and January 2005 from ($3.0) million to ($6.5) million. Without this Amendment, we would have been in violation of the tangible net worth covenant at December 31, 2004. Pursuant to the terms of the revolving credit facility, as amended, we must maintain a tangible net worth of at least ($3.0) million after February 1, 2005. Management believes it will comply with its future financial covenants, however, if we incur operating losses in the future and we fail to comply with our financial covenants in the future or otherwise default on our debt, our creditors could foreclose on our assets. On April 8, 2005, we announced that Refac, an affiliated company, expressed an interest in exploring an acquisition of us in a stock transaction and that we and Refac had entered into discussions regarding same. On August 22, 2005, we announced that we had entered into an agreement and plan of merger with Refac. Under the terms of the merger agreement, as amended on November 11, 2005, (i) each of the Company's preferred stockholders will receive 0.04029244 shares of Refac common stock for each share of the Company's common stock underlying the Company's preferred stock they hold, (ii) Palisade will receive 0.04029244 shares of Refac common stock for each share of the Company's common stock it holds and (iii) each other of the Company's stockholders will receive 0.0472 shares of Refac common stock for each share of the Company's common stock they hold and the Company will become a wholly-owned subsidiary of Refac. As a condition to the merger, the Company's preferred stockholders have agreed to convert all of their preferred stock into the Company's common stock prior to the merger. The merger requires the approval of the holders of at least 55% of the outstanding shares of Refac common stock. Palisade, as the Company's majority stockholder, has executed a written consent approving the merger, which consent shall be effective within 20 days after the Company mails an information statement to its stockholders. The Company originally expected the merger to close by the end of 2005. We now, however, expect that the merger will be consummated on or before April 30, 2006. Refac also announced that it had entered into a definitive agreement with U.S. Vision, Inc., another affiliated company, which is privately-held and operates the 6th largest retail optical chain in the United States, under which Refac will acquire U.S. Vision, Inc. We, Refac and U.S. Vision are all controlled by Palisade which beneficially owns approximately 89% of our outstanding common stock (on a fully diluted basis), 90% of Refac's outstanding common stock and 88% of U.S. Vision's outstanding common stock. RESULTS OF OPERATIONS Three Months Ended September 30, 2005 Compared to the Three Months Ended September 30, 2004 Managed Vision revenue. Managed Vision revenue represents fees received under our managed care contracts. Managed Vision revenue increased to approximately $6.6 million for the three months ended September 30, 2005 compared to approximately $6.5 million for the three months ended September 30, 2004, an increase of approximately $0.1 million or 1.6%. The increase in Managed Vision revenue relates primarily to approximately $0.8 million in sales from new contracts entered into and sales growth in existing contracts. These sales increases were partially offset by approximately $0.7 million in lower revenues related to membership declines experienced by two of our larger customers. Effective September 1, 2005, the Texas state legislature reinstated a vision benefit in its Children's Health Insurance Program (CHIP). We previously administered these benefits for a number of health plans in Texas until the benefit was eliminated in September 2003. We have successfully negotiated a number of new contracts under this reinstated program. In July 2005, Cigna informed us of their intention to terminate or renegotiate certain aspects 14 of the five contracts we currently have with them. For the three months ended September 30, 2005, total revenues derived from these five contracts approximated 12% of our consolidated revenues. Three of the five contracts cover both routine vision care, including exams and/or hardware, and medical/surgical procedures and the two remaining contracts cover routine vision care only. Cigna has indicated that it will terminate all of the contracts as they relate to the routine vision care. To date we have received four contract termination notices with effective dates of December 1, 2005 and January 1, 2006, respectively. In subsequent discussions, Cigna expressed an interest in possibly extending two of the contracts on a renegotiated basis as they relate to medical/surgical procedures only. At this time, we have executed one contract amendment related to medical/surgical procedures and are reviewing a draft amendment for another. However, there can be no assurances that any other of the contracts will be renegotiated on favorable terms. We believe, however, that the potential impact from the termination or renegotiated Cigna contracts will be mitigated in part by the new contracts we have entered into related to the CHIPS program. Product sales revenue. Product sales primarily include the sale of optical products through our Consumer Vision segment. Product sales revenue remained relatively flat at approximately $2.9 million for the three months ended September 30, 2005 and September 30, 2004. Other services revenue. Other services revenue primarily includes revenue earned from providing eye care services in our Consumer Vision segment. Other services revenue increased to approximately $5.3 million for the three months ended September 30, 2005 compared to approximately $4.8 million for the three months ended September 30, 2004, an increase of approximately $0.5 million or 11.4%. This increase is primarily due to increased services volume in the medical, optometry and surgical areas attributable to an increase in the number of patients seen in the third quarter 2005 as compared to 2004. We expect services revenue to remain at these levels or to increase slightly in the future. Other income. Other income represents non-recurring settlements on Health Service Organization ("HSO") contracts. Other income for the three months ended September 30, 2005 was approximately $0.1 million. There were no non-recurring settlements on HSO contracts for the three months ended September 30, 2004. Further we believe income from these settlements will be negligible in the future. Medical claims expense. Medical claims expense decreased to approximately $4.8 million for the three months ended September 30, 2005 compared to approximately $4.9 million for the three months ended September 30, 2004. The medical claims expense loss ratio (MLR) representing medical claims expense as a percentage of Managed Vision revenue decreased to 71.8% for the three months ended September 30, 2005 from 75.0% for the three months ended September 30, 2004. The favorable change in MLR is a result of changes to existing contracts and the performance of new contracts entered into in the latter half of 2004. Cost of product sales. Cost of product sales, which are primarily optical products sold through our Consumer Vision operation, remained relatively constant at approximately $1.0 million for the three months ended September 30, 2005 compared to approximately $1.1 million for the three months ended September 30, 2004. Cost of services. Cost of services increased to approximately $2.1 million for the three months ended September 30, 2005 compared to approximately $1.9 million for the three months ended September 30, 2004, an increase of approximately $0.2 million or 12.0%. This increase is primarily due to an increase in the volume of services provided in the Consumer Vision area in this period of 2005 compared to 2004. Selling, general and administrative expenses. Selling, general and administrative expenses decreased to approximately $6.3 million for the three months ended September 30, 2005 compared to approximately $6.6 million for the three months ended September 30, 2004. The three month period ended September 30, 2005 includes approximately $0.2 million in one-time merger related expenses. Excluding the one-time merger expenses, selling, general and administrative expenses decreased approximately $0.5 million or 7.8%. The decrease in 2005 is primarily due to a decrease in compensation expense associated with staff reductions at the corporate level. Discontinued Operations. Income from discontinued operations of approximately $0.9 million for the three months ended September 30, 2005 relates to our settlement of the Yonkers lease obligation. On October 21, 2005, we entered into a surrender agreement with the landlord of the Yonkers facility. We paid $125,000 to the landlord and also agreed to forego $85,000 in a rent deposit that we had paid at the inception of the lease in January 2003. In return, the landlord released us from any and all financial obligations regarding the lease of the Yonkers facility, effective September 30, 2005, and the landlord will release us from all other obligations under the lease agreement, effective December 31, 2005. As a result of this transaction, we adjusted our estimated provision to cover any potential 15 exposure on the Yonkers lease obligation down to $125,000 at September 30, 2005. The offset to this adjustment of approximately $0.9 million was treated as income from discontinued operations in the three months ended September 30, 2005, since the original provision was included in the loss on disposal of discontinued operations for the year ended December 31, 2004. The loss from discontinued operations of approximately $1.3 million for the three months ended September 30, 2004 relates to the operating losses of CC Systems, Inc. and the Distribution business and also includes an adjustment to the loss on the disposal of CC Systems, Inc. which was sold in September 2004. Interest expense. Interest expense decreased to approximately $0.2 million for the three months ended September 30, 2005 from approximately $0.3 million for the three months ended September 30, 2004, a decrease of approximately $0.1 million or 41.3%. The decrease in interest expense is primarily due to a decrease in the average outstanding debt balance resulting from our $6.3 million debt pay down in January 2005. Cash proceeds received from the sale of the Distribution business and the issuance of the Series D preferred stock were used in part for the debt pay down. Income tax expense. Income tax expense recorded for the three months ended September 30, 2004 primarily represents minimum state tax expense. For the three months ended September 30, 2005, the Company has offset its income tax expense, with the releasing of valuation allowances that were setup to offset the net operating loss deferred tax assets. Nine Months Ended September 30, 2005 Compared to the Nine Months Ended September 30, 2004 Managed Vision revenue. Managed Vision revenue increased to approximately $19.4 million for the nine months ended September 30, 2005 compared to approximately $18.9 million for the nine months ended September 30, 2004, an increase of approximately $0.5 million or 3.0%. The increase in Managed Vision revenue relates primarily to approximately $2.1 million in sales from new contracts entered into in 2004 and sales growth in existing contracts. These sales increases were partially offset by approximately $1.6 million in lower revenues related to membership declines experienced by two of our larger customers. Effective September 1, 2005, the Texas state legislature reinstated a vision benefit in its Children's Health Insurance Program (CHIP). We previously administered these benefits for a number of health plans in Texas until the benefit was eliminated in September 2003. We have successfully negotiated a number of new contracts under this reinstated program. In July 2005, Cigna informed us of their intention to terminate or renegotiate certain aspects of the five contracts we currently have with them. For the nine months ended September 30, 2005, total revenues derived from these five contracts approximated 12% of our consolidated revenues. Three of the five contracts cover both routine vision care, including exams and/or hardware, and medical/surgical procedures and the two remaining contracts cover routine vision care only. Cigna has indicated