USON US Oncology (MM)

/FIRST AND FINAL ADD -- DATH009 -- US Oncology, Inc. Earnings/ Results of Operations The Company was affiliated (including under the service line) with the following number of physicians, by specialty, as of September 30, 2003 and 2002: September 30, 2003 2002 Medical oncologists 729 670 Radiation oncologists 115 123 Other oncologists 38 38 Total oncologists 882 831 Diagnostic radiologists --- 39 Total physicians 882 870 The Company was affiliated with the following number of physicians by model: September 30, 2003 2002 PPM 792 836 Service line 90 34 882 870 Subsequent to September 30, 2003, we have affiliated with two additional practices under the service line model, consisting of fourteen oncologists. The following table sets forth the change in the number of physicians affiliated with the Company: Three Months Ended Nine Months Ended September 30, September 30, 2003 2002 2003 2002 Affiliated physicians, beginning of period 836 871 884 868 Physician practice affiliations 14 --- 31 11 Recruited physicians 45 32 65 51 Physician practice separations --- (23) (62) (23) Retiring/Other (13) (10) (36) (37) Affiliated physicians, end of period 882 870 882 870 The following table sets forth the number of cancer centers and PET units managed by the Company: September 30, 2003 2002 Cancer centers 76 77 PET units 21 14 The following table sets forth the key operating statistics as a measure of volume of services provided by our PPM practices: Three Months Ended Nine Months Ended September 30, September 30, 2003 2002 2003 2002 Medical oncology visits 605,966 595,484 1,800,860 1,830,332 Radiation treatments 159,826 160,645 490,754 485,915 Radiation treatments per day 2,497 2,510 2,569 2,544 PET scans 5,453 3,084 14,416 9,096 CT scans 19,247 15,879 54,150 45,830 New patients enrolled in research studies 673 821 2,529 2,435 Net Operating Revenue. Net operating revenue includes three components -- net patient revenue, service line revenue and our other revenue: -- Net patient revenue. We report net patient revenue for those business lines under which our revenue is derived from payments for medical services to patients and we are responsible for billing those patients. Currently, net patient revenue consists of patient revenue of affiliated practices under the PPM model. Net patient revenue also will include revenues of practices that enter into service line agreements for cancer center services. -- Service line revenue. Service line revenues are derived from pharmaceutical services rendered by us under our oncology pharmaceutical services service line agreements. -- Other revenue. Other revenue includes revenue from pharmaceutical research, informational services and activities as a group purchasing organization. The following table shows the components of our net operating revenue for the three and nine months ended September 30, 2003 and 2002 (in thousands): Three Months Ended Nine Months Ended September 30, September 30, 2003 2002 2003 2002 Net patient revenue $589,695 $514,742 $1,708,692 $1,513,309 Service line revenue 39,076 6,020 87,194 7,576 Other revenue 13,003 19,003 46,721 51,404 Net operating revenue $641,774 $539,765 $1,842,607 $1,572,289 Net patient revenue is recorded when services are rendered based on established or negotiated charges reduced by contractual adjustments and allowances for doubtful accounts and other risks of collection. Differences between estimated contractual adjustments and final settlements are reported in the period when final settlements are determined and may result in either increases or decreases in revenues. Net operating revenue is reduced by amounts retained by the practices under our PPM service agreements to arrive at the amount we report as revenue in our financial statements. The following table shows our net operating revenue by segment for the three and nine months ended September 30, 2003 and 2002 (in thousands): Three Months Ended Nine Months Ended September 30, September 30, 2003 2002 2003 2002 Oncology pharmaceutical services $319,021 $234,635 $877,561 $665,219 Other practice management services 229,835 213,621 679,266 628,037 Medical oncology 548,856 448,256 1,556,827 1,293,256 Cancer center services 79,551 73,948 242,007 230,192 Other segment revenue 13,367 17,561 43,773 48,841 $641,774 $539,765 $1,842,607 $1,572,289 Our medical oncology net operating revenue comprises (i) our oncology pharmaceutical services revenue, which represents the revenue attributable to our providing drugs to medical oncologists under either the PPM model or the service line model, plus (ii) our other practice management services revenue, since our practice management services revenue is derived from providing services to medical oncologists. When we announced the introduction of our service line model in the fall of 2001, we offered all of our currently affiliated PPM practices the opportunity to terminate their PPM agreements and instead obtain our services under the service line model. To calculate the amount of oncology pharmaceutical services revenue we derive from practices under the PPM model, we assume that those practices purchase pharmaceuticals through us on the terms offered to such practices in connection with such conversion. Our other practice management services revenue is derived solely from medical oncologists, so a portion of that revenue is attributable to revenues derived from pharmaceuticals, since our PPM agreements include management fees based on overall practice performance. Any change in reimbursement that adversely impacts medical oncologists' financial results would adversely impact our other practice management services revenue, particularly under the net revenue model, and may impact our oncology pharmaceutical services revenue under the service line model. During the first nine months of 2003, approximately $1.2 billion in net operating revenue, out of a total of $1.8 billion, was attributable to amounts paid by payors to physicians for pharmaceuticals. Revenue attributable to services provided in connection with radiation oncology and diagnostic radiology under either the PPM model or the service line model appears as cancer center services revenue. Medical oncology net operating revenue increased from $1,293.3 million in the first nine months of 2002 to $1,556.8 million in the first nine months of 2003, an increase of $263.6 million or 20.4%. Medical oncology net operating revenue increased from $448.3 million in the third quarter of 2002 to $548.9 million for the third quarter of 2003, an increase of $100.6 million or 22.4%. The growth in medical oncology revenue is primarily attributable to the use of a small number of new pharmaceutical products and additional supportive care