Form 10-K

 


 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K

 

For the Fiscal Year Ended December 31, 2002

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

Commission File Number: 1-4034

 

DAVITA INC.

 

21250 Hawthorne Blvd., Suite 800

Torrance, California 90503-5517

Telephone number (310) 792-2600

 

Delaware

(State of incorporation)

 

51-0354549

(I.R.S. Employer

Identification No.)

 

Securities registered pursuant to Section 12(b) of the Act:

 

Class of Security:

 

Registered on:

Common Stock, $0.001 par value

 

New York Stock Exchange

Common Stock Purchase Rights  

 

New York Stock Exchange

 

The Registrant 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 and has been subject to such filing requirements for the past 90 days.

 

Disclosure of delinquent filers pursuant to Item 405 of Regulation S-K will be in the Registrant’s definitive proxy statement, which is incorporated by reference in Part III of this Form 10-K.

 

The Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

 

As of June 30, 2002, the number of shares of the Registrant’s common stock outstanding was 67,317,502 shares and the aggregate market value of the common stock outstanding held by non-affiliates based upon the closing price of these shares on the New York Stock Exchange was approximately $1.60 billion.

 

As of February 14, 2003, the number of shares of the Registrant’s common stock outstanding was 60,838,613 shares and the aggregate market value of the common stock outstanding held by non-affiliates based upon the closing price of these shares on the New York Stock Exchange was approximately $1.24 billion.

 

Documents incorporated by reference

 

Portions of the Registrant’s proxy statement for its 2003 annual meeting of stockholders are incorporated by reference in Part III of this Form 10-K.

 



 

PART I

 

Item 1.    Business.

 

The following should be read in conjunction with our consolidated financial statements and accompanying notes contained elsewhere in this Form 10-K. This Form 10-K contains forward-looking statements that involve risks and uncertainties. Our actual results may differ significantly from the results discussed in the forward-looking statements.

 

The Company is required to file reports pursuant to the Securities Exchange Act of 1934. Accordingly, the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to section 13(a) or 15(d) of the Exchange Act are made available free of charge through the Company’s website, located at http://www.davita.com, as soon as reasonably practicable after the reports have been filed with the Securities and Exchange Commission, or SEC. The SEC also maintains an Internet site at http://www.sec.gov where these reports and other information about the Company can also be located.

 

Overview

 

DaVita Inc. is the second largest provider of dialysis services in the United States for patients suffering from chronic kidney failure, also known as end stage renal disease, or ESRD. We currently operate 515 outpatient dialysis centers located in 33 states and the District of Columbia, serving approximately 45,000 patients. In addition, we provide acute inpatient dialysis services in approximately 270 hospitals.

 

Prior to mid-1999, the company had an aggressive growth strategy of acquiring other dialysis businesses. This rapid growth through acquisitions had a significant impact on administrative functions and operating efficiencies. In the second half of 1999, a new management team initiated a turnaround plan focused on improving our financial and operational infrastructure. During 2000 and 2001, we divested substantially all of our operations outside the continental United States, made significant improvements in our billing and collecting operations, reduced our debt and restructured our credit facilities. During 2002, we made significant investments in new systems and processes. These investments will continue through 2003.

 

The dialysis industry

 

The loss of kidney function is generally not reversible. ESRD is the stage of advanced kidney impairment that requires routine dialysis treatments or kidney transplantation to sustain life. Dialysis is the removal of toxins, fluids and salt from the blood of ESRD patients by artificial means. Patients suffering from ESRD generally require dialysis at least three times per week for the rest of their lives.

 

Since 1972, the federal government has provided universal reimbursement for dialysis under the Medicare ESRD program regardless of age or financial circumstances. Under this system, Congress establishes Medicare reimbursement rates for dialysis treatments and related supplies, tests and medications.

 

ESRD patient base

 

According to the United States Renal Data System, or USRDS, there were approximately 275,000 ESRD dialysis patients in the United States at the end of 2000. The recent historical compound annual growth rate in the number of ESRD patients has been approximately 4% to 6%. We do not anticipate any significant change in the growth rate in the future. We believe factors affecting this growth include:

 

  The continued aging of the general population;

 

  Better treatment and longer survival of patients with diseases that typically lead to ESRD, including diabetes and hypertension;

 

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  Improved medical and dialysis technology; and

 

  The growth of minority populations that have a higher incidence rate of ESRD.

 

Treatment options for ESRD

 

Treatment options for ESRD are hemodialysis, peritoneal dialysis and kidney transplantation. In 2002, outpatient hemodialysis treatments, peritoneal dialysis treatments and inpatient or acute dialysis treatments accounted for approximately 88%, 8% and 4% of our total dialysis treatments, respectively.

 

  Hemodialysis

 

Hemodialysis, the most common form of ESRD treatment, is usually performed either in a freestanding or hospital-based outpatient center. A patient can also perform hemodialysis at home with assistance. The hemodialysis machine uses an artificial kidney, called a dialyzer, to remove toxins, fluids and salt from the patient’s blood. The dialysis process occurs across a semi-permeable membrane that divides the dialyzer into two distinct chambers. While blood is circulated through one chamber, a pre-mixed fluid is circulated through the other chamber. The toxins, salt and excess fluids from the blood selectively cross the membrane into the fluid, allowing cleansed blood to return into the patient’s body. Each hemodialysis treatment typically lasts approximately three and one-half hours. Hemodialysis is usually performed three times per week.

 

  Peritoneal dialysis

 

A patient generally performs peritoneal dialysis at home. The most common methods of peritoneal dialysis are continuous ambulatory peritoneal dialysis, or CAPD, and continuous cycling peritoneal dialysis, or CCPD. All forms of peritoneal dialysis use the patient’s peritoneal, or abdominal, cavity to eliminate fluid and toxins. Because it does not involve going to a center three times a week for treatment, peritoneal dialysis is an attractive alternative to hemodialysis for patients who desire more freedom in their lifestyle. However, peritoneal dialysis is not a suitable method of treatment for many patients, including patients who are not able to perform the necessary procedures and those at greater risk of peritoneal infection.

 

CAPD introduces dialysis solution into the patient’s peritoneal cavity through a surgically placed catheter. Toxins in the blood continuously cross the peritoneal membrane into the dialysis solution. After several hours, the patient drains the used dialysis solution and replaces it with fresh solution. This procedure is usually repeated four times per day.

 

CCPD is performed in a manner similar to CAPD, but uses a mechanical device to cycle dialysis solution through the patient’s peritoneal cavity while the patient is sleeping or at rest.

 

  Transplantation

 

An alternative treatment that we do not provide is kidney transplantation. Although transplantation, when successful, is generally the most desirable form of therapeutic intervention, the shortage of suitable donors, side effects of immunosuppressive drugs given to transplant recipients and dangers associated with transplant surgery for some patient populations limit the use of this treatment option.

 

Outpatient dialysis services

 

Our dialysis centers are designed specifically for outpatient hemodialysis. Throughout our network of outpatient dialysis centers, we also provide training, supplies and on-call support services to our home dialysis patients.

 

As required by law, we contract with an individual nephrologist or a group of affiliated nephrologists to provide medical director services at each of our centers. In addition, other nephrologists may apply for practice

 

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privileges in order to treat their patients at our centers. Each center also has an administrator, typically a registered nurse, who supervises the day-to-day operations of the center and its staff. The staff of each center typically consists of registered nurses, licensed practical or vocational nurses, patient care technicians, a social worker, a registered dietician, biomedical technicians and other administrative and support personnel.

 

In addition, many of our centers offer services for home dialysis patients, primarily CAPD and CCPD. Home dialysis services consist of providing equipment and supplies, training, patient monitoring and follow-up assistance to patients who prefer and are able to receive peritoneal dialysis treatments in their homes. Registered nurses train patients and their families or other patient assistants to perform either CAPD or CCPD at home. Our training programs for home dialysis generally last two to three weeks. In 2002, peritoneal dialysis accounted for approximately 8% of our total dialysis treatments.

 

Quality care

 

We believe our reputation for providing quality care is a key factor in attracting patients and physicians and in securing relationships with managed care payors. We engage in organized and systematic efforts through our quality management programs to monitor and improve the quality of services we deliver. These efforts include the development and implementation of patient care policies and procedures, clinical education and training programs, and audits of the quality of services rendered at each of our centers.

 

Our quality management programs are under the direction of our chief medical officer. Our director of quality management and approximately 40 regional quality management coordinators implement these programs in our centers. In addition, our regional biomedical quality management coordinators audit the technical and biomedical quality of our centers. The corporate and regional teams also work with each center’s multi-disciplinary quality management team, including the medical director, to implement the programs.

 

We have a national physician council of ten physicians to advise our senior management on clinical issues impacting our operations across the country. In addition, we have an eight-physician laboratory advisory committee which acts as a medical advisory board for our clinical laboratory. Our chief medical officer participates in the national physician council and laboratory advisory committee meetings.

 

Location and capacity of our centers

 

As of December 31, 2002, we operated 515 outpatient dialysis centers in the continental United States. We owned 485 of these centers, either through wholly-owned subsidiaries or through majority-owned joint ventures. Of the remaining 30 centers, we owned minority interests in seven centers, which were accounted for as equity investments, and managed 23 centers in which we have no ownership interest. The locations of the 485 wholly-owned and majority-owned centers were as follows:

 

State


    

Number of Centers


  

State


    

Number of Centers


  

State


    

Number of Centers


California

    

84

  

Michigan

    

13

  

South Dakota

    

3

Florida

    

44

  

Louisiana

    

11

  

New Mexico

    

2

Texas

    

43

  

Illinois

    

10

  

Kentucky

    

2

Georgia

    

32

  

Indiana

    

10

  

South Carolina

    

2

North Carolina

    

29

  

Kansas

    

9

  

Delaware

    

1

New York

    

26

  

Washington

    

8

  

Alabama

    

1

Minnesota

    

26

  

Arizona

    

7

  

Nebraska

    

1

Oklahoma

    

21

  

New Jersey

    

7

  

Ohio

    

1

Virginia

    

19

  

District of Columbia

    

5

  

Wisconsin

    

1

Pennsylvania

    

18

  

Missouri

    

5

  

Oregon

    

1

Colorado

    

18

  

Nevada

    

5

           

Maryland

    

16

  

Utah

    

4

           

 

3


 

We believe we have adequate capacity within our existing network to accommodate greater patient volume. In addition, we are currently expanding capacity at some of our centers by adding dialysis stations or relocating to larger facilities, and we intend to open and acquire additional centers in 2003.

 

Inpatient dialysis services

 

We provide inpatient dialysis services, excluding physician professional services, to patients in approximately 270 hospitals. We render these services for a per-treatment fee individually negotiated with each hospital. When a hospital requests our services, we typically administer the dialysis treatment at the patient’s bedside or in a dedicated treatment room in the hospital. In some cases the hospital transports the patient to our center for treatment. Inpatient dialysis services are required for patients with acute kidney failure resulting from trauma, patients in the early stages of ESRD, and ESRD patients who require hospitalization for other reasons.

 

Ancillary services

 

We also provide a range of ancillary services to ESRD patients, including:

 

  EPO and other pharmaceuticals.    Our most significant ancillary service is the administration of physician-prescribed pharmaceuticals, including erythropoietin, or EPO, vitamin D analogs and calcium and iron supplements. EPO is a genetically engineered form of a naturally occurring protein that stimulates the production of red blood cells. EPO is used in connection with all forms of dialysis to treat anemia, a medical complication ESRD patients frequently experience. The administration of EPO accounts for approximately one-fourth of our net operating revenues.

 

  ESRD laboratory services.    We own a licensed clinical laboratory, located in Florida, specializing in ESRD patient testing. The specialized laboratory provides both routine laboratory tests covered by the Medicare composite reimbursement rate for dialysis and other physician-prescribed laboratory tests for ESRD patients. Our laboratory provides these tests primarily for our own ESRD patients throughout the United States. These tests are performed to monitor a patient’s ESRD condition, including the adequacy of dialysis, as well as other diseases a patient may have. Our laboratory utilizes a proprietary information system which provides information to our dialysis centers regarding critical outcome indicators. We also operated another laboratory in Minnesota until November 2001, when it was combined with the operations of the Florida laboratory.

 

  ESRD clinical research programs.    Our subsidiary DaVita Clinical Research conducts renal and renal-related Phase I through IV clinical research trials of new drugs and devices designed to improve outcomes, enhance the quality of life and reduce costs for pre-ESRD and ESRD patients. DaVita Clinical Research has conducted over 350 clinical trials for FDA approval of new drugs and devices over the last 17 years. These trials are conducted primarily under contracts with the drug and device manufacturers.

 

  Physician services.    We provide management services to a small number of nephrology practices and own two such practices directly. Physician services account for less than one half percent of our net operating revenues.

 

Growth of our business

 

Our business has grown through increasing capacity at our existing centers, developing new centers, acquiring centers or entering into agreements to manage centers. We expand capacity at our existing centers by increasing hours and/or days of operation or, if additional space is available within a center, through the addition of dialysis stations. The development of a typical outpatient center generally requires $1 million to $1.5 million for initial construction and equipment and approximately $350,000 for working capital in the first year. Based on our experience, a new center typically opens nine to thirteen months after the property lease is signed, normally achieves operating profitability by the ninth to eighteenth month of operation and normally reaches maturity within

 

4


three years. Acquiring an existing center requires a substantially greater initial investment, but profitability and cash flow are initially more predictable. In addition to acquiring centers, we enter into agreements to manage third-party-owned centers in return for management fees, typically based on a percentage of revenues.

 

The table below shows the growth of our company by number of dialysis centers. In February 1998, we completed a merger with Renal Treatment Centers, then the fourth largest provider of dialysis services in the United States, approximately doubling the size of our operations. The pace of our acquisitions slowed significantly during the second half of 1999 and was very limited in 2000, 2001 and 2002, while we focused on restructuring our balance sheet and improving our financial infrastructure and center operations.