that it will terminate all of the contracts as they relate to routine vision care. To date we have received four contract termination notices with effective dates of December 1, 2005 and January 1, 2006, respectively. In subsequent discussions, Cigna expressed an interest in possibly extending two of the contracts on a renegotiated basis as they relate to medical/surgical procedures only. At this time, we have executed one contract amendment related to medical/surgical procedures and are reviewing a draft amendment for another. However, there can be no assurances that any other of the contracts will be renegotiated on favorable terms. We believe, however, that the potential impact from the termination or renegotiated Cigna contracts will be mitigated in part by the new contracts we have entered into related to the CHIPS program. Product sales revenue. Product sales primarily include the sale of optical products through our Consumer Vision segment. Product sales revenue remained relatively flat at approximately $8.8 million for the nine months ended September 30, 2005 compared to approximately $8.9 million for the same period of 2004. Other services revenue. Other services revenue primarily includes revenue earned from providing eye care services in our Consumer Vision segment. Other services revenue decreased to approximately $15.1 million for the nine months ended September 30, 2005 compared to approximately $15.3 million for the nine months ended September 30, 2004, a decrease of approximately $0.2 million or 1.2%. This decrease is primarily due to decreased services volume in the medical, optometry and surgical areas attributable to decline in the number of patients seen in the first half of 2005 as compared to 2004, which were slightly offset by increased volume in the third quarter of 2005 compared to the same period of 2004. Other income. Other income represents non-recurring settlements on HSO contracts. Other income for the nine months ended September 30, 2005 was approximately $0.8 million compared to approximately $1.5 million for the nine months ended September 30, 2004, representing a decrease of approximately $0.7 million or 41.8%, which 16 resulted from a decrease in the number of settlements in the nine months ended September 30, 2005. Further we believe income from these settlements will be negligible in the future. Medical claims expense. Medical claims expense remained relatively flat at approximately $14.2 million for the nine months ended September 30, 2005 compared to approximately $14.3 million for the same period of 2004. The MLR decreased to 73.1% in 2005 from 75.7% in 2004. The favorable change in MLR is a result of changes to existing contracts and the performance of new contracts entered into 2004. Cost of product sales. Cost of product sales, which are primarily optical products sold through our Consumer Vision operation, remained relatively constant at approximately $3.1 million for the nine months ended September 30, 2005 compared to approximately $3.2 million for the nine months ended September 30, 2004. Cost of services. Cost of services decreased to approximately $5.7 million for the nine months ended September 30, 2005 compared to approximately $6.4 million for the nine months ended September 30, 2004, a decrease of approximately $0.7 million or 10.1%. This decrease is primarily due to a decrease in the volume of services provided in the Consumer Vision area in this period of 2005 compared to 2004. Selling, general and administrative expenses. Selling, general and administrative expenses decreased to approximately $18.7 million for the nine months ended September 30, 2005 compared to approximately $19.3 million for the nine months ended September 30, 2004. The nine month period ended September 30, 2005 includes approximately $0.3 million in one-time merger related expenses. Excluding the one-time merger expenses, selling, general and administrative expenses decreased approximately $0.9 million or 4.7%. The decrease in 2005 is primarily due to a decrease in compensation expense associated with staff reductions at the corporate level. Interest expense. Interest expense decreased to approximately $0.6 million for the nine months ended September 30, 2005 from approximately $0.9 million for the nine months ended September 30, 2004, a decrease of approximately $0.3 million or 37.6%. The decrease in interest expense is primarily due to a decrease in the average outstanding debt balance resulting from our $6.3 million debt pay down in January 2005. Cash proceeds received from the sale of the Distribution business and the issuance of the Series D preferred stock were used in part for the debt pay down. Discontinued Operations. Income from discontinued operations of approximately $0.9 million for the nine months ended September 30, 2005 relates to our settlement of the Yonkers lease obligation. On October 21, 2005, we entered into a surrender agreement with the landlord of the Yonkers facility. We paid $125,000 to the landlord and also agreed to forego $85,000 in a rent deposit that we had paid at the inception of the lease in January 2003. In return, the landlord released us from any and all financial obligations regarding the lease of the Yonkers facility, effective September 30, 2005, and the landlord will release us from all other obligations under the lease agreement, effective December 31, 2005. As a result of this transaction, we adjusted our estimated provision to cover any potential exposure on the Yonkers lease obligation down to $125,000 at September 30, 2005. The offset to this adjustment of approximately $0.9 million was treated as income from discontinued operations in the nine months ended September 30, 2005, since the original provision was included in the loss on disposal of discontinued operations for the year ended December 31, 2004. The loss from discontinued operations of approximately $3.8 million for the nine months ended September 30, 2004 relates to the operating losses of CC Systems, Inc. and the Distribution business and also includes the loss on the disposal of CC Systems, Inc. which was sold in September 2004. Income tax expense. Income tax expense recorded for the nine months ended September 30, 2005 and September 30, 2004 primarily represents minimum state tax expense. For the nine months ended September 30, 2005, the Company has offset its income tax expense, other than the minimum state tax expense, with the releasing of valuation allowances that were setup to offset the net operating loss deferred tax assets. CRITICAL ACCOUNTING POLICIES The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of our financial statements. Management bases its estimates and judgments on historical experience, current economic and industry conditions and on various other facts that are believed to be reasonable under the circumstances. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions. The accounting policies and judgments, estimates and assumptions are described in greater detail in our Annual Report on Form 10-K, as amended, in the "Critical Accounting Policies and Estimates" of 17 Management's Discussion and Analysis of Financial Condition and Results of Operations and in Note 3 to the Consolidated Financial Statements for the year ended December 31, 2004. Management believes critical accounting estimates are used in determining the adequacy of the allowance for doubtful accounts, insurance disallowances, managed care claims accrual, valuation allowance for deferred tax assets and in evaluating goodwill and intangibles for impairment. LIQUIDITY AND CAPITAL RESOURCES Liquidity Our primary sources of liquidity have been cash flows generated from operations in our Managed Vision and Consumer Vision segments, other income from litigation settlements and borrowings under our term loan and revolving credit facility with CapitalSource and recently, borrowings under our loan from Refac. We have continued to settle outstanding litigation with positive results through September 2005, but expect future revenue from these settlements to be negligible in the future. As of September 30, 2005, we had cash and cash equivalents of approximately $2.1 million and additional availability under our revolving credit facility with CapitalSource of approximately $1.6 million. The Company's over advance facility with CapitalSource expired on August 31, 2005 and our term loan with CapitalSource becomes due on January 26, 2006. On September 1, 2005, Refac made a subordinated loan to us of $1.0 million. As a result of operating losses our condensed consolidated financial statements for the three months ended March 31, 2004, we were not in compliance with the minimum fixed charge ratio covenant under our term loan and revolving credit facility with CapitalSource as of March 31, 2004. In addition, we were not in compliance with this covenant as of April 30 or May 31, 2004. As discussed below, we amended our term loan and revolving credit facility with CapitalSource on August 16, 2004 and received a waiver from CapitalSource for any non-compliance with this covenant as of March 31, 2004, April 30, 2004, May 31, 2004 and June 30, 2004. On January 12, 2005, we amended the term loan and revolving credit facility with CapitalSource to reduce the tangible net worth covenant for December 2004 and January 2005 from ($3.0) million to ($6.5) million. Without this amendment, we would have been in violation of the tangible net worth covenant at December 31, 2004. Under the term loan and revolving credit facility, as amended, we must maintain a tangible net worth of at least ($3.0) million after February 1, 2005. We paid CapitalSource $12,500 in financing fees in connection with this amendment. We have been in compliance with all of our covenants at each month end for the period January 31, 2005 through September 30, 2005. The following table sets forth a year-over-year comparison of the components of our liquidity and capital resources for the nine months ended September 30, 2005 and 2004: (In millions) 2005 2004 CHANGE ---- ---- ------- Cash and cash equivalents $ 2.1 $ 3.0 $ (0.9) Cash provided by (used in): Operating activities (0.6) 3.4 (4.0) Investing activities 2.8 0.3 2.5 Financing activities (2.3) (2.4) 0.1 Net cash used in operating activities was approximately $0.6 million for the nine months ended September 30, 2005 compared to approximately $3.4 million of net cash provided by operations for the nine months ended September 30, 2004. The decrease of approximately $4.0 million in net cash from operating activities in the nine months ended September 30, 2005 compared to nine months ended September 30, 2004 is primarily attributable to an approximate $5.2 million net increase in the non-cash components of working capital in 2005 compared to 2004. This amount was offset in part by an increase of approximately $1.2 million in net income from continuing operations in the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004. The increase in the non-cash 18 components of working capital resulted primarily from a decrease in accounts payable and accrued expenses of approximately $5.3 million and an approximate $0.1 million net increase in other assets and liabilities. The decrease of approximately $5.3 million in accounts payable and accrued expenses resulted primarily from expenses associated with the sale of the Distribution business, including professional fees being settled in 2005. Net cash provided by investing activities was approximately $2.8 million for the nine months ended September 30, 2005 compared to approximately $0.3 million of net cash provided by investing activities for the nine months ended September 30, 2004. Net cash provided by investing activities in 2005 included approximately $3.4 million in proceeds received related to the sale of the Distribution business in January 2005 and approximately $0.1 million of payments received on notes receivable both of which were partially offset by approximately $0.2 million used to purchase fixed assets, approximately $0.2 million used for earn out payments related to an acquisition and approximately $0.2 million of managed care deposits. Net cash provided by investing activities in 2004 included $0.7 million in proceeds received related to the sale of CC Systems, our technology business, in September 2004 and approximately $0.1 million of payments received on notes receivable both of which were partially offset