drugs, in addition to increased patient volume. During the third quarter of 2003, PPM medical oncology visits increased by 1.8% compared to the same prior year period. Same practice PPM medical oncology visits for the third quarter of 2003 increased 6.8% over the same prior year period, which excludes the impact of disaffiliations and service line conversions. Also contributing to the increase in medical oncology revenue for the third quarter of 2003 is an increase in service line revenue of $33.0 million and increased group purchasing organization revenues of $2.1 million as compared to the comparable prior year quarter. In addition to conversions, since September 30, 2002 and through September 30, 2003, we have entered into service line agreements with nine medical oncology practices, representing 43 physicians. Cancer center services net operating revenue increased from $230.2 million in the first nine months of 2002 to $242.0 million in the first nine months of 2003, an increase of $11.8 million, or 5.1%. Cancer center services net operating revenue increased from $73.9 million in the third quarter of 2002 to $79.6 million for the third quarter of 2003, an increase of $5.6 million, or 7.6%. Such increases are attributable to increased radiology revenue from diagnostic services and to an increase in radiation oncology revenue. PET scans increased from 3,084 in the third quarter of 2002 to 5,453 in the third quarter of 2003, an increase of 76.8%. The increase in the number of PET scans is attributable to our opening seven PET units since September 30, 2002, as well as growth of 29.5% in the number of scans on the fourteen PET units that were operational during the third quarter of 2002. Also contributing to the increase in diagnostic revenue is an increase in CT scans, which increased 21.2% from 15,879 in the third quarter of 2002 to 19,247 in the third quarter of 2003. Radiation treatments decreased from 160,645 in the third quarter of 2002 to 159,826 in the third quarter of 2003, a decrease of 0.5% as a result of our disaffiliation with two radiation oncology practices with operations in three cancer centers since September 30, 2003. In addition, we have opened four cancer centers and closed one center since the third quarter of 2002. Same practice radiation treatments increased from 151,517 in the third quarter of 2002 to 154,126 in the third quarter of 2003, an increase of 1.7%. We currently have eight cancer centers and five PET installations in various stages of development. Partially offsetting the increases in PET and radiation oncology is a decrease in diagnostic revenue resulting from our sale of technical radiology assets during the third quarter of 2002 and our disaffiliation with a radiology practice consisting of 39 physicians in the second quarter of 2003. Other segment net operating revenue decreased from $48.8 million in the first nine months of 2002 to $43.8 million in the first nine months of 2003, a decrease of $5.1 million, or 10.4%. Other segment net operating revenue decreased from $17.6 million in the third quarter of 2002 to $13.4 million for the third quarter of 2003, a decrease of $4.2 million, or 23.9%. The decrease is primarily attributable to an 18.0% decline in new patients enrolled in research studies in the third quarter as compared to the third quarter of 2002 due to the completion of two large trials during the second quarter of 2003. During the third quarter of 2003, 92.0% of our net operating revenue was derived from practices under the PPM model as of September 30, 2003. The following table shows the amount of operating revenue we derived under each type of service agreement at the end of the respective period for the three and nine months ended September 30, 2003 and 2002 (in thousands): Three Months Ended Three Months Ended September 30, 2003 September 30, 2002 Revenue % Revenue % Earnings model $439,991 68.5 $359,889 66.7 Net revenue model 150,679 23.5 165,242 30.6 Service line model 39,076 6.1 6,020 1.1 Other 12,028 1.9 8,614 1.6 $641,774 100.0 $539,765 100.0 Nine Months Ended Nine Months Ended September 30, 2003 September 30, 2002 Revenue % Revenue % Earnings model $1,241,026 67.3 $1,043,410 66.4 Net revenue model 469,188 25.5 496,284 31.6 Service line model 87,194 4.7 7,576 0.4 Other 45,199 2.5 25,019 1.6 $1,842,607 100.0 $1,572,289 100.0 Since the beginning of 2001 and through September 30, 2003, eighteen practices accounting for 27.0% of net operating revenue in 2002 have converted from the net revenue model to the earnings model. The following table indicates the number of practices on each model as of September 30, 2003 and as of December 31, 2002: September 30, 2003 December 31, 2002 Earnings model 26 25 Net revenue model 11 12 Service line model 14 7 During the first quarter of 2003, we transitioned one net revenue model practice to the service line model and one net revenue model practice to the earnings model, and disaffiliated from ten physicians who had practiced at the group that converted to the earnings model. We also commenced operations at two new practices under the service line model. During the second quarter of 2003, we commenced operations at one new service line practice and disaffiliated with a radiology group consisting of 39 physicians accounting for $11.4 million of our net operating revenue for the first six months of 2003. During the third quarter of 2003, we converted the medical oncology portion of a net revenue model practice, which accounted for $22.0 million of our net operating revenue for the first nine months of 2003 to the service line model. That practice's six radiation oncology physicians disaffiliated during the second quarter. We also disaffiliated with one practice consisting of 39 radiologists and commenced operations at three new practices under the service line model, comprising 14 physicians. Subsequent to September 30, 2003, we have affiliated with two additional practices under the service line, consisting of fourteen physicians. Revenue. Our revenue is net operating revenue, less the amount retained by our affiliated physician practices under PPM service agreements. The following presents the amounts included in determination of our revenue for the three and nine months ended September 30, 2003 and 2002 (in thousands): Three Months Ended Nine Months Ended September 30, September 30, 2003 2002 2003 2002 Net operating revenue $641,774 $539,765 $1,842,607 $1,572,289 Amounts retained by practices (132,674) (121,472) (394,885) (351,892) Revenue $509,100 $418,293 $1,447,722 $1,220,397 Amounts retained by practices increased from $351.9 million in the first nine months of 2002 to $394.9 million in the first nine months of 2003, an increase of $43.0 million, or 12.2%. Amounts