 

    

2002


  

2001


  

2000


  

1999


  

1998


  

1997


  

1996


  

1995


Number of centers at beginning of year

  

495

  

490

  

572

  

508

  

197

  

134

  

68

  

42

Acquired centers

  

11

  

21

  

10

  

45

  

263

  

52

  

57

  

23

Developed centers

  

19

  

7

  

11

  

13

  

24

  

12

  

9

  

3

New managed centers

  

2

  

3

  

8

  

18

  

32

              

Divestitures, closures and terminations

  

12

  

26

  

111

  

12

  

8

  

1

         

Number of centers at end of year

  

515

  

495

  

490

  

572

  

508

  

197

  

134

  

68

 

In 2000, we completed the sale of our operations outside the continental United States, with the exception of our centers in Puerto Rico. Net cash proceeds from the completed sales were approximately $133 million, most of which was applied to reduce debt outstanding under our credit facilities in accordance with the conditions under which our lenders consented to the sales. The sale of our centers in Puerto Rico was completed in June 2002.

 

Physician relationships

 

An ESRD patient generally seeks treatment at a dialysis center near his or her home and at which his or her treating nephrologist has practice privileges. Our relationships with local nephrologists and our ability to meet their needs and the needs of their patients are key factors in the success of a dialysis center. Over 1,500 nephrologists currently refer patients to our centers. As is typical in the dialysis industry, one or a few physicians, including the center’s medical director, usually account for all or a significant portion of a dialysis center’s patient referral base. Our medical directors account for a substantial majority of our patient referrals. The loss of the medical director or other key referring physicians at a particular center could therefore materially reduce the revenue of that center.

 

Participation in the Medicare ESRD program requires that treatment at a dialysis center be “under the general supervision of a director who is a physician.” Generally, the medical director must be board eligible or board certified in internal medicine or nephrology and have had at least 12 months of experience or training in the care of patients at dialysis centers. We have engaged physicians or groups of physicians to serve as medical directors for each of our centers. At some centers, we also separately contract with one or more physicians to serve as assistant or associate medical directors or to direct specific programs, such as home dialysis training programs. We have contracts with approximately 275 individual physicians and physician groups to provide medical director services.

 

Medical directors enter into written contracts that specify their duties and fix their compensation for periods of one or more years. The compensation of our medical directors is the result of arm’s length negotiations and generally depends upon competitive factors in the local market, the physician’s professional qualifications and the specific duties and responsibilities of the physician.

 

Our medical director agreements generally include covenants not to compete. Also, when we acquire a center from one or more physicians, or where one or more physicians own interests in centers as co-owners with us, these physicians have agreed to refrain from owning interests in competing centers within a defined

 

5


geographic area for various periods. These noncompetition agreements restrict the physicians from owning, or providing medical director services to, other dialysis centers, but do not restrict the physicians from referring patients to competing centers. Many of these noncompetition agreements expire at the same time as the corresponding medical director agreements. We have from time to time experienced competition from a new dialysis center established by a former medical director following the termination of his or her relationship with us.

 

Sources of revenue

 

Overview

 

The following table sets forth the percentage of our net patient operating revenues provided by the respective payor category for our continental U.S. operations.

 

    

Year ended December 31,


 
    

2002


    

2001


    

2000


 

Percent of total dialysis revenues for continental U.S. operations:

                    

Medicare

  

51

%

  

52

%

  

53

%

Medicaid

  

5

 

  

5

 

  

5

 

    

  

  

    

56

 

  

57

 

  

58

 

HMO’s, health insurance carriers and private patient payments

  

44

 

  

43

 

  

42

 

    

  

  

    

100

%

  

100

%

  

100

%

    

  

  

 

Medicare reimburses dialysis providers for the treatment of individuals who are diagnosed with ESRD and are eligible for participation in the Medicare ESRD program, regardless of age or financial circumstances. ESRD patients receiving dialysis become eligible for primary Medicare coverage at various times, depending on their age or disability status, as well as whether they are covered by an employer group health plan. Generally, for a patient not covered by an employer group health plan, Medicare becomes the primary payor either immediately or after a three-month waiting period. For a patient covered by an employer group health plan, Medicare generally becomes the primary payor after 33 months, or earlier if the patient’s employer group health plan coverage terminates. When Medicare becomes the primary payor, the payment rate we receive for that patient shifts from the employer group health plan rate to the Medicare reimbursement rate.

 

For each treatment, Medicare pays 80% of the amount set by the Medicare reimbursement system. The patient is responsible for the remaining 20%, and in most cases a secondary payor, such as Medicare supplemental insurance, a state Medicaid program or a private payor, covers all or part of these balances. Some patients who do not qualify for Medicaid but otherwise cannot afford secondary insurance can apply for premium payment assistance from charitable organizations, primarily a program offered by the American Kidney Fund. We and other dialysis providers support the American Kidney Fund and similar programs through voluntary contributions.

 

If a patient does not qualify for Medicaid based on financial need and does not purchase secondary insurance through a private insurer, the dialysis provider may not be reimbursed for the 20% portion of the ESRD composite rate that Medicare does not pay. Congress passed legislation in 1998 requiring the Office of the Inspector General of the United States Department of Health and Human Services, or OIG, to consider adopting regulations to allow dialysis providers to pay their patients’ premiums for secondary insurance. These insurance premiums are generally less than the 20% co-payment that a private insurer would pay. Accordingly, dialysis providers could capture the difference between the premiums paid to these secondary insurers and the reimbursement amounts received from them. In December 2002, the OIG announced its decision not to pursue these regulations, citing concerns that allowing the direct payment of these premiums carries too much potential for improperly influencing patients’ selection of a health care provider and would create demands for similar

 

6


exceptions from other health care providers. The OIG also stated that it was not persuaded that these direct premiums were necessary in light of the American Kidney Fund and similar programs.

 

Medicare reimbursement

 

Under the Medicare ESRD program, reimbursement rates for dialysis are established by Congress. The Medicare composite rate set by the Centers for Medicare and Medicaid Services, or CMS, determines the Medicare reimbursement available for a designated group of dialysis services, including the dialysis treatment, supplies used for that treatment, some laboratory tests and some medications. The Medicare composite rate is subject to regional differences based upon several factors, including regional differences in wage levels. Other services and items are eligible for separate reimbursement under Medicare and are not part of the composite rate, including EPO, vitamin D analogs and calcium and iron supplements.

 

Medicare reimburses for home dialysis services under one of two methods. Under the first method, a dialysis center is designated as the supplier of home supplies and services, and provides all dialysis treatment-related services, including equipment and supplies. The center is reimbursed using a methodology based on the Medicare composite rate. Under the second method, a durable medical equipment supply company is designated as the direct supplier, provides the patient directly with all necessary equipment and supplies and is reimbursed by Medicare subject to a capitated ceiling. Under the second method, the patient also selects an outpatient dialysis center to provide additional required support services. The center is reimbursed for these support services on a monthly fee-for-service basis subject to a capitated ceiling. The reimbursement rates under these two methods differ, but both are determined prospectively and are subject to adjustment by Congress. Most of our centers are approved to provide home dialysis services under the first method and home dialysis support services under the second method. In December 2001, we decided to discontinue providing equipment and supplies under the second method.

 

We receive reimbursement for outpatient dialysis services provided to Medicare-eligible patients at composite rates set by Congress that are currently between $121 and $144 per treatment, with an average rate of $131 per treatment. Historically, there have been very few changes to the Medicare composite reimbursement rate. Since 1972, the rate has declined over 70% in real dollars. The rate did not change from commencement of the program in 1972 until 1983. From 1983 through December 1990, numerous Congressional actions resulted in a net reduction of the average reimbursement rate from $138 per treatment in 1983 to approximately $125 per treatment in 1990. The Medicare composite reimbursement rate was increased by $1.00 in 1991, by 1.2% in 2000 and by 2.4% in 2001.

 

In May 2001, CMS concluded a three-year demonstration project involving the enrollment of Medicare ESRD patients in managed care organizations. The demonstration project was designed to evaluate the feasibility of fixed, or capitated, reimbursement for dialysis services. CMS has not issued a final report on the results of the demonstration project. The timing of, and recommendations from, this report are impossible for us to predict.

 

Based on recent conversations with representatives of CMS, we expect CMS to conduct one or more demonstration projects to examine the desirability of bundling pharmaceutical, laboratory and other services into an expanded Medicare composite reimbursement rate. As CMS has yet to announce the parameters for any such demonstration project, it is impossible for us to predict what impact if any these projects will have on Medicare reimbursement.

 

Medicaid reimbursement

 

Medicaid programs are state-administered programs partially funded by the federal government. These programs are intended to provide health coverage for patients whose income and assets fall below state-defined levels and who are otherwise uninsured. In some states, these programs also serve as supplemental insurance programs for the Medicare co-insurance portion of the ESRD composite rate and provide reimbursement for

 

7


additional services, including some oral medications, that are not covered by Medicare. State regulations generally follow Medicare schedules with respect to reimbursement levels and coverages. Some states, however, require beneficiaries to pay a monthly share of the cost based upon levels of income or assets. We are an authorized Medicaid provider in the states in which we conduct our business.

 

Nongovernment payors

 

Before Medicare becomes the primary payor, a patient’s employer group health plan, private insurance or other nongovernment payor, if any, is responsible for payment at its negotiated rates or, in the absence of negotiated rates, at our usual and customary rates. The patient is responsible for any deductibles and co-payments under the terms of his or her employer group health plan or other insurance. Our usual and customary rates, and the rates paid by nongovernment payors, are typically higher than Medicare reimbursement rates. Also, traditional indemnity plans and preferred provider organization or PPO plans typically pay at higher rates than health maintenance organization or HMO plans. After Medicare becomes the primary payor, the employer group health plan, private insurer or other nongovernment payor, if any, becomes secondary to Medicare. Secondary payors are responsible for the 20% of the Medicare reimbursement rates that Medicare does not pay. Secondary payors are not required to reimburse us for the difference between the rates they previously paid and Medicare rates.

 

Hospital inpatient dialysis services

 

We provide inpatient dialysis services, excluding physician professional services, to patients in hospitals pursuant to written agreements with the hospitals. We provide these services for a per-treatment fee which is individually negotiated with each hospital. Some of these agreements provide that we are the exclusive provider of dialysis services to the hospital, but most are nonexclusive. These agreements also generally allow either party to terminate the agreement without cause.

 

Reimbursement for EPO and other drugs

 

EPO stimulates the production of red blood cells and is beneficial in the treatment of anemia, with the effect of reducing or eliminating the need for blood transfusions for dialysis patients. Most of our dialysis patients receive EPO. Approximately one-fourth of our net operating revenues are generated from the administration of EPO. Therefore, EPO reimbursement significantly impacts our net income and cash flow.

 

The OIG has recommended that Medicare reimbursement for EPO be reduced from the current amount of $10 to $9 per 1,000 units. The Department of Health and Human Services, or HHS, has concurred with this recommendation. In addition, the Clinton Administration proposed the same EPO reimbursement reduction in several budget proposals, but Congress did not pass any EPO reimbursement reduction. EPO reimbursement programs have been, and in the future may be, subject to these and other legislative or administrative proposals. We cannot predict whether future rate or reimbursement method changes will be made.

 

Furthermore, EPO is produced by a single manufacturer, Amgen, and any interruption of supply or product cost increases could adversely affect our operations. Amgen is also developing a new product, darbepoetin alfa, also known as Aranesp®, that could replace EPO or reduce its use with dialysis patients. The FDA has approved this new product for use with dialysis patients. We cannot predict when, or whether, Amgen will seek to market this product for the dialysis market, how Medicare or other payors will reimburse dialysis providers for its use, whether physicians will prescribe it instead of EPO or how it will impact our revenues and earnings.

 

Other drugs that we administer upon physician prescription include vitamin D analogs, calcium and iron supplements, various antibiotics and other medications. Medicare currently reimburses us separately for most of these drugs at a rate of 95% of the average wholesale price of each drug. In December 2000, Congress mandated

 

8


a General Accounting Office, or GAO, study of whether to reduce the reimbursement rates for drugs that are based on the average wholesale price. The GAO made recommendations to Congress in September 2001 to lower drug reimbursement rates, but the majority of the drugs we administer were not included in the GAO’s recommendations. Congress has yet to act on the GAO’s recommendations. Effective January 1, 2003, CMS implemented a new payment structure utilizing a single drug pricer for all drugs, including those for which we are reimbursed separately. Our reimbursement under this single drug pricer will not be materially different than what we received at 95% of average wholesale price. Based on recent statements made by key members of Congress and representatives of CMS, we expect that there will be additional changes in Medicare drug reimbursement. We do not know whether or to what extent future rate changes may be implemented, nor how any such changes will impact our revenues and earnings.

 

Congress has also mandated a government study of whether to include EPO and other pharmaceuticals in the Medicare composite reimbursement rate. Recommendations with respect to possible changes in the services included in the Medicare composite rate were due in July 2002 but have yet to be provided to Congress. We expect the upcoming bundling demonstration projects described above to examine further the desirability of including EPO and other pharmaceuticals in the composite rate. We do not know whether or to what extent future rate changes may be implemented as a result of the study, any demonstration projects or otherwise, nor how any such changes will impact our revenues and earnings.

 

Management fee income

 

We generate management fees from managing dialysis centers which are wholly-owned or majority-owned by third parties. Fees are established by contract and are typically based on a percentage of revenues generated from the centers.

 

United States Attorney’s inquiry

 

In February 2001 the Civil Division of the United States Attorney’s Office for the Eastern District of Pennsylvania in Philadelphia contacted us and requested our cooperation in a review of some of our historical practices, including billing and other operating procedures and our financial relationships with physicians. We have cooperated in this review and provided the requested records to the United States Attorney’s Office. In May 2002, we received a subpoena from the Philadelphia office of the OIG. The subpoena requires an update to the information we provided in our response to the February 2001 request, and also seeks a wide range of documents relating to pharmaceutical and other ancillary services provided to patients, including laboratory and other diagnostic testing services, as well as documents relating to our financial relationships with physicians and pharmaceutical companies. The subpoena covers the period from May 1996 to May 2002. We have provided the documents requested. This inquiry remains at an early stage. As it proceeds, the government could expand its areas of concern. If a court determines that there has been wrongdoing, the penalties under applicable statutes could be substantial.

