10-Q 1 e10-q.txt FORM 10-Q PERIOD ENDED JUNE 30, 2000 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q ---------------- (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2000 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 000-22975 ---------------- ORTHALLIANCE, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 95-4632134 (STATE OR JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 21535 HAWTHORNE BOULEVARD, SUITE 200 TORRANCE, CALIFORNIA 90503 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (310) 792-1300 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) ---------------- 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 [ ]

================================================================================ 2 ORTHALLIANCE, INC. AND SUBSIDIARIES FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2000 INDEX

3 PART I - FINANCIAL INFORMATION ITEM I. FINANCIAL STATEMENTS ORTHALLIANCE, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)

The accompanying notes are an integral part of these condensed consolidated balance sheets. 3 4 ORTHALLIANCE, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements. 4 5 ORTHALLIANCE, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) (UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements. 5 6 ORTHALLIANCE, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) NOTE 1. BUSINESS AND ORGANIZATION OrthAlliance, Inc. ("OrthAlliance"), a Delaware corporation, was incorporated on October 21, 1996 and provides practice management and consulting services to orthodontic and pediatric dental practices throughout the United States. Effective prior to the closing of the initial public offering of shares of OrthAlliance's Class A Common Stock (the "Offering" or "IPO"), Premier Orthodontic Group, Inc. ("Premier") and US Orthodontic Care, Inc. ("USOC") merged with and into OrthAlliance. In the merger, the outstanding common stock of USOC and Premier converted into shares of Class A Common Stock ("Common Stock") and shares of Class B Common Stock ("Class B Common Stock"). On August 26, 1997, OrthAlliance acquired (the "Acquisitions") simultaneously with the closing of the IPO certain operating assets of or the stock of entities holding certain tangible and intangible assets and assumed certain liabilities of 55 orthodontic practices in exchange for shares of Common Stock and cash. The Acquisitions were accounted for in accordance with the Securities and Exchange Commission's Staff Accounting Bulletin No. 48. OrthAlliance's wholly-owned subsidiaries, incorporated in Delaware, include the following: PedoAlliance, Inc. ("PedoAlliance") and OrthAlliance Finance, Inc. ("OA Finance") formed in December 1997, and OrthAlliance Holdings, Inc. and OrthAlliance New Image, Inc. ("OA New Image") formed in January 2000. The subsidiaries were formed to provide practice management, patient financing, consulting and other services (collectively "Management Services") to allied orthodontic and pediatric dental practices (the "Allied Practices") or their patients. OA New Image was formed specifically in connection with the Company's acquisition of substantially all of the assets of New Image Orthodontic Group, Inc., which was effective March 1, 2000. OrthAlliance, Inc. and its subsidiaries are collectively referred to as "OrthAlliance" or the "Company". NOTE 2. BASIS OF PRESENTATION The accompanying interim condensed consolidated financial statements of OrthAlliance are unaudited and reflect all adjustments that, in the opinion of management, are necessary for a fair presentation of the results for the interim period in accordance with Securities and Exchange Commission instructions for Form 10-Q. Accordingly, they do not include all information and footnotes required by generally accepted accounting principles for complete financial statements. The condensed consolidated statements of income for the current interim period are not necessarily indicative of results to be expected for the current year or any other period. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes thereto as well as other information included in the Company's Annual Report on Form 10-K for the year ended December 31, 1999 and other Company filings with the Securities and Exchange Commission. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates. Consolidation The Company does not consolidate the operations of the Allied Practices which it manages as the Company's arrangements with its Allied Practices do not meet the requirements for consolidation as set forth in EITF 97-2. Reclassifications Certain prior period reclassifications have been made to conform to classifications used in the current period. 