retained by practices increased from $121.5 million in the third quarter of 2002 to $132.7 million in the third quarter of 2003, an increase of $11.2 million, or 9.2%. Such increase in amounts retained by practices is directly attributable to the growth in net patient revenue combined with the increase in profitability of affiliated practices. Amounts retained by practices as a percentage of net operating revenue decreased from 22.4% to 21.4% for the first nine months of 2002 and 2003, respectively, and from 22.5% to 20.7% for the third quarters of 2002 and 2003, respectively. The decrease in amounts retained by practices as a percentage of net operating revenue is attributable to increased revenues under the service line model, reduction in operating margins of our affiliated practices and the conversion of practices to the earnings model. Revenue increased from $1,220.4 million for the first nine months of 2002 to $1,447.8 million for the first nine months of 2003, an increase of $227.3 million, or 18.6%. Revenue increased from $418.3 million for the third quarter of 2002 to $509.1 million for the third quarter of 2003, an increase of $90.8 million, or 21.7%. Revenue growth was caused by increases in revenues attributable to pharmaceuticals and new service line revenues, and to a lesser extent, an increase in diagnostic and radiation revenues. The following table shows our revenue by segment for the three and nine months ended September 30, 2003 and 2002 (in thousands): Three Months Ended Nine Months Ended September 30, September 30, 2003 2002 2003 2002 Oncology pharmaceutical services $318,592 $232,846 $876,695 $664,538 Other practice management services 120,207 118,636 359,625 353,167 Medical oncology 438,799 351,482 1,236,320 1,017,705 Cancer center services 56,976 49,952 169,235 157,086 Other segment revenue 13,325 16,859 42,167 45,606 $509,100 $418,293 $1,447,722 $1,220,397 Trends in our revenue by segment are caused by the same factors affecting net operating revenue segments and are discussed above. Medicare is the practices' largest payor. During the first nine months of 2003 and 2002 approximately 41% of the PPM practices' net patient revenue was derived from Medicare payments. This percentage varies among practices. No other single payor accounted for more than 10% of our revenues in the first nine months of 2003 or 2002. However, certain of our individual affiliated practices may have contracts with payors accounting for more than 10% of their revenues. The following table sets forth the percentages of revenue represented by certain items reflected in the Company's Condensed Consolidated Income Statement. Three Months Ended Nine Months Ended September 30, September 30, 2003 2002 2003 2002 Revenue 100.0% 100.0% 100.0% 100.0% Operating expenses: Pharmaceuticals and supplies 58.4 53.3 57.0 52.0 Field compensation and benefits 17.7 20.1 18.5 21.0 Other field costs 9.7 11.7 10.3 11.7 General and administration 3.8 4.0 3.5 3.8 Depreciation and amortization 3.4 4.1 3.8 4.4 Impairment, restructuring and other charges 0.3 18.4 0.1 9.6 Income (loss) from operations 6.7 (11.6) 6.8 (2.5) Interest expense, net (0.9) (1.0) (1.0) (1.3) Loss on early extinguishments of debt --- --- --- (1.1) Income (loss) before income taxes 5.8 (12.6) 5.8 (4.9) Income tax benefit (provision) (2.3) 4.0 (2.2) 1.6 Net income (loss) 3.5% (8.6)% 3.6% (3.3)% Pharmaceuticals and Supplies. Pharmaceuticals and supplies expense, which includes drugs, medications and other supplies used by the practices, increased from $635.0 million in the first nine months of 2002 to $825.5 million in the same period of 2003, an increase of $190.5 million, or 30.0%. Pharmaceuticals and supplies expense increased from $223.1 million in the third quarter of 2002 to $297.5 million in the third quarter of 2003, an increase of $74.4 million, or 33.3%. As a percentage of revenue, pharmaceuticals and supplies increased from 52.0% in the first nine months of 2002 to 57.0% in the same period in 2003 and from 53.3% in the third quarter of 2002 to 58.4% in the third quarter of 2003. The increase was attributable to a larger portion of our operating revenue being derived from pharmaceuticals, more expensive drugs and to a lesser extent the conversion of two affiliated practices to, and the addition of seven practices in new markets under, the service line model since the third quarter of 2002. As noted above, Congress and CMS are both currently considering significant reductions in Medicare reimbursement for pharmaceuticals. These reductions could increase pharmaceutical costs as a percentage of revenue by reducing revenues without corresponding reduction in the amount pharmaceutical companies charge for the products. Any change in reimbursement methodology could also otherwise adversely affect our ability to control costs or change the way in which pharmaceutical companies price their products. We expect that third-party payors will continue to negotiate or mandate the reimbursement rates for pharmaceuticals and supplies, with the goal of lowering reimbursement rates, and that such lower reimbursement rates together with shifts in revenue mix may continue to adversely impact our margins with respect to such items. In both regulatory and litigation activity, federal and state governments are focusing on decreasing the amount governmental programs pay for drugs. Current governmental focus on AWP as a basis for reimbursement could also lead to a wide-ranging reduction in the reimbursement for pharmaceuticals by both governmental and commercial payors. Commercial and governmental payors also continue to try to implement both voluntary and mandatory programs in which the practice must obtain drugs they administer to patients from a third party and that third party, rather than the practice, receives payment for the drugs directly from the payor, and to otherwise reduce drug expenditures. We continue to believe that single-source drugs, possibly including oral drugs, will continue to be introduced at a rapid pace, thus further negatively impacting margins. In response to this decline in margin relating to certain pharmaceutical agents, we have developed and are implementing a number of drug management programs, which are designed to provide affiliated practices with practical tools for process improvement, cost reduction and decision support in relation to pharmaceuticals. The successful conversion of net revenue model practices to the earnings model and implementation of the service line structure should both also help reduce the impact of the increasing cost of pharmaceuticals and supplies and the effect of reduced levels of reimbursement. In addition, we have numerous efforts under way to reduce the cost of