 

At this time, we are unable to determine:

 

  When this matter will be resolved;

 

  What position the Civil Division will take regarding any potential liability on the Company’s part;

 

  Whether any additional areas of inquiry will be opened; and

 

  Any outcome of this inquiry, financial or otherwise.

 

An adverse determination could have a material adverse impact on our business, results of operation and financial condition. As described further below under the subheading “Government regulation,” the penalties under the federal anti-kickback law, Stark laws and False Claims Act and other federal and state statutes can be substantial.

 

9


 

Laboratory payment reviews

 

Our Florida-based laboratory subsidiary is the subject of a third-party carrier review of its Medicare reimbursement claims. The carrier has reviewed claims for six separate review periods. In 1998 the carrier issued a formal overpayment determination in the amount of $5.6 million for the first review period (January 1995 to April 1996). The carrier also suspended all payments of Medicare claims from the laboratory beginning in May 1998. In 1999, the carrier issued a formal overpayment determination in the amount of $15.0 million for the second review period (May 1996 to March 1998). Subsequently, the carrier informed us that $16.1 million of the suspended claims for the third review period (April 1998 to August 1999), $11.6 million of the suspended claims for the fourth review period (August 1999 to May 2000), $2.9 million of the suspended claims for the fifth review period (June 2000 to December 2000) and $0.9 million of the suspended claims for the sixth review period (December 2000 to May 2001) were not properly supported by the prescribing physicians’ medical justification. The carrier’s allegations regarding improperly supported claims represented approximately 99%, 96%, 70%, 72%, 24% and 10%, respectively, of the tests the laboratory billed to Medicare for these six review periods.

 

We have disputed the carrier’s determinations and have provided supporting documentation of our claims. In addition to the formal appeal processes with the carrier and a federal administrative law judge, we have also pursued resolution of this matter through meetings with representatives of CMS and the Department of Justice, or DOJ. We initially met with the DOJ in February 2001, at which time the DOJ requested additional information, which we provided in September 2001.

 

In June 2002, an administrative law judge ruled that the sampling procedures and extrapolations that the carrier used as the basis of its overpayment determinations for the first two review periods were invalid. This decision invalidated the carrier’s overpayment determinations for the first two review periods. The administrative law judge’s decision on the first two review periods does not apply to the remaining four review periods, as each review period is evaluated independently. Moreover, the carrier’s sampling procedures have varied from period to period, and the conclusions the judge arrived at with respect to the first two periods may not hold for the subsequent periods. The hearings before a carrier hearing officer for the third and fourth review periods are scheduled to take place in the second quarter of 2003.

 

During 2000 we stopped accruing Medicare revenue from this laboratory because of the uncertainties regarding both the timing of resolution and the ultimate revenue valuations. Following the favorable ruling by the administrative law judge in 2002 related to the first two review periods covering January 1995 to March 1998, the carrier lifted the payment suspension and began making payments in July 2002 for lab services provided subsequent to May 2001. After making its determination with respect to the fifth and sixth review periods in December 2002, the carrier paid the additional amounts that it is not disputing for the second through sixth review periods. As of December 31, 2002, we had received a total of $68.8 million, which represented approximately 70% of the total outstanding Medicare lab billings for the period from January 1995 through June 2002. Approximately $10 million of these collections related to 2002 lab services provided through June 2002. We will continue to recognize Medicare lab revenue associated with prior periods as cash collections actually occur, to the extent that cumulative recoveries do not exceed the aggregate amount that management believes we will ultimately recover upon final review and settlement of disputed billings.

 

In addition to processing prior period claims, the carrier also began processing billings for current period services on a timely basis. Based on these developments, we began recognizing estimated current period Medicare lab revenue in the third quarter of 2002. As a result, in addition to the $10 million of Medicare lab revenue related to the first half of 2002, we recognized approximately $11 million of current period Medicare lab revenue in the second half of 2002.

 

The carrier is also currently conducting a study of the utilization of dialysis-related laboratory services. During the study, the carrier has suspended all of its previously existing dialysis laboratory prepayment screens.

 

10


The purpose of the study is to determine what ongoing program safeguards are appropriate. In its initial findings from the study, the carrier had determined that some of its prior prepayment screens were invalidating appropriate claims. We cannot determine what prepayment screens, post-payment review procedures, documentation requirements or other program safeguards the carrier may yet implement as a result of its study. The carrier has also informed us that any claims that it reimburses during the study period may also be subject to post-payment review and retraction if determined inappropriate.

 

At this time we are unable to determine:

 

  When this matter will be fully resolved;

 

  The amount of the laboratory claims for which we may be paid;

 

  What action the carrier, the DOJ or HHS may take with respect to this matter; and

 

  Whether the carrier may review additional periods beyond the six identified.

 

An adverse determination could have a material adverse impact on our business, results of operations and financial condition.

 

The Medicare carrier for our Minnesota laboratory is conducting a post-payment review of Medicare reimbursement claims for the period January 1996 through December 1999. The scope of the review is similar to the review being conducted at our Florida laboratory. At this time, we are unable to determine how long it will take the carrier to complete this review. There is currently no overpayment determination or payment suspension with respect to the Minnesota laboratory. The DOJ also requested information with respect to this laboratory, which we have provided. Medicare revenues at the Minnesota laboratory, which were much smaller than the Florida laboratory, were approximately $15 million for the period under review. In November 2001, we closed the operations of this laboratory and combined them with our Florida laboratory.

 

Government regulation

 

Our dialysis operations are subject to extensive federal, state and local governmental regulations. These regulations require us to meet various standards relating to, among other things, government reimbursement programs, dialysis facilities and equipment, management of centers, personnel qualifications, maintenance of proper records, quality assurance programs, and patient care.

 

All of our dialysis centers are certified by CMS, as is required for the receipt of Medicare reimbursement. In some states our dialysis centers also are required to secure additional state health licenses. Governmental authorities, primarily state departments of health, periodically survey our centers to determine if we satisfy applicable federal and state standards and requirements, including the conditions of participation in the Medicare ESRD program. Consistent with recommendations of the OIG, the frequency and intensity of this survey activity increased industry-wide beginning in 2000. We expect this level of survey activity to continue in 2003.

 

Our business could be adversely impacted by:

 

  Loss or suspension of federal certifications;

 

  Loss or suspension of authorization to participate in the Medicare or Medicaid programs;

 

  Loss or suspension of licenses under the laws of any state or governmental authority from which we generate substantial revenues;

 

  Refunds of reimbursement received because of any failures to meet applicable reimbursement requirements; or

 

  Significant reductions in reimbursement or reduction or elimination of coverage for dialysis and ancillary services.

 

11


 

To date, we have not had any material difficulty in maintaining our licenses or our Medicare and Medicaid authorizations. However, we expect that our industry will continue to be subject to significant government regulation and scrutiny, the scope and application of which are difficult to predict. This regulation and scrutiny could adversely impact us in a material way.

 

Fraud and abuse under federal law

 

The “anti-kickback” statute contained in the Social Security Act imposes criminal and civil sanctions on persons who receive or make payments in return for:

 

  The referral of a patient for treatment; or

 

  The ordering or purchasing of items or services that are paid for in whole or in part by Medicare, Medicaid or similar state programs.

 

Federal penalties for the violation of these laws include imprisonment, fines and exclusion of the provider from future participation in the Medicare and Medicaid programs. Civil penalties for violation of these laws include up to $50,000 civil monetary penalties per violation, assessments of up to three times the total payments between the parties and suspension from future participation in Medicare and Medicaid. Some state anti-kickback statutes also include criminal penalties. The federal statute expressly prohibits traditionally criminal transactions, such as kickbacks, rebates or bribes for patient referrals. Court decisions have also held that, under certain circumstances, the statute is also violated whenever a purpose of a payment is to induce referrals.

 

In July 1991, November 1992 and November 1999, the Secretary of HHS published regulations that create exceptions or “safe harbors” for some business transactions and arrangements. Transactions and arrangements structured within these safe harbors do not violate the anti-kickback statute. A business transaction or arrangement must satisfy each and every element of a safe harbor to be protected by that safe harbor. Transactions and arrangements that do not satisfy all elements of a relevant safe harbor do not necessarily violate the anti-kickback statute, but enforcement agencies may subject them to greater scrutiny and could determine that they violate the statute.

 

Because our medical directors refer patients to our centers, the federal anti-kickback statute may apply. Among the available safe harbors is one for personal services, which is relevant to our arrangements with our medical directors. Most of our agreements with our medical directors do not satisfy all seven of the requirements of the personal services safe harbor. We believe that, except in cases where a center is in transition from one medical director to another or where the term of an agreement with a physician has expired and a new agreement is in negotiation, our agreements with our medical directors satisfy most of the elements of this safe harbor. One of the requirements not satisfied is a requirement that if the services provided under the agreement are on a part-time basis, as they are with our medical directors, the agreement must specify the schedule of intervals of service, their precise length and the exact charge for such intervals. Because of the nature of our medical directors’ duties, we believe it is impossible to meet this requirement. Also, one of the requirements is that the compensation is fair market value for the services rendered. There is little guidance available as to what constitutes fair market value for medical director services. Although our medical director agreements are the result of arm’s length negotiations, an enforcement agency could challenge the level of compensation that we pay our medical directors. Accordingly, we could in the future be required to change our practices, pay substantial fines or otherwise experience a material adverse effect as a result of a challenge to these arrangements. One of the areas that the United States Attorney’s inquiry described above covers is our financial relationships with physicians.

 

At 31 of our dialysis centers, physicians who refer patients to the centers hold interests in partnerships or limited liability companies owning the centers. The anti-kickback statute may apply to these situations. Among the available safe harbors with respect to these arrangements is one for small entity investment interests. Although none of our arrangements satisfy all of the elements of this small entity investment interests safe harbor, we believe that each of these partnerships and limited liability companies satisfies a majority of the safe harbor’s elements, as well as the intent of the regulations.

 

12


 

We lease approximately 50 of our centers from entities in which physicians hold interests and we also sublease space to referring physicians at approximately 90 of our dialysis centers. The anti-kickback statute may apply in these situations. Among the available safe harbors with respect to these arrangements is one for space rentals. We believe that the leases and subleases we have entered into are in material compliance with the safe harbor.

 

Because we are purchasing and selling items and services in the operation of our centers that may be paid for in whole, or in part, by Medicare or a state healthcare program and because these items and services might be purchased or sold at a discount, the federal anti-kickback statute may apply. Among the available safe harbors is one for discounts, which is relevant to our discount arrangements. We believe that the discount arrangements that we have entered into are in material compliance with the anti-kickback statute and that these arrangements satisfy, in all material respects, each of the elements of the discounts’ safe harbor applicable to these arrangements.

 

Fraud and abuse under state law

 

Several states, including California, Florida, Georgia, Kansas, Louisiana, Maryland, New York, Utah and Virginia, in which we operate dialysis centers jointly owned with referring physicians, have statutes prohibiting physicians from holding financial interests in various types of medical facilities to which they refer patients. Some states also have laws similar to the federal anti-kickback statute that may affect our ability to receive referrals from physicians with whom we have financial relationships, such as our medical directors. Some of these statutes include exemptions applicable to our medical directors and other physician relationships. Some, however, include no explicit exemption for medical director services or other services for which we contract with and compensate referring physicians or for joint ownership interests of the type held by some of our referring physicians. If these statutes are interpreted to apply to referring physicians with whom we contract for medical director and similar services or to referring physicians who hold joint ownership interests, we would be required to restructure some or all of our relationships with these referring physicians and could be subject to financial penalties. We cannot predict the consequences of this type of restructuring.

 

Stark I/Stark II

 

The Omnibus Budget Reconciliation Act of 1989 includes provisions, known as Stark I, that restrict physician referrals for clinical laboratory services to entities with which a physician or an immediate family member has a “financial relationship.” Federal regulatory agencies may interpret Stark I to apply to our operations. Regulations interpreting Stark I, however, have created an exception to its applicability regarding services furnished in a dialysis center if payment for those services is included in the ESRD composite rate.

 

The Omnibus Budget Reconciliation Act of 1993 contains provisions, known as Stark II, that restrict physician referrals for “designated health services” to entities with which a physician or immediate family member has a “financial relationship.” The entity is prohibited under Stark II, as is the case for entities restricted by Stark I, from claiming reimbursement for such services under the Medicare or Medicaid programs, is liable for the refund of amounts received pursuant to prohibited claims, is subject to civil penalties of up to $15,000 per service and can be excluded from future participation in the Medicare and Medicaid programs. Stark II includes certain exceptions. Stark II provisions that may be relevant to us became effective in January 1995. Phase I of federal regulations interpreting Stark II were issued in January 2001, and became effective, in relevant part, in the first quarter of 2002. CMS has yet to propose Phase II of these regulations.

 

A “financial relationship” with an entity under Stark II is defined as an ownership or investment interest in, or a compensation arrangement with, the entity. We have entered into compensation agreements with our medical directors. Some of our medical directors own equity interests in entities that operate our dialysis centers. Some of our dialysis centers are leased from entities in which referring physicians hold interests and we sublease space to referring physicians at some of our dialysis centers. In addition, while nearly all of our stock option

 

13


arrangements with referring physicians were terminated in 2000, a few medical directors still own options to acquire our common stock because we did not have the contractual right to terminate their options. Under the Stark II regulations, these stock options constitute compensation arrangements that must meet an applicable exception. Also, some medical directors and other physicians own our common stock, which they either purchased in the open market or received from us as consideration in an acquisition of dialysis centers from them. Although we believe that the ownership of our stock and the other ownership interests and lease arrangements for our centers are in material compliance with Stark II, it is possible that CMS could view them as prohibited arrangements that must be restructured or for which we could be subject to other applicable penalties.