6 7 ORTHALLIANCE, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) NOTE 3. ACQUISITION OF NEW IMAGE Effective March 1, 2000, the Company acquired substantially all of the assets of New Image Orthodontic Group, Inc. ("New Image"), a privately held Georgia corporation based in Atlanta, Georgia, for a total consideration (including acquisition costs) of approximately $33.8 million. New Image was founded in February 1997 and provided business operations, financial, marketing and administrative services to orthodontic practices in nine states in accordance with long term service and employment agreements and had practice management agreements with 36 orthodontists operating in 50 locations. The acquisition price included a cash payment of $5.5 million, an estimated $1.5 million in acquisition costs, promissory notes issued of approximately $12.9 million, the assumption of approximately $13.4 million of existing debt due to New Image's former orthodontic practices, and the issuance of approximately 273,000 stock options. The promissory notes issued and assumed have interest rates ranging from 9%-10% and are repayable over a one to five year period. The Company will utilize substantially all the acquired assets in the continued operation of the business. The acquisition has been accounted for as a purchase. Intangible assets of approximately $33.2 million resulted from the acquisition. The results of operations of New Image are included with the results of operations of the Company from March 1, 2000. The Company has obtained the appropriate consents from its lenders regarding this transaction. The following pro forma results of operations are presented to illustrate the effect of the acquisition on the historical operating results of OrthAlliance and New Image for the three and six month periods ended June 30, 2000 and June 30, 1999. These pro forma results of operation gives effect to the acquisition as if it occurred as of January 1, 2000 and January 1, 1999, respectively. The pro forma results of operations are based on management's current estimates and may not be indicative of the results of operations that actually would have occurred if the transaction had been at the dates indicated.

7 8 ORTHALLIANCE, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)

---------- (a) Because the transaction with New Image was effective March 1, 2000, the results of operations for New Image and the pro forma adjustments are for the two months period ended February 29, 2000. NOTE 4. PRACTICE AFFILIATIONS During the three months ended June 30, 2000, the Company entered into practice affiliation agreements with 5 practitioners to provide management services and acquire certain operating assets for a total consideration (including acquisition costs) of $3.7 million. The consideration consisted of $3 million cash and $0.7 million debt. These Allied Practices operate 12 locations and generated historical patient revenue over the prior 12 months of approximately $4 million. Prior patient revenue is not necessarily indicative of the level of revenue that these practices may be expected to generate in the future. NOTE 5. BANK LINE OF CREDIT On December 30, 1997, the Company entered into a $25 million Revolving Credit Facility (the "$25 Million Credit Facility") with First Union N.A., which had an expiration date of December 30, 2000. The Revolving Credit Facility bears interest on borrowings at variable rates including the bank's prime lending rate plus a percentage or LIBOR plus a percentage as determined by certain factors defined in the Revolving Credit Agreement. Amounts borrowed are secured by the Company's assets including accounts receivable, management and service agreements and the capital stock of the Company's wholly owned subsidiaries. On March 26, 1999, the Company executed an amended Revolving Credit Facility for borrowings of up to $55 million (the "$55 Million Credit Facility") with First Union National Bank, US Bank National Association and Union Bank of California N.A. (due March 2002) under substantially the same terms and conditions as the $25 Million Revolving Credit Facility which was repaid in full at the closing. Effective April 14, 2000, the Company expanded its Revolving Credit Facility to $75 million (the "$75 Million Credit Facility") with First Union National Bank, City National Bank, Union Bank of California, U.S. Bank National Association and Wells Fargo Bank, N.A. (due April 13, 2003) under substantially the same terms and conditions as the $55 Million Credit Facility. As of June 30, 2000 and December 31, 1999, the outstanding borrowings under the Revolving Credit Facilities were $ 57 million and $ 47.5 million, respectively. As of June 30, 2000 the Company was in compliance with the terms and covenants of the $75 Million Credit Facility. NOTE 6. OPERATING SEGMENTS The Company adopted Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131") in 1998. This statement establishes standards for the reporting of information about operating segments and also requires disclosures about products and services, geographic areas and major customers. The adoption of SFAS No. 131 did not affect the Company's consolidated financial position or results of operations. Because the Company did not have any significant segments in the prior year, the adoption of SFAS No. 131 did not affect previous disclosures of segment information. 8 9 ORTHALLIANCE, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) The Company has two reportable segments organized as business units that provide management or consulting services to the two distinct types of Allied Practices: "Orthodontic Practices" which include the OrthAlliance Allied Orthodontists (includes New Image orthodontists) and "Pediatric Practices" which include the PedoAlliance Allied Dentists. Each business unit provides similar management and consulting services to the respective Allied Practices and the Company does not manage the business units separately. The remaining segments identified as "All Other" derive revenues from interest income and primarily consist of patient contract financing operations. Management utilizes multiple views of data to measure segment performance and to allocate resources to the segments. The following is a summary of certain financial data for each of the segments:

Included in the operating income of the orthodontic practice segment are certain corporate expenses that are not allocated to the pediatric practice segment or to the "all others" category. Examples of these expenses are corporate office salaries, rent, overhead expenses, and amortization expense. A reconciliation between total segment operating income and consolidated net income or loss is set forth below:

9 10 ORTHALLIANCE, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) NOTE 7. TREASURY STOCK In February 2000, the Company acquired 270,000 shares of its common stock at a cost of approximately $1.9 million. NOTE 8. SUBSEQUENT EVENTS New Affiliations In July 2000, the Company entered into an agreement with an Affiliated Practice to expand such Affiliated Practice through the acquisition of certain operating assets of a non-affiliated orthodontic practice. The total consideration paid to the non-affiliated orthodontic practice consisted of $224,000 cash and a promissory note of $96,000. 10 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Cautionary Statement The information contained in this Form 10-Q and documents incorporated by reference are intended to update the information contained in the Company's Annual Report on Form 10-K for the year ended December 31, 1999 and presumes that readers have access to, and will have read, the "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other information contained in such Form 10-K and other Company filings with the Securities and Exchange Commission ("SEC"). This Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934 and such forward-looking statements are subject to the safe harbors created thereby. For this purpose, any statements contained in this Form 10-Q except for historical information may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, words such as "may," "will," "expect," "believe," "anticipate," "intend," "could," "estimate" or "continue" or the negative or other variations thereof or comparable terminology are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The forward-looking statements included herein are based on current expectations that involve a number of risks and uncertainties, as well as on certain assumptions that could cause actual future activities and results of operations to be materially different from those set forth in the forward-looking statements. Important factors that could cause actual results to differ include, among other things, risks associated with Allied Practice affiliations, availability of capital or that the Company will remain in compliance with its credit facilities, fluctuations in operating results because of affiliations and variations in stock price, dependence upon revenues generated by Allied Practices, continued compliance with the listing requirements for the Nasdaq national market listing, changes in government regulations, competitive conditions, risks of operations and growth of existing and newly affiliated practices, ability to staff the Allied Practices with qualified personnel, the continued availability of adequate insurance, ability of Allied Practices to attract and retain patients and other risks. Additional factors that may affect future operating results are discussed in more detail in Exhibit 99.1 of the Company's Annual Report on Form 10-K. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions, and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond the control of the Company. Although the Company believes that the assumptions underlying the forward-looking statements are reasonable, the business and operations of the Company are subject to risks that increase the uncertainty inherent in the forward-looking statements, and the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. In addition, risks, uncertainties and assumptions change as events or circumstances change. The Company disclaims any obligation to publicly release the results of any revisions to these forward-looking statements which may be made to reflect events or circumstances occurring subsequent to the filing of this Form 10-Q with the SEC or otherwise to revise or update any oral or written forward-looking statement that may be made from time to time by or on behalf of the Company. The information contained in this Form 10-Q is not a complete description of the Company's business or the risks associated with an investment in the Company. Readers are urged to carefully review and consider the various disclosures made by the Company in this Report and in the