by approximately $0.3 million used to purchase fixed assets and approximately $0.2 million of managed care deposits. Net cash used in financing activities was approximately $2.3 million for the nine months ended September 30, 2005 compared to approximately $2.4 million of net cash used in financing activities for the nine months ended September 30, 2004. Net cash used in financing activities in 2005 resulted primarily from approximately $7.8 million in debt repayments under our revolving credit facility and term loan with Capital Source, offset in part by cash proceeds received of approximately $4.4 million from the issuance of Series D preferred stock and $1.0 million from the subordinated loan from Refac. Debt repayments of approximately $7.8 million were made in part with cash proceeds received from the sale of the Distribution business, the subordinated loan from Refac and from the issuance of the Series D preferred stock. Net cash used in financing activities in 2004 was primarily attributable to approximately $2.4 million in debt repayments under our revolving credit facility and term loan with Capital Source. We incurred operating losses in 2004 due primarily to substantial operating losses at Wise Optical. In January 2005, we sold our Distribution business including the Wise Optical operation. In September 2004, we sold our Technology business, CC Systems, Inc. The sale of these operations generated cash proceeds and reduced demands on working capital and corporate personnel. In addition, in January 2005, we sold 280,618 shares of newly created Series D preferred stock, which is convertible into our common stock, for an aggregate price of approximately $4.4 million. In addition, in 2003 the Managed Vision segment began shifting away from the lower margin and long sales cycle of our third party administrator, or TPA style business to the higher margin and shortened sales cycle of a direct-to-employer business. This direct-to-employer business also removes some of the volatility that is often experienced in our TPA-based revenues. We continue to grow our direct-to-employer business, however, the direct-to-employer business continues to be relatively small in comparison to the overall Managed Vision business. We 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. In the nine month period ended September 30, 2005, revenue and profitability in the Consumer Vision segment have remained relatively constant with the comparable period of 2004. We believe the combination of the above initiatives executed in the operating segments will continue to improve our liquidity and should ensure compliance with CapitalSource covenants in the future. We believe that our future cash flow from operations, borrowings under our amended term loan and revolving credit facility with CapitalSource, borrowings under our subordinated loan agreement with Refac and operating and capital lease financing will provide us with sufficient funds to finance our operations for the next 12 months, including the purchase of certain operating equipment. The CapitalSource Loan and Security Agreement As of September 30, 2005, we had borrowings of $1.5 million outstanding under our term loan with CapitalSource, $0.9 million of advances outstanding under our revolving credit facility with CapitalSource and $1.6 million of additional availability under this revolving credit facility. Our temporary over-advance facility with CapitalSource expired on August 31, 2005. Our term loan with CapitalSource matures on January 25, 2006 and our revolving credit facility matures on January 25, 2007. 19 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 $15.0 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 extend 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, (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 terminated 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. We did not meet our fixed charge ratio covenant in January and February 2004. Accordingly, on March 29, 2004, we amended and restated the terms of our term loan and revolving credit facility with Capital Source which incorporated 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 this amendment, we agreed to pay $25,000 to CapitalSource in financing fees. 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, (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 20 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 2.0% 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 2.0%. 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, we amended our 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 provided a $1.0 million guarantee against the loan balance due to CapitalSource related to this amendment. We paid CapitalSource $15,000 in financing fees in connection with this amendment. On January 12, 2005, we amended the term loan and revolving credit facility with CapitalSource to reduce the tangible net worth covenant for December 2004 and January 2005 from ($3.0) million to ($6.5) million. Without this amendment, we would have been in violation of the tangible net worth covenant at December 31, 2004. Under the term loan and revolving credit facility, as amended, we must maintain a tangible net worth of at least ($3.0) million after February 1, 2005. We paid CapitalSource $12,500 in financing fees in connection with 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 dated March 29, 2004, as amended on August 16, 2004, August 27, 2004 and January 12, 2005. 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 and to maintain a minimum net worth, both as discussed above. Upon the occurrence of certain events or conditions described in the revolving credit, term 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, our term loan with CapitalSource matures on January 25, 2006 and our revolving credit facility matures on January 25, 2007. We are required to make monthly principal payments of $25,000 on the term loan with the balance due at maturity. Although we may borrow up to $15.0 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 9.0%) 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. 