 

We believe that our compensation arrangements with medical directors and other contract physicians materially satisfy the personal services compensation arrangement exception to the Stark II prohibitions. Payments made by a lessor to a lessee for the use of premises are also excepted from Stark II prohibitions if specific requirements are met. We believe that our leases and subleases with referring physicians materially satisfy this exception to the Stark II prohibitions. The Stark II exception applicable to physician ownership interests in entities to which they make referrals does not encompass the kinds of ownership arrangements that referring physicians hold in several of our subsidiaries that operate dialysis centers. Accordingly, it is possible that CMS could require us to restructure some of these arrangements or seek to impose substantial fines or additional penalties on us.

 

For purposes of Stark II, “designated health services” include clinical laboratory services, equipment and supplies, home health services, outpatient prescription drugs and inpatient and outpatient hospital services. We believe that the language and legislative history of Stark II and Phase I of the final Stark II regulations indicate that Congress did not intend to include dialysis services and the services and items provided incident to dialysis services as a part of designated health services. For example, the final Stark II regulations exempt from the referral prohibition referrals for clinical laboratory services furnished in an ESRD center if payment for those services is included in the ESRD composite rate and for EPO and other dialysis-related outpatient prescription drugs furnished in or by an ESRD center. However, our provision of, or arrangement and assumption of financial responsibility for, certain other outpatient prescription drugs, center dialysis services and supplies, home dialysis supplies and equipment and services to hospital inpatients under our dialysis services agreements with hospitals, include services and items that still could be construed as designated health services within the meaning of Stark II. Although we bill the hospital and not Medicare or Medicaid for hospital inpatient services, our medical directors may request or establish a plan of care that includes dialysis services for hospital inpatients that may be considered a referral to us within the meaning of Stark II.

 

Because the Stark II regulations do not expressly address all of our operations, it is possible that CMS could interpret Stark II to apply to parts of our operations. Consequently, it is possible that CMS could determine that Stark II requires us to restructure existing compensation agreements with our medical directors and to repurchase or to request the sale of ownership interests in subsidiaries and partnerships held by referring physicians or, alternatively, to refuse to accept referrals for designated health services from these physicians. We would be materially impacted if CMS interprets Stark II to apply to us and we either could not achieve material compliance with Stark II or the cost of achieving that compliance would be substantial.

 

Medicare reform

 

Because the Medicare program represents a substantial portion of the federal budget, Congress takes action in almost every legislative session to modify the Medicare program for the purpose of, or with the result of, reducing the amounts payable from the program to healthcare providers or placing additional burdens or restrictions on healthcare providers. Legislation or regulations may be enacted in the future that may significantly modify the ESRD program or substantially reduce the amount paid for our services. Further, statutes or regulations may be adopted that impose additional requirements for eligibility to participate in the federal and state payment programs. Any legislation or regulations of this type could adversely affect our business operations in a material way.

 

14


 

The False Claims Act

 

The federal False Claims Act, or FCA, is a means of policing false bills or false requests for payment in the healthcare delivery system. In part, the FCA imposes a civil penalty on any person who:

 

  Knowingly presents, or causes to be presented, to the federal government a false or fraudulent claim for payment or approval;

 

  Knowingly makes, uses, or causes to be made or used, a false record or statement to get a false or fraudulent claim paid or approved by the federal government;

 

  Conspires to defraud the federal government by getting a false or fraudulent claim allowed or paid; or

 

  Knowingly makes, uses or causes to be made or used, a false record or statement to conceal, avoid, or decrease an obligation to pay or transmit, money or property to the federal government.

 

The penalties for a violation of the FCA range from $5,500 to $11,000 for each false claim plus three times the amount of damages caused by each such claim. The federal government has used the FCA to prosecute a wide variety of issues as Medicare fraud, including coding errors, billing for services not rendered, the submission of false cost reports, billing services at a higher reimbursement rate than appropriate, billing under a comprehensive code as well as under one or more component codes included in the comprehensive code and billing for care that is not medically necessary. Although subject to some dispute, at least two federal district courts have also determined that an alleged violation of the federal anti-kickback statute or Stark I and Stark II are sufficient to state a claim for relief under the FCA. In addition to the civil provisions of the FCA, the federal government can use several other criminal statutes to prosecute persons who submit false or fraudulent claims for payment to the federal government.

 

The Health Insurance Portability and Accountability Act of 1996

 

The Health Insurance Portability and Accountability Act of 1996, or HIPAA, among other things, allows individuals who lose or change jobs to transfer their insurance, limits exclusions for preexisting conditions and establishes a pilot program for medical savings accounts. In addition, HIPAA also expanded federal attempts to combat healthcare fraud and abuse by making amendments to the Social Security Act and the federal criminal code. Among other things, HIPAA created a new “Health Care Fraud Abuse Control Account,” under which advisory opinions are issued by the OIG regarding the application of the anti-kickback statute, criminal penalties for Medicare and Medicaid fraud were extended to other federal healthcare programs, the exclusion authority of the OIG was expanded, Medicare and Medicaid civil monetary penalty provisions were extended to other federal healthcare programs, the amounts of civil monetary penalties were increased and a criminal healthcare fraud statute was established.

 

HIPAA also includes provisions relating to the privacy of medical information. HHS published HIPAA privacy regulations in December 2000 and modified these regulations in August 2002. Based on our initial review of the privacy rules, compliance will require the development of extensive policies and procedures, the designation of privacy officers and the implementation of elaborate administrative safeguards with respect to private health information in our possession. Under HIPAA, compliance with the proposed privacy regulations is required by April 2003. Furthermore, HIPAA includes provisions relating to standards for electronic transactions and electronic signatures. Based on our review of the proposed standards, compliance will require us to develop additional information systems and administrative and electronic safeguards to protect data integrity. Under HIPAA, compliance with the standards for electronic transactions is required no later than October 2003. Compliance with the proposed electronic signature standards is required in 2004.

 

Complying with the HIPAA privacy rules and the proposed security and electronic signature standards will require substantial time and may require us to incur significant expenditures.

 

15


 

Other regulations

 

Our operations are subject to various state hazardous waste and non-hazardous medical waste disposal laws. These laws do not classify as hazardous most of the waste produced from dialysis services. Occupational Safety and Health Administration regulations require employers to provide workers who are occupationally subject to blood or other potentially infectious materials with prescribed protections. These regulatory requirements apply to all healthcare facilities, including dialysis centers, and require employers to make a determination as to which employees may be exposed to blood or other potentially infectious materials and to have in effect a written exposure control plan. In addition, employers are required to provide or employ hepatitis B vaccinations, personal protective equipment and other safety devices, infection control training, post-exposure evaluation and follow-up, waste disposal techniques and procedures, and engineering and work practice controls. Employers are also required to comply with various record-keeping requirements. We believe that we are in material compliance with these laws and regulations.

 

A New York statute prohibits publicly-held companies from owning the health facility license required to operate a dialysis center in New York. Although we own substantially all of the assets, including the fixed assets, of our New York dialysis centers, the licenses are held by privately-owned companies with which we have agreements to provide a broad range of administrative services, including billing and collecting. The New York State Department of Health has approved these types of arrangements; however, we cannot guarantee that they will not be challenged as prohibited under the relevant statute. If they are successfully challenged, we cannot predict the impact on our business in New York. We have a similar management relationship with physician practices in several states which prohibit the corporate practice of medicine, and with a privately-owned company in New Jersey for some, but not all, of our New Jersey dialysis centers. We have had difficulty securing licenses for new centers in New Jersey in our own name because the New Jersey Department of Aging and Senior Services refuses to grant new licenses to companies that have more than a small number of outstanding survey issues throughout all of their facilities in the entire United States, regardless of the respective size of the companies’ operations.

 

A few states have certificate of need programs regulating the establishment or expansion of healthcare facilities, including dialysis centers. We believe that we are in material compliance with all applicable state certificate of need laws.

 

Although we believe we comply materially with current applicable laws and regulations, our industry will continue to be subject to substantial regulation, the scope and effect of which are difficult to predict. Our activities could be reviewed or challenged by regulatory authorities at any time in the future.

 

Corporate compliance program

 

We have implemented a company-wide corporate compliance program as part of our commitment to comply fully with all applicable laws and regulations and to maintain the high standards of conduct we expect from all of our employees. We continuously review this program and enhance it as necessary. The primary purposes of the program include:

 

  Increasing through training and education, the awareness of our employees and affiliated professionals of the necessity of complying with all applicable laws and regulations in an increasingly complicated regulatory environment;

 

  Auditing our dialysis centers, laboratories and billing offices on a regular basis to identify any potential instances of noncompliance in a timely manner; and

 

  Ensuring that we take steps to resolve instances of non-compliance or to address areas of potential non-compliance as promptly as we become aware of them.

 

We have a code of conduct that each of our employees and affiliated professionals must follow and we have a confidential toll-free hotline (888-272-7272) for employees to report potential instances of non-compliance.

 

16


Our chief compliance officer administers the compliance program. The chief compliance officer reports directly to our chief executive officer and chief operating officer and to the compliance committee of our board of directors.

 

Competition

 

The dialysis industry is highly competitive, particularly in terms of acquiring existing dialysis centers. Competition for qualified physicians to act as medical directors and for inpatient dialysis services agreements with hospitals is also vigorous. We have also, from time to time, experienced competition from former medical directors or referring physicians who have opened their own dialysis centers.

 

The market share of the large multi-center providers has increased significantly over the last several years and the four largest dialysis chains, including us, now comprise approximately 65% of the market, compared to approximately 30% in 1992. We expect consolidation by these large chain providers to continue. Approximately half of the independent centers are owned or controlled by hospitals or non-profit organizations. Hospital-based and non-profit dialysis units typically are more difficult to acquire than independent, physician-owned centers.

 

Large chain dialysis providers with whom we compete include Fresenius Medical Care, Gambro and Renal Care Group. Some of our competitors have substantially greater financial resources than we do and may compete with us for acquisitions and the development of new centers in markets we have also targeted. There are also a number of large healthcare providers and product suppliers that have entered or may decide to enter the dialysis business.

 

Our two largest competitors, Fresenius and Gambro, manufacture a full line of dialysis supplies and equipment in addition to owning and operating dialysis centers. This may give them cost advantages over us because of their ability to manufacture their own products. In addition, Fresenius is our largest supplier of dialysis products and is also our largest competitor in the dialysis services market.

 

A portion of our business also consists of monitoring and providing supplies for ESRD treatments in patients’ homes. Other companies provide similar services. A company, AKsys, has developed a hemodialysis system designed to enable patients to perform hemodialysis on a daily basis in their homes. In March 2002, AKsys received FDA clearance to market its Personal Hemodialysis (PHD) system. To date there has not been significant adoption of the PHD system by our patients or physicians, however, we expect to test the concept in a few of our centers. We are unable to determine how this system will affect our business over the longer-term.

 

Insurance

 

We carry property and general liability insurance, professional liability insurance, directors’ and officers’ liability insurance, workers compensation, and other insurance coverage in amounts and on terms deemed adequate by management, based on our claims experience and expectations for future claims. Future claims could, however, exceed our applicable insurance coverage. Physicians practicing at our dialysis centers are required to maintain their own malpractice insurance and our medical directors maintain coverage for their individual private medical practices. Our liability policies also cover our medical directors for the performance of their duties as medical directors.

 

Employees

 

As of December 31, 2002, we had approximately 13,000 teammates:

 

•   Licensed professional staff (nurses, dieticians and social workers)

  

4,800

•   Other patient care and center support staff and laboratory personnel

  

6,700

•   Corporate, billing and regional administrative staff

  

1,500

 

Our dialysis business requires nurses with specialized training for patients with complex care needs. Recruitment and retention of nurses and nurse aides are growing concerns for health care providers generally because of the disparity between the supply and demand for nurses, which has led to a nursing shortage. We have an active program of investing in our professional healthcare teammates to help ensure we meet our recruitment and retention targets, including expanded training opportunities, tuition reimbursements, and other incentives.

 

17


 

Item 2.    Properties.

 

We own the land and building for only two of our dialysis facilities. Our other dialysis centers are located on premises that we lease. Our leases generally cover periods from five to ten years and typically contain renewal options of five to ten years at the fair rental value at the time of renewal or at rates subject to periodic consumer price index increases. Our outpatient dialysis centers range in size from 500 to 30,000 square feet, with an average size of approximately 6,500 square feet.

 

We maintain our corporate headquarters in approximately 40,000 square feet of office space in Torrance, California, which we currently lease for a term expiring in 2008. Our business office in Tacoma, Washington is in an 80,000-square foot facility leased for a term expiring in 2009. We maintain a 57,000-square foot facility in Berwyn, Pennsylvania, which we currently lease for a term expiring in 2006, principally for additional billing and collections staff. Our Florida-based laboratory is located in a 30,000-square foot facility owned by us, with a long-term ground lease, and we lease 15,000 square feet of additional space for laboratory administrative staff for a term expiring in 2007.

 

Some of our dialysis centers are operating at or near capacity. However, we believe that we have adequate capacity within most of our existing dialysis centers to accommodate additional patient volume through increased hours and/or days of operation, or, if additional space is available within an existing facility, by adding dialysis stations. In addition, we often can build new centers if existing centers reach capacity. With respect to relocating centers or building new centers, we believe that we can generally lease space at economically reasonable rates in the area planned for each of these centers. Expansion or relocation of our dialysis centers is subject to review for compliance with conditions relating to participation in the Medicare ESRD program. In states that require a certificate of need or center license, additional approvals would generally be necessary for expansion or relocation.

 

Item 3.    Legal Proceedings.

 

See the heading “United States Attorney’s inquiry” in “Item 1. Business” of this report for information on our cooperation with the Civil Division of the United States Attorney’s Office for the Eastern District of Pennsylvania in a review of some of our historical practices, including billing and other operating procedures and our financial relationships with physicians.

 

See the heading “Laboratory payment reviews” in “Item 1. Business” of this report for information on the payment dispute with our Florida laboratory’s Medicare carrier.

 

In addition, we are subject to claims and suits in the ordinary course of business. We do not believe that the ultimate resolution of these additional pending proceedings, whether the underlying claims are covered by insurance or not, will have a material adverse effect on our results of operations or financial condition.