Company's other filings with the SEC that attempt to advise interested parties of certain risks, uncertainties and other factors that may affect the Company's business. General The Company began providing practice management services to Allied Practices in the United States on August 26, 1997. The initial 55 Allied Practices included 82 practitioners operating 147 offices in 16 states. By the end of 1997, the Company had affiliated with 11 new practices, including 17 additional practitioners operating out of 31 new locations. In 1998, the Company affiliated with 36 new practices, including 45 additional orthodontists and pediatric dentists operating out of 70 locations. In 1999, the Company affiliated with 36 new practices, including 40 additional orthodontists and pediatric dentists operating out of 73 locations. During the six month period ended June 30, 2000, the Company affiliated with 5 new practices, including 5 practitioners operating out of 12 locations. The Company anticipates that future growth will come from new affiliations, satellite expansion of Allied Practices, and the development of new orthodontic practices, increased internal growth and improved operating efficiencies. 11 12 The Company derives net revenues by providing services pursuant to long-term service agreements or consulting agreements (collectively, "Management Agreements") with Allied Practices. The Company provides management or consulting services to each Allied Practice and assumes substantially all operating expenses except for compensation to the allied orthodontists and pediatric dentists ("Allied Orthodontists") and other employees that the Company cannot employ according to applicable state laws. In exchange for assuming these expenses and providing services, the Company records revenues in amounts equal to the assumed expenses plus a service fee or consulting fee, as described below. In general, the Management Agreements provide for the recognition of fees to the Company based on a negotiated percentage of the "Adjusted Patient Revenue" of Allied Practices. The timing of the payment of such service fees is based upon cash collected. Adjusted Patient Revenue is net patient revenue, as determined under generally accepted accounting principles, including certain accrual adjustments, including those related to patient prepayments, and adjustments for contractual allowances and other discounts, plus an adjustment for uncollectible accounts. Patient revenue is recognized as services are performed. For orthodontic services, approximately 20% to 24% of the orthodontic contract revenues are recognized at the time of initial treatment. The balance of the contract revenue is realized evenly over the remaining treatment period. The 20% to 24% estimated revenue at the initial treatment date is based on the estimated costs incurred by the practice at that time as compared to the total costs of providing the contracted services and is consistent with industry standards. The percentage includes the estimated costs of diagnosis and treatment plan development, initial treatment by orthodontic personnel, orthodontic supplies, and associated administrative services. The service fee is earned and paid monthly to the Company by each Allied Practice using one of several different fee structures set forth in the Management Agreements: (i) a designated percentage ranging from 13.5% to 20% of Adjusted Patient Revenue. The average designated percentage is 17% for the Allied Practices subject to this fee structure. In some cases, the Allied Practice must guarantee a minimum level of management fees to be paid by the Allied Practice for a portion of the agreement ranging from one to 25 years. (ii) a designated percentage of Adjusted Patient Revenue, ranging from 14% to 17%, subject to an annual adjustment based upon improvements in the Allied Practice's operating margin in the most recent calendar year as compared with the immediately preceding calendar year. No annual adjustment will be made which would result in reducing the designated percentage below the percentage applicable during the first year of the Management Agreement. Operating margin is defined as the percentage determined by dividing operating profit by Adjusted Patient Revenue. Operating profit is equal to Adjusted Patient Revenue less operating expenses, excluding the management fee and such expenses associated with the Allied Practices which the Company is prohibited from incurring, primarily consisting of orthodontist compensation. The average designated percentage is 16.2% for the Allied Practices subject to this fee structure. (iii) a fixed dollar fee with annual fixed dollar increases for each year of the term of the Management Agreement. (iv) the Company's management service fee related to the practices affiliated in connection with the New Image transaction is generally based on a designated percentage of patient revenues. The fee is determined by several factors including the dollar amount of patient revenues during the measurement period and the actual overhead expense of the practice expressed as a percentage of patient revenues. Generally, the fee percentage for this group of practice