21 We believe that we will be able to comply with our financial covenants under our amended credit facility with CapitalSource. However, if we incur operating losses and we fail to comply with our financial covenants or otherwise default on our debt, our creditors could foreclose on our assets, in which case we would be obligated to seek alternate sources of financing. There can be no assurance that alternate sources of financing will be available to us on terms acceptable to us, if at all. If additional funds are needed, we may attempt to raise such funds through the issuance of equity or convertible debt securities. If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and our stockholders may experience dilution of their interest in us. If additional funds are needed and are not available or are not available on acceptable terms, our ability to fund our operations, take advantage of unanticipated opportunities, develop or enhance services or products or otherwise respond to competitive pressures may be significantly limited and may have a material adverse impact on the business and operations. The Refac Loan Agreement On September 1, 2005, Refac loaned us $1.0 million. This loan is evidenced by a subordinated secured note and is subordinate to our senior indebtedness with CapitalSource. Pursuant to the terms and conditions of the loan agreement with Refac, the principal balance together with any accrued but unpaid interest shall be due and payable by us on January 25, 2007. However, if the merger provided for in our merger agreement with Refac is not completed on or before January 31, 2006, the maturity date shall be March 31, 2006. We did not incur any loan origination fees associated with the subordinated loan from Refac. The note bears interest at a rate equivalent to prime plus 5.5%. The entire amount of loan proceeds was used to repay a portion of our outstanding indebtedness under the revolving credit facility with CapitalSource. The Series B Preferred Stock As of September 30, 2005, we had 3,204,959 shares of Series B Preferred Stock issued and outstanding. Subject to the senior liquidation preference of the Series C and Series D Preferred Stock described below, the Series B Preferred Stock ranks senior to all other currently issued and outstanding classes or series of our stock with respect to dividends, redemption rights and rights on liquidation, winding up, corporate reorganization and dissolution. Each share of Series B Preferred Stock is convertible into a number of shares of common stock equal to such share's current liquidation value, divided by a conversion price of $0.14, subject to adjustment for dilutive issuances. The number of shares of common stock into which each share of Series B Preferred Stock is convertible will increase over time because the liquidation value of the Series B Preferred Stock, which was $2.16 per share as of September 30, 2005, increases at a rate of 12.5% per year, compounded annually. The Series C Preferred Stock As of September 30, 2005, we had 406,158 shares of Series C Preferred Stock issued and outstanding. The Series C Preferred Stock has an aggregate liquidation preference of approximately $16.2 million and ranks senior to all other currently issued and outstanding classes or series of our stock with respect to liquidation rights with exception of the Series D Preferred Stock. Each share of Series C Preferred Stock is convertible into 50 shares of common stock and has the same dividend rights, on an as converted basis, as our common stock. The Series D Preferred Stock In January 2005, we issued and sold an aggregate of 280,618 shares of our newly created Series D Preferred Stock, which are initially convertible into an aggregate of 11,224,720 shares of our common stock, to Palisade and Ms. Yimoyines, the spouse of our Chairman and former Chief Executive Officer, for an aggregate purchase price of approximately $4.4 million. Each share of Series D Preferred Stock has a senior liquidation preference over all other series and classes of our currently outstanding capital stock equal to (a) $15.84 and (b) an amount in cash equal to all accrued but unpaid dividends thereon. Each share of Series D Preferred Stock is initially convertible, at the option of the holder, into 40 shares of our common stock based on an initial conversion price of $0.396. The conversion price is subject to adjustment for dividends on our common stock and subdivisions and/or reclassifications of our common stock. Each holder of Series D Preferred Stock is entitled to vote, on an as converted basis, on all matters with the holders of our common stock and receive dividends equally and ratably with the holders of our common stock in an amount equal to the dividends such holder would receive if it had converted its Series D Preferred Stock into common stock on the date the dividends are declared. 22 Impact of Reimbursement Rates Our revenue is subject to pre-determined Medicare reimbursement rates which, for certain products and services have decreased over the past three years. A decrease in Medicare reimbursement rates could have an adverse effect on our results of operations if we cannot manage these reductions through increases in revenues or decreases in operating costs. To some degree, prices for health care are driven by Medicare reimbursement rates, so that our non-Medicare business is also affected by changes in Medicare reimbursement rates. FORWARD-LOOKING INFORMATION AND RISK FACTORS The statements in this Form 10-Q and elsewhere (such as in other filings by us with the Securities and Exchange Commission, press releases, presentations by us or our management and oral statements) that relate to matters that are not historical facts are "forward-looking statements" within the meaning of Section 27A of the Securities Exchange Act of 1934, as amended. When used in this document and elsewhere, words such as "anticipate," "believe," "expect," "plan," "intend," "estimate," "project," "could," "may," "predict" and similar expressions are intended to identify forward-looking statements. Such forward-looking statements include those relating to: o Our expectation that the merger with Refac will be consummated on or before April 30, 2006 and the expected consideration to be received by our stockholders in the merger; 