 

Item 4.    Submission of Matters to a Vote of Securities Holders.

 

No matters were submitted to a vote of security holders during the fourth quarter of 2002.

 

18


PART II

 

Item 5.    Market for the Registrant’s Common Equity and Related Stockholder Matters.

 

Our common stock is traded on the New York Stock Exchange under the symbol “DVA”. The following table sets forth, for the periods indicated, the high and low closing prices for our common stock as reported by the New York Stock Exchange.

 

    

High


  

Low


Year ended December 31, 2001:

             

1st quarter

  

$

19.55

  

$

14.60

2nd quarter

  

 

20.33

  

 

16.18

3rd quarter

  

 

22.36

  

 

18.31

4th quarter

  

 

24.45

  

 

17.05

Year ended December 31, 2002:

             

1st quarter

  

$

26.00

  

$

21.50

2nd quarter

  

 

26.13

  

 

20.40

3rd quarter

  

 

23.91

  

 

19.46

4th quarter

  

 

25.87

  

 

22.80

 

The closing price of our common stock on February 14, 2003 was $20.41 per share. According to The Bank of New York, our registrar and transfer agent, as of February 14, 2003, there were 2,604 holders of record of our common stock. Since our recapitalization in 1994, we have not declared or paid cash dividends to holders of our common stock. We do not anticipate paying cash dividends in the foreseeable future. Our bank credit agreements restrict our ability to pay dividends on our common stock. Also, see the heading “Liquidity and capital resources” under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the notes to our consolidated financial statements.

 

19


 

Item 6.    Selected Financial Data.

 

The following table presents selected consolidated financial and operating data for the periods indicated. The following financial and operating data should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements filed as part of this report.

 

    

Year ended December 31,


 
    

2002


    

2001


    

2000


    

1999


    

1998


 
    

(in thousands, except share data)

 

Income statement data:

                                            

Net operating revenues(1)

  

$

1,854,632

 

  

$

1,650,753

 

  

$

1,486,302

 

  

$

1,445,351

 

  

$

1,203,738

 

Total operating expenses(2)

  

 

1,463,300

 

  

 

1,332,761

 

  

 

1,311,587

 

  

 

1,509,333

 

  

 

1,068,825

 

    


  


  


  


  


Operating income (loss)

  

 

391,332

 

  

 

317,992

 

  

 

174,715

 

  

 

(63,982

)

  

 

134,913

 

Other income (loss), net

  

 

5,790

 

  

 

4,644

 

  

 

(7,201

)

  

 

(1,895

)

  

 

4,894

 

Debt expense(3)

  

 

71,636

 

  

 

72,438

 

  

 

116,637

 

  

 

110,797

 

  

 

84,003

 

Minority interests in income of consolidated subsidiaries

  

 

(9,299

)

  

 

(9,260

)

  

 

(5,942

)

  

 

(5,152

)

  

 

(7,163

)

    


  


  


  


  


Income (loss) before income taxes, extraordinary items and cumulative effect of change in accounting principle

  

 

316,187

 

  

 

240,938

 

  

 

44,935

 

  

 

(181,826

)

  

 

48,641

 

Income tax expense (benefit)

  

 

129,500

 

  

 

104,600

 

  

 

27,960

 

  

 

(34,570

)

  

 

38,449

 

    


  


  


  


  


Income (loss) before extraordinary items and cumulative effect of change in accounting principle

  

$

186,687

 

  

$

136,338

 

  

$

16,975

 

  

$

(147,256

)

  

$

10,192

 

    


  


  


  


  


Net income (loss)(4)

  

$

157,329

 

  

$

137,315

 

  

$

13,485

 

  

$

(147,256

)

  

$

(9,448

)

    


  


  


  


  


Basic earnings (loss) per common share:

                                            

Income (loss) before extraordinary items and cumulative effect of change in accounting principle

  

$

2.60

 

  

$

1.63

 

  

$

0.21

 

  

$

(1.81

)

  

$

0.12

 

    


  


  


  


  


Net income (loss)(4)

  

$

2.19

 

  

$

1.64

 

  

$

0.17

 

  

$

(1.81

)

  

$

(0.12

)

    


  


  


  


  


Diluted earnings (loss) per common share:

                                            

Income (loss) before extraordinary items and cumulative effect of change in accounting principle

  

$

2.28

 

  

$

1.51

 

  

$

0.20

 

  

$

(1.81

)

  

$

0.12

 

    


  


  


  


  


Net income (loss)(4)

  

$

1.96

 

  

$

1.52

 

  

$

0.16

 

  

$

(1.81

)

  

$

(0.12

)

    


  


  


  


  


Ratio of earnings to fixed charges(5)(6)

  

 

4.35:1

 

  

 

3.63:1

 

  

 

1.32:1

 

  

 

See   (6)

 

  

 

1.49:1

 

Balance sheet data:

                                            

Working capital(7)

  

$

251,925

 

  

$

175,983

 

  

$

148,348

 

  

$

(1,043,796

)

  

$

388,064

 

Total assets

  

 

1,775,693

 

  

 

1,662,683

 

  

 

1,596,632

 

  

 

2,056,718

 

  

 

1,911,619

 

Long-term debt(8)

  

 

1,311,252

 

  

 

811,190

 

  

 

974,006

 

  

 

5,696

 

  

 

1,225,781

 

Shareholders’ equity(9)

  

 

70,264

 

  

 

503,637

 

  

 

349,368

 

  

 

326,404

 

  

 

473,864

 


(1) Net operating revenues include $58,778 in 2002 of prior years’ services revenue relating to Medicare lab revenue, and $22,000 in 2001 of prior years’ dialysis services revenue relating to cash settlements and collections in excess of prior estimates.
(2)

Total operating expenses include expense offsets from recoveries of $5,192 in 2002, and $35,220 in 2001 of accounts receivable reserved in 1999, a net gain for impairments and valuation adjustments of $380 in 2002

 

20


 

and net impairment losses of $4,556 in 2000, $139,805 in impairment and valuation losses in 1999 principally associated with the disposition of the Company’s non-continental U.S. operations and merger-related costs of $78,188 in 1998.

(3) Debt expense includes write-offs of deferred financing costs of $1,192 in 2000 and $1,601 in 1999, and a loss on termination of interest rate swap agreements related to refinanced debt of $9,823 in 1998.
(4) Net income (loss) includes an extraordinary loss of $29,358 ($0.41 per share—basic, $0.32 per share—diluted) in 2002 resulting from the write-off of deferred financing costs associated with the retirement of the $225,000 outstanding 9¼% Senior Subordinated Notes due 2011, an extraordinary gain of $977 ($0.01 per share) in 2001 relating to the write-off of deferred financing costs and the associated accelerated swap liquidation gains resulting from debt refinancing, and extraordinary losses associated with early extinguishment of debt of $3,490 ($0.04 per share) in 2000 and $12,744 ($0.16 per share) in 1998. In 1998 we adopted AICPA Statement of Position No. 98-5 Reporting on the Costs for Start-up Activities which requires that pre-opening and organization costs be expensed as incurred. As a result, unamortized deferred pre-opening and organizational costs of $6,896 ($0.08 per share) were written off as a cumulative effect of a change in accounting principle in 1998.
(5) The ratio of earnings to fixed charges is computed by dividing fixed charges into earnings. Earnings for this purpose is defined as pretax income from operations adjusted by adding back fixed charges excluding interest capitalized during the period. Fixed charges are defined as the total of interest expense, amortization of financing costs, capitalized interest and the estimated interest component of rental expense on operating leases.
(6) Due to our loss in 1999, the ratio coverage in 1999 was less than 1:1. We would have had to generate additional earnings of $182,535 to achieve a coverage of 1:1.
(7) The working capital calculation as of December 31, 1999 includes long-term debt of $1,425,610 that was potentially callable under covenant provisions.
(8) Long-term debt as of December 31, 1999 excludes $1,425,610 that was potentially callable under covenant provisions.
(9) We repurchased 27,327,477 shares of common stock for $642,171 in 2002 and 888,700 shares of common stock for $20,360 in 2001.

 

21


Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Forward looking statements

 

This Form 10-K contains statements that are forward-looking statements within the meaning of the federal securities laws, including statements about our expectations, beliefs, intentions or strategies for the future. These statements involve known and unknown risks and uncertainties, including risks resulting from the regulatory environment in which we operate, economic and market conditions, competitive activities, other business conditions, accounting estimates, and the risk factors set forth in this Form 10-K. These risks, among others, include those relating to possible reductions in private mix and private and government reimbursement rates, the concentration of profits generated from PPO and private indemnity patients and from ancillary services including the administration of pharmaceuticals, changes in pharmaceutical practice patterns or reimbursement policies, the ongoing review of the Company’s Florida laboratory subsidiary by its Medicare carrier and the DOJ, the ongoing review by the US Attorney’s Office and the OIG in Philadelphia and the Company’s ability to maintain contracts with physician medical directors. Our actual results may differ materially from results anticipated in our forward-looking statements. We base our forward-looking statements on information currently available to us, and we have no current intention to update these statements, whether as a result of changes in underlying factors, new information, future events or other developments.

 

The following should be read in conjunction with our consolidated financial statements and “Item 1. Business.”

 

Results of operations

 

Our operating results, excluding prior-period service recoveries, for the year ended December 31, 2002 were in line with our projected range, with no significant unanticipated changes in dialysis revenue, expense trends or EBITDA, and no material changes in our general risk assessments. However, positive developments regarding disputed Medicare claims at our Florida laboratory have allowed us to recognize Medicare lab revenue for current and prior services beginning in the third quarter of 2002.

 

The following is a summary of continental U. S. and non-continental U.S. operating revenues and operating expenses:

 

    

Year ended December 31,


 
    

2002


    

2001


    

2000


 
    

(dollars in millions)

 

Operating revenues:

                                         

Continental U.S. 

  

$

1,849

  

100

%

  

$

1,636

  

99

%

  

$

1,412

  

95

%

Non-continental U.S. 

  

 

6

         

 

15

  

1

%

  

 

74

  

5

%

    

  

  

  

  

  

    

$

1,855

  

100

%

  

$

1,651

  

100

%

  

$

1,486

  

100

%

    

  

  

  

  

  

Operating expenses:

                                         

Continental U.S. 

  

$

1,458

  

100

%

  

$

1,317

  

99

%

  

$

1,234

  

94

%

Non-continental U.S. 

  

 

6

         

 

16

  

1

%

  

 

73

  

6

%

Impairment valuation adjustments

                              

 

4

      
    

  

  

  

  

  

    

$

1,464

  

100

%

  

$

1,333

  

100

%

  

$

1,311

  

100

%

    

  

  

  

  

  

 

22


 

The divestiture of our dialysis operations outside the continental United States was substantially completed during 2000, and the sale of our remaining centers in Puerto Rico was completed during the second quarter of 2002. Therefore, the non-continental U.S. operating results are excluded from the revenue and cost trends discussed below.

 

Continental operating results were as follows (see Note 18 to the consolidated financial statements for non-continental U.S. operating results):

 

Continental U.S. Operations

 

    

Year ended December 31,


 
    

2002


    

2001


    

2000


 
    

(dollars in millions)

 

Net operating revenues:

                                               

Current period services

  

$

1,790

 

  

100

%

  

$

1,614

 

  

100

%

  

$

1,412

 

  

100

%

Prior years’ services—laboratory

  

 

59

 

                                      

Prior years’ services—dialysis

                  

 

22

 

                      

Operating expenses:

                                               

Dialysis centers and labs

  

 

1,212

 

  

68

%

  

 

1,087

 

  

67

%

  

 

973

 

  

69

%

General and administrative

  

 

154

 

  

9

%

  

 

129

 

  

8

%

  

 

120

 

  

8

%

Depreciation and amortization(a)

  

 

65

 

  

4

%

  

 

62

 

  

4

%

  

 

58

 

  

4

%

Provision for uncollectible accounts(b)

  

 

32

 

  

2

%

  

 

32

 

  

2

%

  

 

38

 

  

3

%

    


         


         


      
    

 

1,463

 

  

82

%

  

 

1,310

 

  

81

%

  

 

1,189

 

  

84

%

    


         


         


      

Operating income—current period services(a)(b)

  

$

327

 

  

18

%

  

$

304

 

  

19

%

  

$

223

 

  

16

%

    


         


         


      

Impairments and valuation losses (gains):

                                               

Continental U.S. operations

  

$

1

 

         

$

(1

)

         

$

5

 

      

Non-continental U.S. operations

  

 

(1

)

         

 

1

 

         

 

(1

)

      
    


         


         


      
    

$

—  

 

         

$

—  

 

         

$

4

 

      
    


         


         


      

Dialysis treatments (000’s)

  

 

5,975

 

         

 

5,690

 

         

 

5,354

 

      

Average dialysis treatments per treatment day

  

 

19,090

 

         

 

18,185

 

         

 

17,066

 

      

Average dialysis revenue per treatment

  

$

291

 

         

$

278

 

         

$

256

 

      

(a) For comparison purposes, excludes goodwill amortization of $42 million in 2001, and $45 million in 2000. Goodwill is not amortized effective for 2002 per SFAS No. 142.
(b) Excludes approximately $5 and $35 million of recoveries in 2002 and 2001 of amounts reserved in 1999. Operating income as presented also excludes $59 and $22 million of prior years’ services revenues in 2002 and 2001.

 

Because of the inherent uncertainties associated with predicting third-party reimbursements in the healthcare industry, our revenue recognition involves significant estimation risks. Such risks and uncertainties are addressed in AICPA Statement of Position (SOP) No. 00-1 Auditing Health Care Third-Party Revenues and Related Receivables. Our estimates are developed based on the best information available to us and our best judgement as to the reasonably assured collectibility of our billings as of the reporting date. Changes in estimates are reflected in the financial statements based upon on-going actual experience trends, or subsequent settlements and realizations depending on the nature and predictability of the estimates and contingencies.