ranges up to 19.5% of patient revenues. In certain cases, the New Image Allied Practice must guarantee a minimum management fee over the term of the management agreement. The average management fee percentage during 1999 was approximately 16.6% of patient revenues. The Company has entered into agreements with certain Allied Practices to make the payment of service fees after the first two years contingent on various factors, including practice profitability compared to acquisition consideration, timely reporting of information, participation in practice improvement programs and orthodontist hours worked. Expenses reported by the Company include certain of the expenses to operate the orthodontic or pediatric dental offices and all of the expenses of any corporate offices, facilities or functions. Therefore, salaries and benefits include the wages, benefits, taxes or other employment costs for all employees of the Company, including practice office staff, business office staff and management personnel. Rent includes facility expenses for both practice offices and corporate offices. General and administrative expenses include professional services, such as legal and accounting, utilities, advertising, marketing, insurance, telephone, license fees, office supplies and shipping expenses. Advertising and marketing costs, which are included in general and administration costs, includes practice activities to attract new patients and corporate activities to attract new orthodontists or pediatric dentists to affiliate with the Company. Practice supplies include only those expenses required by the Allied Orthodontists to provide treatment to patients. 12 13 RESULTS OF OPERATIONS The following table sets forth certain selected unaudited condensed consolidated income statement data for the periods indicated in thousands of dollars and as a percentage of total net revenues:

Operating Income and Net Income Operating income for the three months ended June 30, 2000 increased 38% to $6.6 million from $4.7 million in the comparable 1999 quarter. Operating income for the six months ended June 30, 2000 increased 37% to $12.3 million from $8.9 million in the comparable 1999 quarter. Net income for the three months ended June 30, 2000 increased 15% to $2.7 million from $2.4 million in the comparable 1999 quarter. Net income for the six months ended June 30, 2000 increased 17% to $5.3 million from $4.5 million in the comparable 1999 quarter. Net Revenues Net revenues for the three months ended June 30, 2000 increased 51% to $36.1 million from $23.9 million in the comparable 1999 quarter. Similarly, net revenues for the six months ended June 30, 2000 increased 47% to $66.2 million from $45.2 million in the comparable 1999 quarter. The increase in net revenues for the three and six months ended June 30, 2000 is primarily due to an increase in affiliations of Allied Practices, the New Image acquisition and an increase in the internal growth of comparative same-store collections of approximately ten percent for the current period. Net revenues as reported by the Company include the Company's contractual service or consulting fee based in part on patient revenues, as well as reimbursed expenses of the Allied Practices. Operating Expenses Total operating expenses increased 54% to $29.4 million, or 82% of net revenues, in the three months ended June 30, 2000 from $19.1 million, or 80% of net revenues, for the comparable 1999 quarter. Total operating expenses increased 49% to $53.9 million, or 81% of net revenues, in the six months ended 13 14 June 30, 2000 from $36.3 million, or 80% of net revenues, for the comparable 1999 quarter. Direct expenses including salaries and benefits, orthodontic and dental supplies, and rent increased 44% to $16.4 million, or 45% of net revenues, in the three months ended June 30, 2000 from $11.4 million, or 48% of net revenues, for the comparable 1999 quarter. Direct expenses increased 38% to $30.2 million, or 46% of net revenues, in the six months ended June 30, 2000 from $21.9 million, or 49% of net revenues, for the comparable 1999 quarter. Direct expenses have increased in absolute dollars as a result of the acquisition of additional Allied Practices during the periods as well as the expansion and growth of previously existing Allied Practices. Salaries and benefits increased 39% to $9.9 million, or 27% of revenues, in the three months ended June 30, 2000 from $7.1 million, or 30% of net revenues for the comparable 1999 quarter. Salaries and benefits increased 33% to $18.5 million, or 28% of revenues, in the six months ended June 30, 2000 from $13.9 million, or 31% of net revenues for the comparable 1999 quarter. The decrease in salaries and benefits as a percentage of net revenues is a result of practice affiliations of which employees remained employees of the Allied Practice's professional corporations. Accordingly, for these practices, salary and benefit expenses are not reported by the Company. The Company expects that in future periods salaries and benefits will increase in absolute dollars, but may vary as a percentage of net revenues. General and administrative expenses increased 67% to $11.3 million, or 