pharmaceuticals by negotiating discounts for volume purchases and by streamlining processes for efficient ordering and inventory control and are assessing other strategies to address this trend. We also continue to seek to expand into areas that are less affected by lower pharmaceutical margins, such as radiation oncology and diagnostic radiology. However, as long as pharmaceuticals continue to become a larger part of our revenue mix as a result of changing treatment patterns (rather than growth of our business), we believe that our overall margins could continue to be adversely impacted. In addition, the pharmacy service line is a lower-margin business than our PPM model. Although we believe it reduces risk in certain respects and requires less capital investment than the PPM model, to the extent we add additional service line practices under the pharmacy service line, we would expect our overall margin percentages to be adversely impacted. Field Compensation and Benefits. Field compensation and benefits, which includes salaries and wages of our field-level employees and the practices' employees (other than physicians), increased from $256.4 million in the first nine months of 2002 to $267.5 million in the first nine months of 2003, an increase of $11.1 million, or 4.3%. Field compensation and benefits increased from $84.1 million in the third quarter of 2002 to $90.1 million in the third quarter of 2003, an increase of $6.0 million or 7.1%. As a percentage of revenue, field compensation and benefits decreased from 21.0% in the first nine months of 2002 to 18.5% in the first nine months of 2003, and from 20.1% in the third quarter of 2002 to 17.7% in the third quarter of 2003. The decrease as a percentage of revenue is attributable to increases in pharmaceutical revenues and the incremental service line revenue in 2003. Other Field Costs. Other field costs, which consist of rent, utilities, repairs and maintenance, insurance and other direct field costs, increased from $143.3 million in the first nine months of 2002 to $148.1 million in the first nine months of 2003, an increase of $4.8 million, or 3.3%. Other field costs increased from $49.0 million in the third quarter of 2002 to $49.4 million in the third quarter of 2003, an increase of $0.4 million, or 0.8%. The increase in other field costs is partially attributable to $0.9 million recognized in the second quarter of 2003 in connection with the disaffiliation of a radiology practice consisting of 39 physicians effective June 30, 2003. As a percentage of revenue, other field costs decreased from 11.7% in the first nine months of 2002 to 10.3% in the first nine months of 2003, and from 11.7% in the third quarter of 2002 to 9.7% in the third quarter of 2003. The decrease as a percentage of revenue is attributable to increases in pharmaceutical revenues and the incremental service line revenue in 2003. General and Administrative. General and administrative expenses increased from $45.9 million in the first nine months of 2002 to $51.2 million in the first nine months of 2003, an increase of $5.3 million, or 11.5%. General and administrative expenses increased from $16.6 million in the third quarter of 2002 to $19.2 million in the third quarter of 2003, an increase of $2.6 million, or 15.6%. Such increases are attributable to additional personnel and operating expenses incurred in order to support our development efforts since 2002 combined with our initiative to provide support for the service line operations. As a percentage of revenue, general and administrative costs decreased from 3.8% in the first nine months of 2002 to 3.5% in the first nine months of 2003, and from 4.0% in the third quarter of 2002 to 3.8% in the third quarter of 2003. Included in our results for the first nine months of 2003 are fees of $2.1 million in the first quarter of 2003, $1.0 million in the second quarter of 2003, and $1.5 million in the third quarter of 2003 for outside consultants providing strategic planning and other services that we would not expect to incur in future periods. Overall, we experienced a decline in operating margins with earnings before taxes, interest, depreciation, amortization, loss on early extinguishment of debt and impairment, restructuring and other charges (EBITDA), as a percentage of revenue, decreasing from 11.5% in the first nine months of 2002 to 10.7% in the first nine months of 2003, and from 10.9% in the third quarter of 2002 to 10.4% in the third quarter of 2003. The decline in operating margins is attributable to the increase in pharmaceutical costs and, to a lesser extent, the increase in service line model agreements, which typically have lower margins. The table below presents information about reported segments for the nine months ended September 30, 2003 (in thousands): Oncology Other Practice Cancer Pharmaceutical Management Center Services Services Services Other Total Net operating revenue $877,561 $679,266 $242,007 $43,773 $1,842,607 Amounts retained by affiliated practices (866) (319,641) (72,772) (1,606) (394,885) Revenue 876,695 359,625 169,235 42,167 1,447,722 Operating expenses (793,545) (295,443) (136,466) (123,550) (1,349,004) Income (loss) from operations 83,150 64,182 32,769 (81,383) 98,718 Depreciation and amortization 106 --- 21,791 33,069 54,966 Impairment, restructuring and other charges --- --- --- 1,752 1,752 EBITDA $83,256 $64,182 $54,560 $(46,562) $155,436 The table below presents information about reported segments for the nine months ended September 30, 2002 (in thousands): Oncology Other Practice Cancer Pharmaceutical Management Center Services Services Services Other Total Net operating revenue $665,219 $628,037 $230,192 $48,841 $1,572,289 Amounts retained by affiliated practices (681) (274,870) (73,106) (3,235) (351,892) Revenue 664,538 353,167 157,086 45,606 1,220,397 Operating expenses (602,562) (285,742) (122,764) (239,612) (1,250,680) Income (loss) from operations 61,976 67,425 34,322 (194,006) (30,283) Depreciation and amortization 173 --- 14,754 38,403 53,330 Impairment, restructuring and other charges --- --- --- 116,804 116,804 EBITDA $62,149 $67,425 $49,076 $(38,799) $139,851 The table below presents information about reported segments for the three months ended September 30, 2003 (in thousands): Oncology Other Practice Cancer Pharmaceutical Management Center Services Services Services Other Total Net operating revenue $319,021 $229,835 $79,551 $13,367 $641,774 Amounts retained by affiliated practices (429) (109,628) (22,575) (42) (132,674) Revenue 318,592 120,207 56,976 13,325 509,100 Operating expenses (286,993) (96,498) (47,625) (44,033) (475,149) Income (loss) from operations 31,599 23,709 9,351 (30,708) 33,951 Depreciation and amortization 