 

The net operating revenues for continental U.S. operations of $1,790 million in 2002 and $1,614 million in 2001 represent annual increases of $176 million or 11% and $202 million or 14%, respectively. Approximately 50% and 60% of the increase in dialysis services revenue for 2002 and 2001 was attributable to increases in the average reimbursement rate per treatment and approximately 50% and 40% was due to an increase in the number of dialysis treatments. The increase in 2002 also included approximately $21 million of current year Medicare laboratory revenue. As discussed below, we had not recognized any Medicare laboratory revenue during 2001 due to the ongoing dispute with the third-party carrier.

 

23


 

Dialysis services revenue

 

Dialysis services revenue, excluding prior period service revenue, represented 97%, 98% and 97% of current operating revenues in 2002, 2001 and 2000, respectively. Lab, other and management fee income account for the balance of revenues.

 

Dialysis services include outpatient center hemodialysis, which accounts for approximately 88% of total dialysis treatments, home dialysis, and inpatient hemodialysis with contracted hospitals. Major components of dialysis revenue include the administration of EPO and other drugs as part of the dialysis treatment, which represents approximately 37% of operating revenues.

 

Dialysis services are paid for primarily by Medicare and state Medicaid programs in accordance with rates established by CMS, and by other third-party payors such as HMO’s and health insurance carriers. Services provided to patients covered by third-party insurance companies are normally reimbursed at rates higher than Medicare or Medicaid rates. Patients covered by employer group health plans convert to Medicare after a maximum of 33 months. As of year-end 2002, the Medicare ESRD dialysis treatment rates were between $121 and $144 per treatment, or an overall average of $131 per treatment, excluding the administration of drugs.

 

The majority of our net earnings from dialysis services are derived from commercial payors, some of which pay at negotiated reimbursement rates and others which pay based on our usual and customary rates. The commercial reimbursement rates are under continual pressure as we negotiate contract rates with large HMO’s and insurance carriers. Additionally, as a patient transitions from commercial coverage to Medicare or Medicaid coverage, the reimbursement rates generally decline substantially.

 

Dialysis services revenues by payor type were as follows:

 

    

Year ended December 31,


 
    

2002


    

2001


    

2000


 

Percent of total dialysis revenue:

                    

Medicare

  

51

%

  

52

%

  

53

%

Medicaid

  

5

 

  

5

 

  

5

 

    

  

  

    

56

 

  

57

 

  

58

 

HMO’s, health insurance carriers and private patient payments

  

44

 

  

43

 

  

42

 

    

  

  

    

100

%

  

100

%

  

100

%

    

  

  

 

The average dialysis revenue recognized per treatment (excluding prior years’ services revenue) was $291, $278 and $256 for 2002, 2001 and 2000, respectively. The increase in average dialysis revenue per treatment in 2002 was principally due to increases in our standard fee schedules (impacting non-contract commercial revenue), changes in mix and intensity of physician-prescribed pharmaceuticals, continued improvements in revenue capture, billing and collecting operations, and payor contracting. The increase in 2001 was principally due to continued improvements in revenue realization due to improved clinical operations and billing and collection processes, and a 2.4% increase in the Medicare composite reimbursement rates.

 

The number of dialysis treatments increased 5.0% in 2002 and 6.3% in 2001, principally attributable to a non-acquired annual growth rate of approximately 4.0% for both years. We continue to expect the non-acquired growth rate to remain in the range of 3.0% to 5.0% through 2003. Acquisitions accounted for the balance of the increases in treatment volumes.

 

The prior years’ services revenue of $22 million in 2001 related to cash recoveries associated with prior years’ services and resulted from improvements in the Company’s billing and collecting operations.

 

24


 

Lab and other services

 

As discussed in Note 16 to the consolidated financial statements (Contingencies), our Florida-based laboratory subsidiary has been under an ongoing third-party carrier review for Medicare reimbursement claims since 1998. Prior to the third quarter 2002, no Medicare payments had been received since May 1998. Following a favorable ruling by an administrative law judge in June 2002 relating to review periods from January 1995 to March 1998, the carrier began releasing funds for lab services provided subsequent to May 2001. During the fourth quarter of 2002, the carrier also released funds related to review periods from April 1998 through May 2001. During the second half of 2002, the carrier paid us a total of $68.8 million, representing approximately 70% of the total outstanding prior Medicare lab billings for the period from January 1995 through June 2002. Approximately $10 million of these collections related to 2002 lab services provided through June 2002. We have recognized prior period services Medicare lab revenue as payments have been received based on our belief that the cumulative recoveries do not exceed the aggregate amount that we will ultimately recover and retain upon final review and settlement of the Medicare billings. At this time we expect no significant additional Medicare lab payments relating to prior periods unless and until the dispute over the remaining disallowed claims are resolved in our favor. In addition to the prior-period claims, the carrier also began processing billings for current period services in the third quarter of 2002. As a result, in addition to the $10 million of Medicare lab revenue related to the first half of 2002, we recognized approximately $11 million of current period Medicare lab revenue in the second half of 2002.

 

Management fee income

 

Management fee income represented less than 1% of total revenues for 2002 and 2001. Our fees are typically based on a percentage of revenue of the center that we manage and are established in the management contract. We managed 23 and 25 third-party dialysis centers as of year end 2002 and 2001.

 

Dialysis centers and lab expenses

 

Operating expenses consist of costs and expenses specifically attributable to the operations of dialysis centers and labs, including direct labor, drugs, medical supplies and other patient care service and support costs. Dialysis centers and lab operating expenses as a percentage of net operating revenue (excluding prior period services revenue) were 68%, 67% and 69% for 2002, 2001 and 2000, respectively. On a per-treatment basis, the operating expenses increased approximately $12 and $9 in 2002 and 2001. The increase in both years was principally due to higher labor and pharmaceutical costs, as well as revenue-impacting changes in the mix of physician-prescribed pharmaceuticals. Increases in revenue per treatment substantially offset these cost increases.

 

General and administrative expenses.    General and administrative expenses consist of those costs not specifically attributable to the dialysis centers and labs and include expenses for corporate and regional administration, including centralized accounting, billing and cash collection functions. General and administrative expenses as a percentage of net operating revenues (excluding prior period services revenue) were approximately 8.6%, 8.0% and 8.5% in 2002, 2001 and 2000, respectively. In absolute dollars, general and administrative expenses increased by approximately $25 million in 2002. The increase was principally due to higher labor costs, continued investments in infrastructure to develop new operating and billing systems, and higher legal costs relating to the laboratory and U.S. Attorney’s reviews (see discussion of contingencies below) and other proactive compliance initiatives.

 

Provision for uncollectible accounts receivable.    The provision for 2002 and 2001, net of recoveries, was $27 million and a net recovery of $3 million. Before considering cash recoveries and excluding prior period services revenue, the provisions for uncollectible accounts receivable were approximately 1.8% of current operating revenues in 2002 as compared to 2.0% in 2001 and 3% in 2000. During 2002 and 2001, we realized recoveries of $5 million and $35 million associated with aged accounts receivables that had been reserved in 1999. The recoveries and lower provisions in 2002 and 2001 resulted from continued improvements that we made in our billing and collecting processes.

 

25


 

Impairments and valuation adjustments.    We perform impairment or valuation reviews for our property and equipment, amortizable intangibles, and investments in and advances to third-party dialysis businesses whenever a change in condition indicates that a review is warranted. Such changes include changes in our business strategy and plans, the quality or structure of our relationships with our partners, or when an owned or third-party dialysis business experiences deteriorating operating performance or liquidity problems. Goodwill is routinely assessed for possible valuation impairment using fair value methodologies.

 

Impairments and valuation adjustments for 2002 consisted of a net loss of approximately $1 million associated with continental U.S. operations and a net gain of approximately $1.3 million associated with the sale of our remaining non-continental U.S. operations.

 

Other income (loss)

 

The net of other income and loss items were income of $5.8 million for 2002, $4.6 million for 2001 and a loss of $7.2 million in 2000. Interest income was $3.4 million, $3.2 million and $7.7 million for 2002, 2001 and 2000, respectively. In 2000, we had losses of $15.5 million related to the settlement of a securities lawsuit and the recognition of the foreign currency translation loss associated with the divestitures of the non-continental U.S. operations.

 

Debt expense

 

Debt expense for 2002, 2001 and 2000 consisted of interest expense of approximately $69, $70 and $113 million respectively, and the amortization of deferred financing costs of approximately $3 million in both 2002 and 2001 and $4 million in 2000. The slight reduction in interest expense in 2002 was the result of lower average interest rates offset by higher debt balances due to our debt restructuring and common stock purchases that occurred as part of our recapitalization plan, as discussed below.

 

Provision for income taxes

 

The provision for income taxes for 2002 represented an effective tax rate of 41.0% as compared to 43.4% in 2001 and 62.2% in 2000. The reduction in the effective tax rate in 2002 compared to 2001 was primarily due to overall lower state income tax rates, the elimination of book amortization not deductible for tax purposes and changes in tax valuation estimates. The high effective rate in 2000 resulted from the relatively low level of pre-tax earnings in relation to significant permanent differences in 2000, including non-deductible amortization and deferred tax valuation allowances.

 

Extraordinary items

 

In 2002, the extraordinary loss of $29.4 million, net of tax, related to our recapitalization plan which included retiring all our $225 million outstanding 9¼% Senior Subordinated Notes due 2011 and extinguishing our then existing senior credit facilities, as discussed below.

 

In 2001, the extraordinary gain of $1 million, net of tax, related to the write-off of deferred financing costs offset by the accelerated recognition of deferred interest rate swap liquidation gains as a result of debt refinancing.

 

In 2000, the extraordinary loss of $3.5 million, net of tax, related to the write-off of deferred financing costs associated with an early extinguishment of debt. In July 2000, we restructured our revolving and term credit facilities.

 

Projections for 2003

 

Our current projections for 2003, based on current conditions and trends, are for normal operating earnings before depreciation and amortization, debt expense and taxes, or EBITDA, to be in the range of $380 million to

 

26


$400 million. These projections and the underlying assumptions involve significant risks and uncertainties, and actual results may vary significantly from these current projections. These risks, among others, include those relating to possible reductions in private and government reimbursement rates, the concentration of profits generated from non-governmental payors and from the administration of physician-prescribed pharmaceuticals, changes in pharmaceutical practice patterns or reimbursement policies, and the ongoing review by the United States Attorney’s Office and the OIG. Additionally, the termination or restructuring of managed care contracts, medical director agreements or other arrangements may result in future impairments or otherwise negatively affect our operating results. We undertake no duty to update these projections, whether due to changes in current or expected trends, underlying market conditions, decisions of the United States Attorney’s Office, the DOJ or the OIG in any pending or future review of our business, or otherwise.

 

Liquidity and capital resources

 

Cash flow from operations during 2002 amounted to $342 million which included $64 million of prior period services recoveries. The non-operating cash flows were primarily associated with our recapitalization plan to restructure our debt and repurchase common stock, as discussed below, and a net investment of $121 million in acquisitions and new center developments, system infrastructure and other capital assets. During 2001 operating cash flow amounted to $265 million, which included $57 million of prior period services recoveries. Non-operating cash flows for 2001 included a net $118 million for acquisitions and capital asset expenditures, and $20 million in stock repurchases.

 

In the first quarter of 2002, we initiated a recapitalization plan to restructure our debt and repurchase common stock. In April 2002, we completed the initial phase of the recapitalization plan by retiring all of our $225 million outstanding 9¼% Senior Subordinated Notes due 2011 for $266 million. Concurrent with the retirement of this debt, we secured a new senior credit facility agreement in the amount of $1.115 billion. The excess of the consideration paid over the book value of the Senior Subordinated Notes and write-off of deferred financing costs associated with extinguishing the existing senior credit facilities and the notes resulted in an extraordinary loss of $29.4 million, net of tax. In June 2002, we completed the next phase of the recapitalization plan with the repurchase of 16,682,337 shares of our common stock for approximately $402 million, or $24.10 per share, through a modified dutch auction tender offer. In May 2002, our Board of Directors authorized the purchase of an additional $225 million of common stock over the next eighteen months. As of December 31, 2002, 7,699,440 shares had been acquired for $172 million under this authorization. No additional purchases have been made under this authorization since December 2002. For the year ended December 31, 2002, stock repurchases, including 2,945,700 shares acquired prior to initiating the recapitalization plan, amounted to $642 million for 27,327,477 shares, for a composite average of $23.50 per share.

 

The new senior credit facility secured during the second quarter of 2002 consists of a Term Loan A for $150 million, a Term Loan B for $850 million and a $115 million undrawn revolving credit facility, which includes up to $50 million available for letters of credit. During the second quarter of 2002, we borrowed all $850 million of the Term Loan B, and $842 million of the Term Loan B remained outstanding as of December 31, 2002. The Term Loan B bears interest equal to LIBOR plus 3.00%, which was a weighted average rate of 4.71% as of December 31, 2002. The interest rates under the Term Loan A, which was fully drawn during January 2003, and the revolving credit facility are equal to LIBOR plus a margin ranging from 1.5% to 2.75% based on our leverage ratio. The current margin is 2.25% for an effective rate of 3.61%. The aggregate annual principal payments for the entire outstanding term credit facility range from $11 million to $51 million in years one through five, and $403 million in each of years six and seven, with the balance due not later than 2009. The new senior credit facility is secured by all our personal property and that of all our wholly-owned subsidiaries. The new senior credit facility also contains financial and operating covenants including investment limitations.

 

During the second quarter of 2001 we issued $225 million of 9¼% Senior Subordinated Notes and completed a refinancing of our senior credit facilities. The net proceeds of these transactions were used to pay down amounts outstanding under our then existing senior credit facilities. The new senior credit facilities

 

27


consisted of two term loans (totaling $114 million as of December 31, 2001) and a $150 million revolving credit facility (undrawn as of December 31, 2001). Total outstanding debt amounted to $820 million at December 31, 2001, a reduction of $156 million during the year. In 2000, we negotiated a major restructuring of the credit facility and we were able to reduce the total outstanding debt by over $482 million from our operating cash flows and the proceeds from divesting our non-continental operations.

 

The continental U.S. accounts receivable balance at December 31, 2002 and 2001 represented approximately 70 and 72 days of net revenue, net of bad debt provision.