31% of net revenues, in the three months ended June 30, 2000 from $6.7 million, or 28% of net revenues, for the comparable 1999 quarter. General and administrative expenses increased 64% to $20.6 million, or 31% of net revenues, in the six months ended June 30, 2000 from $12.6 million, or 28% of net revenues, for the comparable 1999 quarter. General and administrative expenses have shown an increase in absolute dollars primarily related to the acquisition of additional Allied Practices during the period as well as the expansion and growth of previously existing Allied Practices offsetting reductions in marketing and advertising and other costs. Depreciation and amortization expenses increased approximately 85% to $1.7 million or 5% of net revenues in the three months ended June 30,2000 from $0.9 million or 4% of net revenues. Depreciation and amortization expenses increased approximately 81% to $3.1 million or 5% of net revenues in the six months ended June 30, 2000 from $1.7 million or 4% of net revenues. This increase is attributable to the increase in intangible assets associated with the affiliations of Allied Practices and the acquisition of New Image. Intangible assets approximated $120 million and $84 million at June 30, 2000 and December 31, 1999, respectively. Depreciation and amortization expenses primarily relate to the depreciation of capital assets and the amortization of excess cost over the fair value of net assets acquired and certain other intangibles. The Company's policy is to amortize goodwill over the expected period to be benefited, not to exceed 25 years. Interest Expense Interest expense increased to $2 million for the three months ended June 30, 2000 from $0.5 million in the comparable period in 1999. Interest expense increased to $3.2 million for the six months ended June 30, 2000 from $0.9 million in the comparable period in 1999. The increase was primarily due to increased borrowings under the Company's Revolving Credit Facility in support of Allied Practices affiliated and certain debt obligations issued and assumed in connection with New Image acquisition. Company borrowings under the Revolving Credit Facilities were $57 million and $47.5 million at June 30, 2000 and December 31, 1999, total debt was approximately $80.3 million and $49.7 million, respectively. Provision for Income Taxes The provision for income taxes increased 6% to $2.1 million for the three month period ended June 30, 2000 from $2.0 million for the comparable 1999 period. The provision for income taxes increased 12% to $4.1 million for the six month period ended June 30, 2000 from $3.7 million for the comparable 1999 period. The Company's effective income tax rates for the periods ended June 30, 2000 and 1999, respectively, were higher than the statutory tax rate primarily due to the amortization of certain intangible assets not being deductible for income tax purposes. The effective tax rate was 43.8% and 45.8% for the three month period ended June 30, 2000 and for the comparable period in 1999, respectively. The effective tax rate was 43.9% and 45.1% for the six month period ended June 30, 2000 and for the comparable period in 1999, respectively. 14 15 LIQUIDITY AND CAPITAL RESOURCES The Company has funded its operations to date primarily through cash from operations, the Company's line of credit and other available capital resources. This capital is used for affiliations with new Allied Practices, development of Allied Practice satellite offices, capital additions and general working capital needs. As of June 30, 2000 and December 31, 1999 the Company had a working capital balance of $13.2 million and $21.5 million, respectively. As of June 30, 2000 the Company's principal sources of liquidity included cash and short term investments of approximately $10.0 million and the Revolving Credit Facility, which as of that date had $18 million of available credit, with the remaining $57 million in outstanding borrowings bearing interest at the prime interest rate plus a margin or the LIBOR plus a margin. As of June 30, 2000, the Company was in compliance with all terms of the Revolving Credit Facility. On April 14, 2000, the Company expanded its revolving credit facility to $75 million, which expires on April 13, 2003 and has substantially similar terms to the previous facility. The Company's operating activities generated cash of $10.9 million during the six month period ended June 30, 2000. Net cash used in financing activities approximated $0.1 million in the six month period ended June 30, 2000 and consisted of borrowings and repayments on the line of credit and treasury shares purchased. Cash used in investing activities of $12.0 million in the six month period ended June 30, 2000 consisted of payments in connection with Allied Practices affiliated and capital expenditures, primarily for office and computer equipment used in Company operations. The Company does not currently have any material commitments with respect to any capital expenditures. The Company's capital resources needed to continue acquisition and development efforts are expected to be funded through a combination of cash flows provided by ongoing operations, the