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 may not have a material adverse impact on our financial position or results of operations; o Our belief that our direct-to-employer product will lead to increased revenue, gross margins and profitability in our Managed Vision segment; o Our expectation of future revenue, profitability, income and expense levels for our company as a whole and for each of its segments; o Our belief that the termination or renegotiation of Cigna contracts will be mitigated in part by new contracts; o Our expectation that interest rates may not have a material adverse effect on income or cash flows in 2005; o Our belief that our initiatives may continue to improve liquidity and should ensure compliance with covenants in our amended term loan and revolving credit facility with CapitalSource; and o Our belief that cash from operations, borrowings under our amended term loan and revolving credit facility with CapitalSource and loan with Refac and operating and capital lease financings will provide sufficient funds to finance operations for the next 12 months, including the purchase of certain operating equipment. In addition, such forward-looking statements involve known and unknown risks, uncertainties, and other factors which may cause our actual results, performance or achievements to be materially different from any future results expressed or implied by such forward-looking statements. Also, our business could be materially adversely affected and the trading price of our common stock could decline if any of the following risks and uncertainties develop into actual events. Such risk factors, uncertainties and the other factors include: o The fact that we have failed financial covenants and may fail them in the future; o If we default on our debt to CapitalSource, it could foreclose on our assets; o If we default on our debt to Refac, it could foreclose on our assets; o The fact that the proposed merger with Refac may not be consummated in a timely manner, if at all, which could negatively impact our continued operations and prospects as a stand-alone business. 23 o 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; o 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; o The fact that 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; o Loss of the services of key management personnel could adversely affect our business; o If we fail to execute our growth strategy, we may not continue to be profitable; o If we are unable to obtain additional capital, our growth could be limited; o We have a history of losses and may incur further losses in the future; o We may not be able to maintain the listing of our common stock on the American Stock Exchange, which may make it more difficult for stockholders to dispose of our common stock; o 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; o Failure to negotiate profitable capitated fee arrangements could have a material adverse effect on our results of operations and financial condition; o The possibility that we may have potential conflicts of interests with respect to related party transactions which could result in certain of our officers, directors and key employees having interests that differ from our stockholders and us; o Health care regulations or health care reform initiatives could materially adversely affect our business, financial condition and results of operations; o The fact that we are dependent upon letters of credit or other forms of third party security in connection with certain of our contractual arrangements and, thus, would be adversely affected in the event we are unable to obtain such credit as needed; o The fact that our largest stockholder, Palisade, 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; o The fact that conflicts of interest may arise between Palisade and us; o The fact that conflicts of interest may arise between Dean J. Yimoyines and us; and o Other risks and uncertainties discussed elsewhere in this Form 10-Q and detailed from time to time in our periodic earnings releases and reports filed with the Securities and Exchange Commission. Except as required by law, we undertake no obligation to publicly update or revise forward-looking statements to reflect events or circumstances after the date of this Form 10-Q or to reflect the occurrence of unanticipated events. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are subject to market risk from exposure to changes in interest rates based on our financing activities under our credit facility with CapitalSource and the loan from Refac, due to their variable interest rates. The nature and amount of our indebtedness may vary as a result of future business requirements, market conditions and other factors. The extent of our interest rate risk is not quantifiable or predictable due to the variability of future interest rates and financing needs. We do not expect changes in interest rates to have a material effect on income or cash flows in the year 2005, although there can be no assurances that interest rates will not significantly change. A 10% change in the interest rate payable by us on our variable rate debt would have increased or decreased the nine-month interest expense by approximately $41,000 assuming that our borrowing level is unchanged. We did not use derivative instruments to adjust our interest rate risk profile during the nine months ended September 30, 2005. 24 ITEM 4. CONTROLS AND PROCEDURES (A) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES As required by Rule 13a-15 under the Exchange Act, our management, under the supervision and with the participation of the our Chief Executive Officer and Corporate Controller and Chief Accounting Officer, performed an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, these officers have concluded that, as of September 30, 2005, our disclosure controls and procedures were adequate and designed to provide reasonable assurance that the information required to be disclosed is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. (B) CHANGES IN INTERNAL CONTROLS There have been no changes in our internal controls over financial reporting, identified in connection with our evaluation of such internal controls, which have occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to material affect, our internal controls over financial reporting. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS HEALTH SERVICE ORGANIZATION LAWSUITS In July 2005, we reached settlement with John C. Hagan, III, M.D., an HSO practice that we were in litigation in the matter of In re Prime Vision Health, Inc., Contract Litigation, MDL 1466, which was previously reported in our Annual Report on Form 10-K, as amended, for the year ended December 31, 2004. This settlement resulted in a cash payment to us and mutual termination of the HSO service agreement. The HSO lawsuits are coming to conclusion and we do not expect substantial income from additional settlements in the future. ITEM 5. OTHER INFORMATION On October 21, 2005, we entered into a surrender agreement with the landlord of the Yonkers facility. We paid $125,000 to the landlord and also agreed to forego $85,000 in a rent deposit that we had paid at the inception of the lease in January 2003. In return, the landlord released us from any and all financial obligations regarding the lease of the Yonkers facility, effective September 30, 2005, and the landlord will release us from all other obligations under the lease agreement, effective December 31, 2005. On November 11, 2005, we received the resignation of Gordon A. Bishop, President, Consumer Vision Division effective February, 28, 2006. We have selected David Gaio to succeed Mr. Bishop as the President of the Consumer Vision Division. Mr. Gaio currently serves as an Executive Vice President for the Consumer Vision Division. On November 11, 2005, we executed an amendment to Section 8.01 of the agreement and plan of merger dated August 22, 2005 among us, Refac and OptiCare Merger Sub, Inc. amending the merger termination date to April 30, 2006 from December 31, 2005. ITEM 6. EXHIBITS The following Exhibits are filed as part of this Quarterly Report on Form 10-Q: EXHIBIT DESCRIPTION ------- ----------- 2.1 Agreement and Plan of Merger by and among Refac, OptiCare Merger Sub, Inc. and the 25 Registrant dated as of August 22, 2005, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed August 23, 2005, Exhibit 2.1. 2.2 Amendment No.1 dated as of November 11, 2005 to the Agreement and Plan of Merger by and among Refac, OptiCare Merger Sub, Inc. and the Registrant dated as of August 22, 2005.* 10.1 Loan Agreement by and among Refac, the Registrant and OptiCare Eye Health Centers, Inc. dated as of September 1, 2005, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed September 8, 2005, Exhibit 10.1. 10.2 The Registrant's Promissory Note dated September 1, 2005, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed September 8, 2005, Exhibit 10.2. 10.3 Subordination Agreement by and among Refac, the Registrant, OptiCare Eye Health Centers, Inc., Primevision Health, Inc. and CapitalSource Finance LLC dated as of September 1, 2005, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed September 8, 2005, Exhibit 10.3. 10.4 Employment Agreement dated July 19, 2005 by and between the Registrant and Vincent S. Miceli, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed July 25, 2005, Exhibit 10.1. 10.5 Amendment No. 1 to Amended and Restated Employment Agreement dated July 19, 2005 by and between the Registrant and Christopher Walls, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed July 25, 2005, Exhibit 10.2. 10.6 Surrender of Lease Agreement dated October 21, 2005 by and between the Registrant and MACK-CALI SO. WEST REALTY ASSOCIATES L.L.C.* 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* 31.2 Certification of Corporate Controller and Chief Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* 32 Certification of Chief Executive Officer and Corporate Controller and Chief Accounting Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* * Filed herewith. 26 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be filed on its behalf by the undersigned, hereunto duly authorized. Date: November 14, 2005 OPTICARE HEALTH SYSTEMS, INC. By: /s/ Vincent S. Miceli -------------------------------------- Vincent S. Miceli Corporate Controller (Principal Financial and Accounting Officer and duly authorized officer) 27 EXHIBIT INDEX EXHIBIT DESCRIPTION ------- ----------- 2.1 Agreement and Plan of Merger by and among Refac, OptiCare Merger Sub, Inc. and the Registrant dated as of August 22, 2005, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed August 23, 2005, Exhibit 2.1. 2.2 Amendment No.1 dated as of November 11, 2005 to the Agreement and Plan of Merger by and among Refac, OptiCare Merger Sub, Inc. and the Registrant dated as of August 22, 2005.* 10.1 Loan Agreement by and among Refac, the Registrant and OptiCare Eye Health Centers, Inc. dated as of September 1, 2005, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed September 8, 2005, Exhibit 10.1. 10.2 The Registrant's Promissory Note dated September 1, 2005, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed September 8, 2005, Exhibit 10.2. 10.3 Subordination Agreement by and among Refac, the Registrant, OptiCare Eye Health Centers, Inc., Primevision Health, Inc. and CapitalSource Finance LLC dated as of September 1, 2005, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed September 8, 2005, Exhibit 10.3. 10.4 Employment Agreement dated July 19, 2005 by and between the Registrant and Vincent S. Miceli, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed July 25, 2005, Exhibit 10.1. 10.5 Amendment No. 1 to Amended and Restated Employment Agreement dated July 19, 2005 by and between the Registrant and Christopher Walls, incorporated herein by reference from the Registrant's Current Report on Form 8-K filed July 25, 2005, Exhibit 10.2. 10.6 Surrender of Lease Agreement dated October 21, 2005 by and between the Registrant and MACK-CALI SO. WEST REALTY ASSOCIATES L.L.C.* 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* 31.2 Certification of Corporate Controller and Chief Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* 32 Certification of Chief Executive Officer and Corporate Controller and Chief Accounting Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* * Filed herewith. 28