 

During 2002 we increased our capital expenditures by approximately $50 million over 2001, principally for new dialysis centers, relocations and expansions, and for major information technology systems and upgrades. We acquired a total of 11 centers and opened 19 new centers.

 

We believe that we will have sufficient liquidity and operating cash flows to fund our scheduled debt service and other obligations over the next twelve months.

 

Off-balance sheet arrangements and aggregate contractual obligations

 

In addition to the debt obligations reflected on our balance sheet, we have commitments associated with operating leases, letters of credit and our investments in third-party dialysis businesses. Nearly all of our facilities are leased. We have potential acquisition obligations for several jointly-owned centers, in the form of put options exercisable at the third-party owners’ discretion. These put obligations require us to purchase the third-party owners’ interests at either the appraised fair market value or a predetermined multiple of earnings or cash flow. The following is a summary of these contractual obligations and commitments as of December 31, 2002 (000’s):

 

    

Within One Year


  

1-3 Years


  

4-5 Years


  

After 5 Years


  

Total


Scheduled payments under contractual obligations:

                                  

Long-term debt

  

$

7,285

  

$

17,000

  

$

438,437

  

$

849,688

  

$

1,312,410

Capital lease obligations

  

 

693

  

 

698

  

 

2,380

  

 

3,049

  

 

6,820

Operating leases

  

 

48,916

  

 

88,026

  

 

69,832

  

 

88,655

  

 

295,429

    

  

  

  

  

    

$

56,894

  

$

105,724

  

$

510,649

  

$

941,392

  

$

1,614,659

    

  

  

  

  

Potential cash requirements under existing commitments:

                                  

Letters of credit

  

$

7,418

                       

$

7,418

Acquisition of dialysis centers

  

 

33,000

  

$

17,000

  

 

10,000

         

 

60,000

Working capital advances to managed and minority-owned centers

  

 

5,000

                       

 

5,000

    

  

  

  

  

    

$

45,418

  

$

17,000

  

$

10,000

  

$

—  

  

$

72,418

    

  

  

  

  

 

Contingencies

 

Health care provider revenues may be subject to adjustment as a result of (1) examination by government agencies or contractors, for which the resolution of any matters raised may take extended periods of time to finalize; (2) differing interpretations of government regulations by different fiscal intermediaries or regulatory authorities; (3) differing opinions regarding a patient’s medical diagnosis or the medical necessity of services provided; (4) retroactive applications or interpretations of governmental requirements; and (5) claims for refunds from private payors.

 

Our Florida-based laboratory subsidiary is the subject of a third-party carrier review of its Medicare reimbursement claims. The carrier has reviewed claims for six separate review periods. In 1998 the carrier issued

 

28


a formal overpayment determination in the amount of $5.6 million for the first review period (January 1995 to April 1996). The carrier also suspended all payments of Medicare claims from the laboratory beginning in May 1998. In 1999, the carrier issued a formal overpayment determination in the amount of $15.0 million for the second review period (May 1996 to March 1998). Subsequently, the carrier informed us that $16.1 million of the suspended claims for the third review period (April 1998 to August 1999), $11.6 million of the suspended claims for the fourth review period (August 1999 to May 2000), $2.9 million of the suspended claims for the fifth review period (June 2000 to December 2000) and $0.9 million of the suspended claims for the sixth review period (December 2000 through May 2001) were not properly supported by the prescribing physicians’ medical justification. The carrier’s allegations regarding improperly supported claims represented approximately 99%, 96%, 70%, 72%, 24% and 10%, respectively, of the tests the laboratory billed to Medicare for these six review periods.

 

We have disputed each of the carrier’s determinations and have provided supporting documentation of our claims. In addition to the formal appeal processes with the carrier and a federal administrative law judge, we also pursued resolution of this matter through meetings with representatives of the Centers for Medicare and Medicaid Services, or CMS, and the Department of Justice, or DOJ. We initially met with the DOJ in February 2001, at which time the DOJ requested additional information, which we provided in September 2001.

 

In June 2002 an administrative law judge ruled that the sampling procedures and extrapolations that the carrier used as the basis of its overpayment determinations for the first two review periods were invalid. This decision invalidated the carrier’s overpayment determinations for the first two review periods. The administrative law judge’s decision on the first two review periods does not apply to the remaining four review periods, as each review period is evaluated independently. Moreover, the carrier’s sampling procedures have varied from period to period, and the conclusions the judge arrived at with respect to the first two periods may not hold for the subsequent periods. The hearings before a carrier hearing officer for the third and fourth review periods are scheduled to take place in the second quarter of 2003.

 

During 2000 we stopped accruing Medicare revenue from this laboratory because of the uncertainties regarding both the timing of resolution and the ultimate revenue valuations. Following the favorable ruling by the administrative law judge in 2002 related to the first two review periods covering January 1995 to March 1998, the carrier lifted the payment suspension and began making payments in July 2002 for lab services provided subsequent to May 2001. After making its determination with respect to the fifth and sixth review periods in December 2002, the carrier paid the additional amounts that it is not disputing for the second through sixth review periods. As of December 31, 2002, we had received a total of $68.8 million, which represented approximately 70% of the total outstanding Medicare lab billings for the period from January 1995 through June 2002. Approximately $10 million of these collections related to 2002 lab services provided through June 2002. These cash collections were recognized as revenue in the quarter received. We will continue to recognize Medicare lab revenue associated with prior periods as cash collections actually occur, to the extent that cumulative recoveries do not exceed the aggregate amount that management believes we will ultimately recover upon final review and settlement of disputed billings.

 

In addition to processing prior period claims during the third quarter of 2002, the carrier also began processing billings for current period services on a timely basis. Based on these developments, we began recognizing estimated current period Medicare lab revenue in the third quarter of 2002. As a result, in addition to the $10 million of Medicare lab revenue related to the first half of 2002, we recognized approximately $11 million of current period Medicare lab revenue in the second half of 2002.

 

The carrier is also currently conducting a study of the utilization of dialysis-related laboratory services. During the study, the carrier has suspended all of its previously existing dialysis laboratory prepayment screens. The purpose of the study is to determine what ongoing program safeguards are appropriate. In its initial findings from the study, the carrier had determined that some of its prior prepayment screens were invalidating appropriate claims. We cannot determine what prepayment screens, post-payment review procedures,

 

29


documentation requirements or other program safeguards the carrier may yet implement as a result of its study. The carrier has also informed us that any claims that it reimburses during the study period may also be subject to post-payment review and refund if determined inappropriate.

 

The Medicare carrier for our Minnesota laboratory is conducting a post-payment review of Medicare reimbursement claims for the period January 1996 through December 1999. The scope of the review is similar to the review being conducted at our Florida laboratory. At this time, we are unable to determine how long it will take the carrier to complete this review. There is currently no overpayment determination or payment suspension with respect to the Minnesota laboratory. The DOJ also requested information with respect to this laboratory, which we have provided. Medicare revenues at the Minnesota laboratory, which was much smaller than the Florida laboratory, were approximately $15 million for the period under review. In November 2001, we closed the operations of this laboratory and combined them with our Florida laboratory.

 

In February 2001 the Civil Division of the United States Attorney’s Office for the Eastern District of Pennsylvania in Philadelphia contacted us and requested our cooperation in a review of some of our historical practices, including billing and other operating procedures and our financial relationships with physicians. We cooperated in this review and provided the requested records to the United States Attorney’s Office. In May 2002, we received a subpoena from the Philadelphia office of the Office of Inspector General of the Department of Health and Human Services, or OIG. The subpoena requires an update to the information we provided in our response to the February 2001 request, and also seeks a wide range of documents relating to pharmaceutical and other ancillary services provided to patients, including laboratory and other diagnostic testing services, as well as documents relating to our financial relationships with physicians and pharmaceutical companies. The subpoena covers the period from May 1996 to May 2002. We have provided the documents requested. This inquiry remains at an early stage. As it proceeds, the government could expand its areas of concern. If a court determines that there has been wrongdoing, the penalties under applicable statutes could be substantial.

 

In addition to the foregoing, we are subject to claims and suits in the ordinary course of business. Management believes that the ultimate resolution of these additional pending proceedings, whether the underlying claims are covered by insurance or not, will not have a material adverse effect on our financial condition, results of operations or cash flows.

 

Critical accounting estimates and judgements

 

Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States. These accounting principles require us to make estimates, judgements and assumptions that affect the reported amounts of revenues, expenses, assets, liabilities, and contingencies. All significant estimates, judgements and assumptions are developed based on the best information available to us at the time made and are regularly reviewed and updated when necessary. Actual results will generally differ from these estimates. Changes in estimates are reflected in our financial statements in the period of change based upon on-going actual experience trends, or subsequent settlements and realizations depending on the nature and predictability of the estimates and contingencies. Interim changes in estimates are generally applied prospectively within annual periods. Certain accounting estimates, including those concerning revenue recognition and provision for uncollectible accounts, impairments and valuation adjustments, and accounting for income taxes, are considered to be critical in evaluating and understanding our financial results because they involve inherently uncertain matters and their application requires the most difficult and complex judgements and estimates.

 

Revenue recognition and provision for uncollectible accounts

 

Revenues are recognized as services are provided to patients. Operating revenues consist primarily of reimbursement for dialysis and ancillary services to patients. A usual and customary fee schedule is maintained for our dialysis treatment and other patient services; however, actual collectible revenue is normally at a discount to the fee schedule. Medicare and Medicaid programs are billed at pre-determined net realizable rates per

 

30


treatment that are established by statute or regulation. Most non-governmental payors, including contracted managed care payors, are billed at our usual and customary rates, but a contractual allowance is recorded to adjust to the expected net realizable revenue for services provided. Contractual allowances along with provisions for uncollectible accounts are estimated based upon credit risks of third-party payors, contractual terms, inefficiencies in our billing and collection processes, regulatory compliance issues and historical collection experience. Revenue recognition uncertainties inherent in the Company’s operations are addressed in AICPA Statement of Position (SOP) No. 00-1 Auditing Health Care Third-Party Revenues and Related Receivables. As addressed in SOP No. 00-1, net revenue recognition and allowances for uncollectible billings require the use of estimates of the amounts that will actually be realized considering, among other items, retroactive adjustments that may be associated with regulatory reviews, audits, billing reviews and other matters.

 

Lab service revenues for current period dates of services are recognized at the estimated net realizable amounts to be received after considering possible retroactive adjustments that may be made as a result of the ongoing third-party carrier review. Prior-period services Medicare lab revenue is currently being recognized as cash collections actually occur, to the extent that the cumulative recoveries do not exceed the aggregate amount that we believe we will ultimately realize upon final review and settlement of the third-party carrier’s review.

 

Impairments of long-lived assets

 

We account for impairment of long-lived assets, which include property and equipment, investments, amortizable intangible assets and goodwill, in accordance with the provisions of SFAS No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets or SFAS No. 142 Goodwill and Other Intangible Assets, as applicable. An impairment review is performed annually or whenever a change in condition occurs which indicates that the carrying amounts of assets may not be recoverable. Such changes include changes in our business strategies and plans, changes in the quality or structure of our relationships with our partners and deteriorating operating performance of individual dialysis centers. We use a variety of factors to assess the realizable value of assets depending on their nature and use. Such assessments are primarily based upon the sum of expected future undiscounted net cash flows over the expected period the asset will be utilized, as well as market values and conditions. The computation of expected future undiscounted net cash flows can be complex and involves a number of subjective assumptions. Any changes in these factors or assumptions could impact the assessed value of an asset and result in an impairment charge equal to the amount by which its carrying value exceeds its actual or estimated fair value.

 

Accounting for income taxes

 

We estimate our income tax provision to recognize our tax expense for the current year and our deferred tax liabilities and assets for future tax consequences of events that have been recognized in our financial statements using current enacted tax laws. Deferred tax assets must be assessed based upon the likelihood of recoverability from future taxable income and to the extent that recovery is not likely, a valuation allowance is established. The allowance is regularly reviewed and updated for changes in circumstances that would cause a change in judgement about the realizability of the related deferred tax assets. These calculations and assessments involve complex estimates and judgements because the ultimate tax outcome can be uncertain or future events unpredictable.

 

Variable compensation accruals

 

We estimate variable compensation accruals monthly based upon the annual amounts expected to be earned and paid out resulting from the achievement of certain employee-specific and or corporate financial and operating goals. Our estimates, which include compensation incentives for bonuses, awards and benefit plan contributions, are updated periodically due to changes in our economic condition or cash flows that could ultimately impact the actual final award. Actual results may vary due to the subjective nature of fulfilling employee specific and or corporate goals as well as the final determination and approval of amounts by the Company’s Board of Directors.

 

31


 

Significant new accounting standards for 2002

 

Statement of Financial Accounting Standards (SFAS) No. 142 Goodwill and Other Intangible Assets became effective in 2002. Under SFAS No. 142, beginning in 2002 goodwill is no longer amortized, but is required to be assessed for possible valuation impairment as circumstances warrant and at least annually. An impairment charge must be recorded against current earnings to the extent that the book value of goodwill exceeds its fair value. We recognized no goodwill impairments upon transition to this standard. If this standard had been implemented at the beginning of 2000, amortization expense would have been reduced by $25 million and $27 million, net of tax, for 2001 and 2000. Net income and diluted net income per share would have been approximately $162 million or $1.76 per share and $41 million or $0.49 per share for 2001 and 2000, respectively.

 

SFAS No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets became effective in 2002. SFAS No. 144 superceded SFAS No. 121 Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. SFAS No. 144 allows different approaches in cash flow estimation, and extends discontinued operations treatment, previously applied only to operating segments, to more discrete business components. The impairment model under SFAS No. 144 is otherwise largely unchanged from SFAS No. 121, and adoption of this standard did not have a material effect on our financial statements.

 

SFAS No. 145 Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections will be effective for 2003. Under SFAS No. 145, gains or losses from extinguishment of debt will no longer be classified as extraordinary items, but will be included as a component of income from continuing operations. All comparable prior period extraordinary items will be reclassified for consistent presentation. Although the $29.4 million of extraordinary loss, net of tax, for 2002 will be reclassified in future financial statements as $49 million of ordinary expense before taxes, this classification change will have no impact on net income or net income per share.