Company's line of credit, the issuance of equity and debt securities, as described in the Company's Form S-4 registration statement which became effective on August 6, 1999, and other sources. Management believes that these sources of capital will be sufficient to meet the Company's capital requirements for the next twelve months. The Company may choose to issue debt or equity to meet its future long-term capital needs, as management deems appropriate. There can be no assurance that the Company will be able to raise such additional working capital on acceptable terms, if at all. In the event the Company is unable to raise additional working capital, further measures would be necessary including, without limitation, the delay, or scale back of its operations, new Allied Practice affiliations, marketing programs and other actions. Certain of such measures may require third party consents or approvals, including the banks under the Revolving Credit Facility, and there can be no such assurance that such consents or approvals can be obtained. The Management Agreements provide for short-term advances by the Company to the Allied Practices for working capital requirements and other purposes on terms to be mutually agreed upon. These items are advanced and repaid in a revolving manner. Generally, advances are repaid when Allied Practices deposit patient revenue into their depository accounts. Advances occur when the Allied Practice operating expenses paid exceed patient revenue earned. During the six months ended June 30, 2000, the Company acquired 0.3 million shares of its common stock at an approximate cost of $1.7 million. The Company is authorized to repurchase additional shares from time to time. Payments for such share repurchases come from operating cash flow and/or borrowings under the Revolving Credit Facility. The timing and the amount of shares to be purchased will be determined based on the evaluation of working capital needs and stock market conditions. ACQUISITION OF NEW IMAGE ORTHODONTIC GROUP, INC. On March 1, 2000 the Company, through OrthAlliance New Image, Inc., a wholly owned subsidiary, acquired substantially all the assets of New Image Orthodontic Group, Inc ("New Image"), a privately held Georgia corporation based in Atlanta, Georgia. New Image was founded in February 1997 and provided business operations, financial and marketing and administrative services to orthodontic practices in nine states in accordance with long term service agreements. The transaction was accounted for as a purchase and includes practice management agreements with 36 orthodontic practitioners operating in 50 locations with over $33.0 million in annualized revenues. Collectively, the consideration and transaction costs associated with this transaction totaled approximately $33.8 million. Of this amount, $5.5 million was paid in cash, approximately $13.4 million of debt was assumed and $12.9 million in promissory notes were issued to the sellers, with interest rates ranging from 9% to 10%. The Company has to date transitioned the New Image assets into its business operations. Although management believes that the transition will continue to be successful, there can be no assurances that certain matters outside of management's control will not occur, delaying the successful integration of the New Image business operation, and having an unfavorable impact on operations and working capital. 15 16 YEAR 2000 COMPLIANCE The Company did not experience any system failures or any material effects that would impact the Company's financial condition or results of operations as a result of any Year 2000 issues. Because the Company started operations in August 1997, most of the corporate office systems were already Year 2000 compliant. Accordingly, any costs associated with Year 2000 upgrade were not significant. Currently, the Company has assessed its Year 2000 position and does not expect future problems relating to any Year 2000 issues that would have a material impact on the Company's operations or financial condition. RECENT ACCOUNTING PRONOUNCEMENTS In March 1998, the American Institute of Certified Public Accountants issued a Statement of Position 98-1 "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"), which is effective for the fiscal years beginning after December 15, 1998. The adoption of SOP 98-1 did not have a material effect on the Company's financial position or its results of operations. In January 1999, the Company implemented Statement of Position 98-5 "Reporting on Costs of Start-up Activities." The SOP 98-5 requires net costs of start-up activities, including organizational costs, to be expensed as incurred. In addition, the SOP requires that previously capitalized start-up costs be expensed upon the effective date. The implementation of SOP-85 did not have a material effect on the Company's financial position or the results of operations. In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), which is effective for all fiscal quarters of fiscal years beginning after June 15, 2000, as per the issuance of SFAS 137. SFAS 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. It requires that entities recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The Company has adopted Staff Accounting Bulletin Number 101, "Revenue Recognition Issues," issued December 3, 1999 ("SAB 101"). This pronouncement states that revenue is generally realized or realizable and earned when all of the following criteria are met: i) pervasive evidence of an arrangement exists, ii) delivery has occurred or services rendered, iii) the seller's price to the buyer is fixed or determinable and iv) collectibility is reasonably assured. The adoption of SAB 101 did not have a material impact on the Company's financial position or the results of its operations. INFLATION The Company does not believe that inflation has had a material effect on the results of operations. There can be no assurance that the Company's business will not be affected by inflation in the future. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The Company does not have any derivative financial instruments as of June 30, 2000. Further, the Company is not exposed to interest rate risk as the Company's revolving line of credit agreement has a variable interest rate. Therefore, the fair value of these instruments is not affected by change in market interest rates. The Company believes that the market risk arising from not hedging its financial instruments is not material. 16 17 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS From time to time the Company is involved in various legal proceedings, claims and litigation matters arising in the ordinary course of business, including labor and personnel related issues. In the opinion of management, the outcome of such routine matters will not have a material adverse effect on the Company's business, financial condition or results of operations. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS (a) None (b) None (c) None (d) None ITEM 3. DEFAULTS UPON SENIOR SECURITIES (a) None (b) None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (a) The 2000 Annual Meeting of stockholders of the Company was held on Thursday, June 1, 2000. At this meeting, the following matters were voted upon by the Company's stockholders. (b) Election of Class II and Class III Directors Craig L. McKnight was elected to serve as a Class II director of the Company until the 2001 Annual Meeting of Stockholders or until his successor is elected and qualified. The vote was as follows:

Stephen G. Tracey, D.D.S., M.S., Sam Westover and Larry D. Dormois D.D.S., M.S. were elected to serve as Class III directors of the Company until the 2003 Annual Meeting of Stockholders or until their successors are elected and qualified. The vote was as follows:

17 18 The following directors continued in office following the meeting:

(c)(i) Approval of Amendment to the 1997 Director Stock Option Plan The stockholders of the Company approved amendments to the Director Plan that provided (i) the Compensation Committee shall have authority and discretion to administer the Director Plan and to grant options to any director who is not a full-time employee of the Company ("Eligible Directors"), in addition to the automatic formula grants of options currently permitted in the Director Plan for Eligible Directors, (ii) the automatic formula grant of options to the Chairman of the Board, provided that the Chairman is an Eligible Director, was increased from options to acquire 10,000 shares of Class A Common Stock to options to acquire 20,000 shares of Class A Common Stock, and (iii) an increase in the number of shares of Common Stock which may be issued subject to options granted under the 1997 Employee Stock Option Plan from 200,000 shares to 500,000 subject to certain anti-dilution provisions set forth in the plan. The vote was as follows:

(c)(ii) Selection of Independent Auditors The stockholders of the Company ratified the appointment of Arthur Andersen LLP as the Company's independent auditors for the fiscal year ending December 31, 2000. The vote was as follows:

(d) None ITEM 5. OTHER INFORMATION None 18 19 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a)Exhibits 10.1 Amendment to Employment Agreement by and between OrthAlliance, Inc. and Stephen M. Toon, dated as of May 22, 2000 (incorporated by reference to Exhibit 10.14 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1998) 27.1 Financial Data Schedule for the six month period ended June 30, 2000. 99.1 Safe Harbor Compliance Statement (incorporated by reference to Exhibit 99.1 of the Company's Annual Report on Form 10-K for fiscal year ended December 31, 1997). (b) Reports on Form 8-K On May 15, 2000, the Company filed a Report on Form 8-K/A related to its acquisition of substantially all of the assets of New Image Orthodontic Group, Inc. 19 20 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ORTHALLIANCE, INC. (Registrant) Date: August 11, 2000 By: /s/ Sam Westover ----------------------------------------- Sam Westover, President and Chief Executive Officer (Principal Executive Officer) Date: August 11, 2000 By: /s/ James C. Wilson ----------------------------------------- James C. Wilson, Chief Financial Officer (Principal Financial and Accounting Officer) 20 21 EXHIBIT INDEX

ORTHALLIANCE INC 10-Q