57 --- 7,205 9,925 17,187 Impairment, restructuring and other charges --- --- --- 1,752 1,752 EBITDA $31,656 $23,709 $16,556 $(19,031) $52,890 The table below presents information about reported segments for the three months ended September 30, 2002 (in thousands): Oncology Other Practice Cancer Pharmaceutical Management Center Services Services Services Other Total Net operating revenue $234,635 $213,621 $73,948 $17,561 $539,765 Amounts retained by affiliated practices (1,789) (94,985) (23,996) (702) (121,472) Revenue 232,846 118,636 49,952 16,859 418,293 Operating expenses (209,563) (98,091) (39,586) (119,610) (466,850) Income (loss) from operations 23,283 20,545 10,366 (102,751) (48,557) Impairment, restructuring and other charges --- --- --- 76,831 76,831 Depreciation and amortization (169) --- 4,789 12,492 17,112 EBITDA $23,114 $20,545 $15,155 $(13,428) $45,386 The decrease in EBITDA for the other practice management services for the first nine months ended September 30, 2003 as compared to the same prior year period is primarily attributable to our disaffiliation with two medical oncology practices representing 12 physicians since September 30, 2002. Medical oncology EBITDA margin decreased from 12.7% in the first nine months of 2002 to 11.9% in the first nine months of 2003. This decrease is attributable to an increase in lower margin pharmaceuticals. Cancer center services EBITDA margin increased from 31.2% in the first nine months of 2002 to 32.2% in the first nine months of 2003. This increase is attributable to exiting from unprofitable sites, investment in technology such as intensity modulated radiation therapy (IMRT), combined with growth in same practice radiation treatments and PET scans. Cancer Center Services EBITDA for the three and nine months ended September 30, 2003 includes costs of $0.9 million incurred in connection with our disaffiliation with a radiology group effective June 30, 2003. Depreciation and Amortization. Depreciation and amortization expense increased from $53.3 million in the first nine months of 2002 to $55.0 million in the first nine months of 2003, an increase of $1.6 million or 3.1%. Depreciation and amortization expense increased from $17.1 million in the third quarter of 2002 to $17.2 million in the third quarter of 2003, an increase of $0.1 million or 0.4%. The increase in depreciation and amortization expense is attributable to increased investment in radiation and PET technologies, partially offset by impairments of management service agreements and cancer center assets in 2002. As a percentage of revenue, depreciation and amortization expense decreased from 4.4% in the first nine months of 2002 to 3.8% in the first nine months of 2003, and from 4.1% in the third quarter of 2002 to 3.4% in the third quarter of 2003. The decline in depreciation and amortization expense as a percentage of revenue reflects the impairment charges on intangible assets and cancer center assets totaling $140.8 million recognized in 2002. Impairment, Restructuring and Other Charges. We have recorded no impairment or restructuring charges during the first nine months of 2003. During the third quarter of 2003, we recognized a $1.8 million loss on the sale of a cancer center. During the first nine months of 2002, we have incurred impairment and restructuring costs related to transitional activity, including the following: -- Termination of service agreements related to the conversion of PPM practices to the service line model and in connection with practice disaffiliations. -- Gains and losses related to sales of assets back to practices converting to the service line model or in connection with practice disaffiliations. -- Impairment of intangible assets related to net revenue model service agreements. -- Centralization of accounting and financial processes. -- Allowance on an affiliate receivable. In that context, we recognized the following impairment, restructuring and other charges during the three months and nine months ending September 30, 2002 (in thousands): Three Months Ended Nine Months Ended September 30, 2002 September 30, 2002 Write-off of service agreements $68,314 $107,999 Gain on sale of practice assets (3,415) (5,433) Personnel reduction costs 882 1,791 Allowance on an affiliate receivable 11,050 11,050 Consulting costs for implementing service line --- 1,397 $76,831 $116,804 The following is a detailed summary of the third quarter of 2002 charges (in thousands): Conversion Impairment of to Net Revenue Affiliate Service Practice Model Service Processing Receivable Line Disaffiliations Agreement Centralization Allowance Total Write- off of service agreements $13,054 $4,253 $51,007 $--- $--- $68,314 Gain on sale of practice assets (1,063) (2,352) --- --- --- (3,415) Personnel reduction costs --- --- --- 882 --- 882 Allowance on an affiliate receivable --- --- --- --- 11,050 11,050 $11,991 $1,901 $51,007 $882 $11,050 $76,831 During the first nine months of 2002, we transitioned three of our PPM practices with an aggregate of 23 physicians to the service line model, including one such transition in the third quarter of 2002. In each transaction, the existing PPM service agreement was terminated, the practice repurchased its assets, and future consideration owing to physicians for their initial affiliation with the Company was either accelerated or forfeited. We also disaffiliated with physicians in four net revenue markets during the third quarter of 2002 and terminated a service agreement in one market with respect to certain radiology sites during the second quarter of 2002. In these terminations, practice assets were repurchased and fees were paid in connection with the termination. Remaining consideration owed to the physicians (if any) by us with respect to their original PPM affiliation transaction was accelerated. The impairment of service agreements during the third quarter of 2002 was a non-cash, pretax charge of $68.3 million comprising (i) a $13.0 million charge related to a PPM service agreement that was terminated in connection with conversion to the service line model, (ii) a $51.0 million charge related to three net revenue model service agreements that became impaired during the third quarter of 2002 based upon our analysis of projected cash flows under those agreements, taking into account developments in those markets during the third quarter of 2002 and (iii) a $4.3 million charge related to a group of physicians under a net revenue model service agreement with which we disaffiliated during the third quarter of 2002. The remainder of the charge relating to impairment of service agreements for the first nine months of 2002 were non-cash, pretax charges of $39.7 million during the second quarter comprising (i) a $33.8 million charge related to a net revenue model service line agreement that became impaired during the second quarter of 2002 based upon the Company's analysis of projected cash flows under that agreement, taking into account developments in that market during the second quarter of 2002 and (ii) a $5.9 million charge related to two PPM service agreements that were terminated in connection with conversions to the service line model. The $3.4 million net gain on sale of practice assets during the third quarter of 2002 comprised (a) net proceeds of $4.3 million paid by converting and disaffiliating physicians and (b) a $0.2 million net recovery of working capital assets, partially offset by a $1.1 million net charge arising from our accelerating consideration that would have been due to physicians in the future in connection with those transactions. During the second quarter of 2002 we recognized a $2.0 million net gain on sale of practice assets. During that quarter, we terminated a service agreement as it related to certain radiology sites and sold the related assets, including the right to future revenues attributable to radiology technical fee revenue at those sites, in exchange for delivery to us of 1.1 million shares of our common stock. In connection with that sale, we also recognized a write-off of a receivable of $0.5 million due from the physicians and agreed to make a cash payment to the buyer of $0.6 million to reflect purchase price adjustments during the third quarter of 2002. The transaction resulted in a $3.9 million gain based on the market price of our Common Stock as of the date of the termination. This gain was partially offset by a $1.9 million net impairment of working capital assets relating to service line conversions, disaffiliations and potential disaffiliations. During the third quarter of 2002, in connection with our transition, we commenced an initiative to further centralize certain of our accounting and financial reporting functions at our headquarters in Houston, resulting in a $0.9 million charge for personnel reduction costs. During the first and second quarters of 2002, we recognized $0.3 million and $0.6 million, respectively, for personnel reduction costs. During the third quarter of 2002, we recognized an $11.1 million allowance related to an $11.1 million receivable due to us from one of our affiliated practices. In the course of our PPM activities, we advance amounts to physician groups and retain fees based upon our estimates of practice performance. Subsequent events and related adjustments may result in the creation of a receivable with respect to certain amounts advanced. During the third quarter of 2002, we made the determination that a portion of such amounts owed by physician practices to us may have become uncollectible due to, among other things the age of the receivable and circumstances relating to practice operations. During the second quarter of 2002 we recognized $1.0 million of professional fees for consultants advising us on the implementation of the service line. During the first quarter of 2002, we also recognized charges of $0.4 million in consulting fees related to our introduction of the service line model. As discussed above, during the first nine months of 2002, we have recorded charges related to the impairment of certain net revenue model service agreements. From time to time, we evaluate our intangible assets for impairment, which involves an analysis comparing the aggregate expected future cash flows under the agreement to its carrying value as an intangible asset on our balance sheet. In estimating future cash flows, we consider past performance as well as known trends that are likely to affect future performance. In some cases we also take into account our current activities with respect to that agreement that may be aimed at altering performance or reversing trends. All of these factors used in our estimates are subject to error and uncertainty. Interest. Net interest expense decreased from $15.8 million in the first nine months of 2002 to $14.8 million in the first nine months of 2003, a decrease of $1.0 million, or 6.4%. Net interest expense increased from $4.2 million in the third quarter of 2002 to $4.7 million in the third quarter of 2003, an increase of $0.5 million, or 11.4%. As a percentage of revenue, net interest expense decreased from 1.3% for the first nine months of 2002 to 1.0% for the first nine months of 2003, and from 1.0% in the third quarter of 2002 to 0.9% in the third quarter of 2003. Such decreases are due to payment of physician debt, lower borrowing levels during the first nine months of 2003, reduced interest rates on our leasing facility and, to a lesser extent, an increase in interest income resulting from improved operating cash flows since September 30, 2002. On February 1, 2002, we refinanced our indebtedness by issuing $175 million in 9.625% Senior Subordinated Notes due 2012 and repaid in full our existing senior secured notes and terminated our existing credit facility. Our previously existing $100 million senior secured notes bore interest at a fixed rate of 8.42% and would have matured as to $20 million in each of 2002-2006. Lower levels of debt during the first nine months of 2003, as compared to the same period in 2002, partially offset by the increased rate of interest contributed to the decrease of interest expense. In September 2001, we announced in a press release that our introduction of the service line structure and transition away from the net revenue model and the related realignment of our business would cause us to record unusual charges for write-offs of service agreements and other assets and other charges. These charges include the impairment, restructuring and other charges and loss on early extinguishment of debt we have recorded during 2002. Throughout 2002, we had recorded $10.3 million in unusual cash charges and $153.4 million in unusual non-cash charges in connection with our transition process. We have not recognized any unusual charges in the first nine months of 2003. The principal category of those prior charges related to the impairment of service agreements. Service agreements were impaired either because of a termination of the agreement (both in disaffiliations and conversions to the service line) or because we determined that the agreement was impaired based on expected future cash flow under the agreement. The latter category of impairment related exclusively to net revenue model practices. Currently, our balance sheet reflects $22.8 million in service agreements under the net revenue model and $219.6 million under the earnings model. Based upon the potential for continued declining performance, we would anticipate that the net revenue model agreements, if not converted to the earnings model, could become impaired in the future. Material changes in reimbursement could result in additional charges, including additional impairments of service agreements and other long-term assets. Loss on Early Extinguishment of Debt. During the first quarter of 2002, we recorded a loss of $13.6 million, before income taxes of $5.2 million, in connection with the early extinguishment of our $100 million Senior Secured Notes due 2006 and our existing credit facility. The loss consisted of payment of a prepayment penalty of $11.7 million on the Senior Secured Notes and a write-off of unamortized deferred financing costs of $1.9 million related to the terminated debt agreements. The Company adopted Statement of Financial Accounting Standards No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections" (SFAS 145) effective January 1, 2003. Among other matters, SFAS 145 rescinds Statement of Financial Accounting Standards No. 4, "Reporting Gains and Losses from Extinguishment of Debt," which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. In connection with its adoption, gains and losses from extinguishments of debt are no longer classified as extraordinary items in the Company's statement of operations. In addition, prior period financial statements were reclassified to reflect the new standard. As such, the Company reclassified the $13.6 extraordinary loss on early extinguishment of debt recorded in the three months ended March 31, 2002 as a component of interest expense, net, in its condensed consolidated statement of operations. Income Taxes. We recognized an effective tax rate of 38.3% and (32.1)% for the first nine months of 2003 and 2002, respectively. The lower effective tax rate in 2002 reflects the lack of any state tax benefit related to certain of the impairment, restructuring and other charges recognized in the prior year. Net Income. Net income increased from a loss of $40.5 million, or ($0.41) per share, in the first nine months of 2002 to net income of $51.8 million, or $0.56 per diluted share, in the first nine months 2003, an increase of $92.3 million. Earnings per share has been positively impacted by our repurchase of 9.6 million shares since September 30, 2002 through the third quarter of 2003. Net income increased from a loss of $36.2 million in the third quarter of 2002 to net income of $17.9 million in the third quarter of 2003. Included in net income for the first nine months of 2002 are impairment, restructuring and other charges of $116.8 million and a loss on early extinguishment of debt of $13.6 million. Excluding these charges, net income for the first nine months of 2002 would have been $43.9 million, which represents earnings per share of $0.44. Liquidity and Capital Resources As of September 30, 2003, we had net working capital of $149.6 million, including cash and cash equivalents of $125.4 million. We had current liabilities of $372.8 million, including $80.8 million in current maturities of long-term debt, and $190.3 million of long-term indebtedness. During the first nine months of 2003, we provided $185.8 million in net operating cash flow, invested $61.5 million, and used cash from financing activities in the amount of $73.9 million. As of October 27, 2003, we had cash and cash equivalents of $146.9 million. Cash Flows from Operating Activities During the first nine months of 2003, we provided $185.8 million in cash flows from operating activities as compared to $134.4 million in the comparable prior year period. The increase in cash flow is primarily attributable to improved cash collections during the first nine months of 2003, offset by federal income tax payments of $11.4 million in the nine months ended September 30, 2003. Our accounts receivable days outstanding has improved from 48 days at December 31, 2002 to 44 at September 30, 2003. Cash Flows from Investing Activities During the first nine months of 2003 and 2002, we expended $63.1 million and $45.1 million in capital expenditures, including $42.1 million and $24.6 million on the development and construction of cancer centers, respectively. Maintenance capital expenditures were $21.0 million and $20.5 million in the first nine months of 2003 and 2002, respectively. For all of 2003, we anticipate expending a total of approximately $30-$35 million on maintenance capital expenditures and approximately $50-$55 million on development of new cancer centers and PET installations. Over the next two to three years, we expect to expend $20-$30 million for upgrades to existing cancer centers, including introduction of IMRT and high dose radiotherapy (HDR) equipment. Cash Flows from Financing Activities During the first nine months of 2003, we used cash from financing activities of $73.9 million as compared to cash provided of $5.5 million in the nine months of 2002. Such decrease in cash flow is primarily attributed to the proceeds in 2002 from the issuance of our Senior Subordinated Notes due 2012, net of the cash payments for the retirement of our previously existing indebtedness, including a prepayment premium paid as a result of early extinguishment of our Senior Secured Notes due 2006. In addition, we expended $61.2 million to repurchase 7.5 million shares of our Common Stock during the first nine months of 2003. On February 1, 2002, we entered into a five-year $100 million syndicated revolving credit facility and terminated our existing syndicated revolving credit facility. Proceeds under that credit facility may be used to finance the development of cancer centers and new PET facilities, to provide working capital or for other general business purposes. No amounts have been borrowed under that facility. Our credit facility bears interest at a variable rate that floats with a referenced interest rate. Therefore, to the extent we have amounts outstanding under the credit facility in the future, we would be exposed to interest rate risk under our credit facility. On February 1, 2002, we issued $175 million in 9.625% Senior Subordinated Notes due 2012 to various institutional investors in a private offering under Rule 144A under the Securities Act of 1933. The notes were subsequently exchanged for substantially identical notes in an offering registered under the Securities Act of 1933. The notes are unsecured, bear interest at 9.625% annually and mature in February 2012. Payments under those notes are subordinated in substantially all respects to payments under our credit facility and certain other debt. We entered into a leasing facility in December 1997, under which a lessor entity acquired properties and paid for construction of certain of our cancer centers and leased them to us. It matures in June 2004. As of September 30, 2003, we had $70.2 million outstanding under the facility and no further amounts are available under that facility. The annual rent, which is classified as interest expense, under the lease is approximately $3.2 million, based on interest rates in effect as of September 30, 2003. Since December 31, 2002, we guarantee 100% of the residual value of the properties in the lease and therefore include the $70.2 million outstanding under the lease as indebtedness on our financial statements. We also include assets under the lease as assets on our balance sheet based upon our determination of fair values of those properties at December 31, 2002. During the first nine months of 2003, we began to recognize a depreciation charge in respect of the assets in the leasing facility amounting to $2.8 million. We did not recognize depreciation expense for those off-balance-sheet assets prior to December 31, 2002. The lease is renewable in one-year increments with the consent of the financial institutions that are parties thereto. If the lease is not renewed at maturity or otherwise terminates, we must either purchase the properties under the lease for the total amount outstanding or market the properties to third parties. Defaults under the lease, which include cross-defaults to other material debt, could result in such a termination, and require us to purchase or remarket the properties. If we sell the properties to third parties, we have guaranteed a residual value of 100% of the total amount outstanding for the properties. The guarantees are collateralized by substantially all of our assets. We have not yet determined whether we will seek to renew the lease. Accordingly, in June 2004, assuming we retain all of the properties, we will be required to repay $70.2 million. Therefore, the amount outstanding has been classified as a current maturity of long-term indebtedness. Because the lease payment floats with a referenced interest rate, we are also exposed to interest rate risk under the leasing facility. A 1% increase in the referenced rate would result in an increase in lease payments of $0.7 million annually. Borrowings under the revolving credit facility and advances under the leasing facility bear interest at a rate equal to a rate based on prime rate or the London Interbank Offered Rate, based on a defined formula. The credit facility, leasing facility and Senior Subordinated Notes contain affirmative and negative covenants, including the maintenance of certain financial ratios, restrictions on sales, leases or other dispositions of property, restrictions on other indebtedness and prohibitions on the payment of dividends. Events of default under our credit facility, leasing facility and Senior Subordinated Notes include cross-defaults to all material indebtedness, including each of those financings. Substantially all of our assets, including certain real property, are pledged as collateral under the credit facility and the guarantee obligations of our leasing facility. We are in compliance with covenants under our leasing facility, revolving credit facility and Senior Subordinated Notes, with no borrowings currently outstanding under the revolving credit facility. We have relied primarily on cash flows from our operations to fund working capital and capital expenditures for our fixed assets. We currently expect that our principal use of funds in the near future will be in connection with the purchase of medical equipment, including upgrades and additional equipment such as IMRT and HDR, investment in information systems and the acquisition or lease of real estate for the development of integrated cancer centers and PET centers, and implementation of the service line structure, as well as possible repurchases of our Common Stock. It is likely that our capital needs in the next several years will exceed the cash generated from operations. Thus, we may incur additional debt or issue additional debt or equity securities from time to time. Capital available for health care companies, whether raised through the issuance of debt or equity securities, is quite limited. As a result, we may be unable to obtain sufficient financing on terms satisfactory to management or at all. Continued uncertainty regarding reimbursement or an adverse change in reimbursement could continue to adversely impact our ability to access capital markets, including our ability to extend or refinance our leasing facility. This news release contains forward-looking statements, including statements that include the words "believes," "expects," "anticipates," "estimates," "intends," "plans," "projects," or similar expressions and statements regarding our prospects. All statements concerning business outlook, reimbursement outlook, expected financial results, business development activities, the benefits of the service line model and all other statements other than statements of historical fact included in this news release are forward-looking statements. Although the company believes that the expectations reflected in such statements are reasonable, it can give no assurance that such expectations will prove to have been correct. Matters that could further impact future results and financial condition include reimbursement rates, including in particular, reimbursement for pharmaceutical products, the success of the service line model, transition of existing practices, our ability to maintain good relationships with existing practices, expansion into new markets and development of existing markets, our ability to complete cancer centers and PET facilities currently in development, our ability to recover the costs of our investments in cancer centers, our ability to complete negotiations and enter into agreements with practices currently negotiating with us, reimbursement for health-care services, continued efforts by payors to lower their costs, government regulation and enforcement, continued relationships with pharmaceutical companies and other vendors, changes in cancer therapy or the manner in which care is delivered, drug utilization, increases in the cost of providing cancer treatment services and the operations of the company's affiliated physician practices. Please refer to the attached financial discussion and the company's filings with the Securities and Exchange Commission, including its Annual Report on Form 10-K for 2002 and subsequent SEC filings, for a more extensive discussion of factors that could cause actual results to differ materially from the company's expectations. PRNewswire-FirstCall -- Oct. 30 END FIRST AND FINAL ADD DATASOURCE: US Oncology, Inc. Web site: http://www.usoncology.com/

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