 

FASB Interpretation No. 45 Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others was issued in November 2002. This Interpretation clarifies the requirements for a guarantor’s disclosures in its interim and annual financial statements about its obligations under certain guarantees that it has issued and which remain outstanding. The Interpretation also clarifies the requirements related to the recognition of a liability for the fair value of an obligation undertaken by the guarantor at the inception of the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The disclosure requirements are currently effective, while the recognition and initial measurement provisions will apply to guarantees issued or modified after December 31, 2002. We do not believe that these provisions will have a material impact on our financial statements.

 

SFAS No. 148 Accounting for Stock-based Compensation—Transition and Disclosure, which was issued in December 2002, provides alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation and also requires disclosures in interim as well as annual financial statements regarding our method of accounting for stock-based employee compensation and the effect of the method used on reported results. See Note 1 to our consolidated financial statements for this disclosure.

 

32


RISK FACTORS

 

This Form 10-K contains statements that are forward-looking statements within the meaning of the federal securities laws, including statements about our expectations, beliefs, intentions or strategies for the future. These forward-looking statements include statements regarding our expectations for treatment growth rates, revenue per treatment, expense growth, levels of the provision for uncollectible accounts receivable, earnings before depreciation and amortization, debt expense and taxes, and capital expenditures. We base our forward-looking statements on information currently available to us, and we do not intend to update these statements, whether as a result of changes in underlying factors, new information, future events or other developments.

 

These statements involve known and unknown risks and uncertainties, including risks resulting from economic and market conditions, the regulatory environment in which we operate, competitive activities and other business conditions. Our actual results may differ materially from results anticipated in these forward-looking statements. Important factors that could cause actual results to differ materially from the forward-looking statements include those set forth below. The risks discussed below are not the only ones facing our business.

 

If the percentage of our collections at or near our billed prices declines, then our revenues, cash flows and earnings would be substantially reduced.

 

Approximately 44% of our continental U.S. dialysis revenues are generated from patients who have private payors as the primary payor. A minority of these patients have insurance policies that reimburse us at or near our billed prices, which are significantly higher than Medicare rates. The majority of these patients have insurance policies that reimburse us at lower rates but, in most cases, higher than Medicare rates. We believe that pressure from private payors to decrease the rates they pay us may increase. If the percentage of collections at or near our billed prices decreases significantly, it would have a material adverse effect on our revenues, cash flows and earnings.

 

If the percentage of patients with insurance paying at or near our billed prices declines, then our revenues, cash flows and earnings would be substantially reduced.

 

Our revenue levels are sensitive to the mix of reimbursements from higher paying commercial plans to total reimbursements from all payor plans and program types. If there is a significant change in the number of patients under higher paying commercial plans relative to plans that pay at lower rates, for example a reduction in the average number of patients under indemnity and PPO plans compared with the average number of patients under HMO plans and government programs, it would negatively impact our revenues, cash flows and earnings.

 

If we are unable to renegotiate material contracts with managed care plans on acceptable terms, we may experience a decline in same center growth.

 

We have contracts with some large managed care plans that include unfavorable terms. Although we are attempting to renegotiate the terms of these contracts, we cannot predict whether we will reach agreement on new terms or whether we will renew these contracts. As a result, we may lose numerous patients of these managed care plans and experience a decline in our same center growth, which would negatively impact our revenues.

 

Changes in clinical practices and reimbursement rates or rules for EPO and other drugs could substantially reduce our revenue and earnings.

 

The administration of EPO and other drugs accounts for approximately one third of our net operating revenues. Changes in physician practice patterns and accepted clinical practices, changes in private and governmental reimbursement rates and rules, the introduction of new drugs and the conversion to alternate types of administration, for example from intravenous administration to subcutaneous or oral administration, that may also result in lower or less frequent dosages, could reduce our revenues and earnings from the administration of

 

33


EPO and other drugs. For example, some Medicare fiscal intermediaries are seeking to implement local medical review policies for EPO and vitamin D analogs that would effectively limit utilization of and reimbursement for these drugs.

 

Future declines, or the lack of further increases, in Medicare reimbursement rates would reduce our net income and cash flows.

 

Approximately 51% of our continental U.S. dialysis revenues are generated from patients who have Medicare as their primary payor. The Medicare ESRD program reimburses us for dialysis and ancillary services at fixed rates. Unlike many other Medicare programs, the Medicare ESRD program does not provide for periodic inflation increases in reimbursement rates. Increases of 1.2% in 2000 and 2.4% in 2001 were the first increases in the composite rate since 1991, and were significantly less than the cumulative rate of inflation since 1991. There was no increase in the composite rate for 2002. Increases in operating costs that are subject to inflation, such as labor and supply costs, have occurred and are expected to continue to occur with or without a compensating increase in reimbursement rates. We cannot predict the nature or extent of future rate changes, if any. To the extent these rates are not adjusted to keep pace with inflation, our net income and cash flows would be adversely affected.

 

Future changes in the structure of, and reimbursement rates under, the Medicare ESRD program could substantially reduce our operating earnings and cash flows.

 

In legislation enacted in December 2000, Congress mandated government studies on whether:

 

  The Medicare composite rate for dialysis should be modified to include an annual inflation increase—this study was due July 2002, but has not yet been delivered to Congress;

 

  The Medicare composite rate for dialysis should be modified to include additional services, such as laboratory and other diagnostic tests and the administration of EPO and other pharmaceuticals, in the composite rate—this study was due July 2002, but has not yet been delivered to Congress; and

 

  Reimbursement for many of the outpatient prescription drugs that we administer to dialysis patients should be changed from the historic rate of 95% of the average wholesale price, or AWP. This study was delivered to Congress but Congress has not acted upon it.

 

If Medicare began to include in its composite reimbursement rate any ancillary services that it currently reimburses separately, our revenue would decrease to the extent there was not a corresponding increase in that composite rate. In particular, Medicare revenue from EPO is approximately 25% of our total Medicare revenue. In January 2003, CMS implemented a new payment structure utilizing a single drug pricer for all drugs that Medicare reimburses, including many we administer. Based on the initial prices CMS has set, we do not expect our reimbursement under this single drug pricer in 2003 to differ materially from what it would have been under the AWP-based reimbursement structure. We expect, however, that CMS will change the prices set under this single drug pricer in the future or make other changes to the payment structure for these drugs. If EPO were included in the composite rate, and if the composite rate were not increased sufficiently, our operating earnings and cash flows could decrease substantially. Reductions in current reimbursement rates for EPO or other outpatient prescription drugs would also reduce our net earnings and cash flows.

 

Future declines in Medicaid reimbursement rates would reduce our net income and cash flows.

 

Approximately 5% of our continental U.S. dialysis revenues are generated from Medicaid payors. If state governments change Medicaid programs or the rates paid by those programs for our services, then our revenue and earnings may decline. Some of the states’ Medicaid programs have proposed eligibility changes or have announced that they are considering reductions in the rates for certain services. Any action to reduce the Medicaid coverage rules or reimbursement rates for dialysis and related services would adversely affect our revenue and earnings.

 

34


 

If a significant number of physicians were to cease referring patients to our dialysis centers, whether due to regulatory or other reasons, our revenue and earnings would decline.

 

If a significant number of physicians stop referring patients to our centers, it could have a material adverse effect on our revenue and earnings. Many physicians prefer to have their patients treated at centers where they or other members of their practice supervise the overall care provided as medical directors of the centers. As a result, the primary referral source for most of our centers is often the physician or physician group providing medical director services to the center. If a medical director agreement terminates, whether before or at the end of its term, and a new medical director is appointed, it may negatively impact the former medical director’s decision to treat his or her patients at our center. Additionally, the medical directors have no obligation to refer their patients to our centers.

 

Our medical director contracts are for fixed periods, generally five to ten years. Medical directors have no obligation to extend their agreements with us. In the twelve months ended December 31, 2002, we renewed the agreements with medical directors at 57 centers. In addition, as of December 31, 2002, there were 30 additional centers at which the medical director agreements required renewal on or before December 31, 2003.

 

We also may take actions to restructure existing relationships or take positions in negotiating extensions of relationships in order to assure compliance with anti-kickback and similar laws. These actions could negatively impact physicians’ decisions to extend their medical director agreements with us or to refer their patients to us. In addition, if the terms of an existing agreement were found to violate applicable laws, we may not be successful in restructuring the relationship, which could lead to the early termination of the agreement, or force the physician to stop referring patients to the centers.

 

If the current shortage of skilled clinical personnel or our high level of personnel turnover continues, we may experience disruptions in our business operations and increases in operating expenses.

 

We are experiencing increased labor costs and difficulties in hiring nurses due to a nationwide shortage of skilled clinical personnel. This shortage limits our ability to expand our operations. We also have a high personnel turnover rate in our dialysis centers. Turnover has been the highest among our technicians, nurses and unit secretaries. Recent efforts to reduce this turnover may not succeed. If we are not successful, or if we are unable to hire skilled clinical personnel when needed, our operations and our same center growth will be negatively impacted.

 

Adverse developments with respect to EPO could materially reduce our net income and cash flows and affect our ability to care for our patients.

 

Amgen is the sole supplier of EPO and may unilaterally decide to increase its price for EPO at any time. For example, Amgen unilaterally increased its base price for EPO by 3.9% in each of 2002, 2001 and 2000. Also, we cannot predict whether we will continue to receive the same discount structure for EPO that we currently receive, or whether we will continue to achieve the same levels of discounts within that structure as we have historically achieved. In addition, Amgen has developed a new product, Aranesp®, that may replace EPO or reduce its use with dialysis patients. We cannot predict if or when Aranesp® will be introduced to the U.S. dialysis market, what its cost and reimbursement structure will be, or how it may impact our revenues from EPO. Increases in the cost of EPO and the introduction of Aranesp® could have a material adverse effect on our net income and cash flows.

 

The pending federal review of some of our historical practices and third-party carrier review of our laboratory subsidiary could result in substantial penalties against us.

 

We are voluntarily cooperating with the Civil Division of the United States Attorney’s Office and OIG in Philadelphia in a review of some of our practices, including billing and other operating procedures, financial

 

35


relationships with physicians and pharmaceutical companies, and the provision of pharmaceutical and other ancillary services. In addition, our Florida laboratory and our now closed Minnesota laboratory are each the subject of a third-party carrier review of claims it has submitted for Medicare reimbursement. The DOJ has also requested and received information regarding these laboratories. We are unable to determine when these matters will be resolved, whether any additional areas of inquiry will be opened or any outcome of these matters, financial or otherwise. Any negative findings could result in substantial financial penalties against us and exclusion from future participation in the Medicare and Medicaid programs.

 

If we fail to adhere to all of the complex government regulations that apply to our business, we could suffer severe consequences that would substantially reduce our revenue and earnings.

 

Our dialysis operations are subject to extensive federal, state and local government regulations, including Medicare and Medicaid reimbursement rules and regulations, federal and state anti-kickback laws, and federal and state laws regarding the collection, use and disclosure of patient health information. The regulatory scrutiny of healthcare providers, including dialysis providers, has increased significantly in recent years. In addition, the frequency and intensity of Medicare certification surveys and inspections of dialysis centers has increased markedly since 2000.

 

We endeavor to comply with all of the requirements for receiving Medicare and Medicaid reimbursement and to structure all of our relationships with referring physicians to comply with the anti-kickback laws; however, the laws and regulations in this area are complex and subject to varying interpretations. In addition, our historic dependence on manual processes that vary widely across our network of dialysis centers exposes us to greater risk of errors in billing and other business processes.

 

Due to regulatory considerations unique to each of these states, all of our dialysis operations in New York and part of our dialysis operations in New Jersey are conducted through privately-owned companies to which we provide a broad range of administrative services. These operations account for approximately 7% of our continental U.S. dialysis revenues. We believe that we have structured these operations to comply with the laws and regulations of these states, but we can give no assurances that they will not be challenged.

 

If any of our operations are found to violate these or other government regulations, we could suffer severe consequences, including:

 

  Mandated practice changes that significantly increase operating expenses;

 

  Suspension of payments from government reimbursement programs;

 

  Refunds of amounts received in violation of law or applicable reimbursement program requirements;

 

  Loss of required government certifications or exclusion from government reimbursement programs;

 

  Loss of licenses required to operate healthcare facilities in some of the states in which we operate;

 

  Fines or monetary penalties for anti-kickback law violations, submission of false claims or other failures to meet reimbursement program requirements and patient privacy law violations; and

 

  Claims for monetary damages from patients who believe their protected health information has been used or disclosed in violation of federal or state patient privacy laws.

 

Our rollout of new information technology systems will significantly disrupt our billing and collection activity, may not work as planned and could have a negative impact on our results of operations and financial condition.

 

We will be continuing the rollout of new information technology systems and new processes to each of our dialysis centers over the next fifteen months. It is likely that this rollout will disrupt our billing and collection

 

36


activity and may cause other disruptions to our business operations, which may negatively impact our cash flows. Also, the new information systems may not work as planned or improve our billing and collection processes as expected. If they do not, we may have to spend substantial amounts to enhance or replace these systems.

 

Provisions in our charter documents and compensation programs we have adopted may deter a change of control that our stockholders would otherwise determine to be in their best interests.

 

Our charter documents include provisions which may deter hostile takeovers, delay or prevent changes of control or changes in our management, or limit the ability of our stockholders to approve transactions that they may otherwise determine to be in their best interests. These include provisions prohibiting our stockholders from acting by written consent, requiring 60 days advance notice of stockholder proposals or nominations to our Board of Directors and granting our Board of Directors the authority to issue up to five million shares of preferred stock and to determine the rights and preferences of the preferred stock without the need for further stockholder approval, and a poison pill that would substantially dilute the interest sought by an acquirer that our board of directors does not approve.

 

In addition, most of our outstanding employee stock options include a provision accelerating the vesting of the options in the event of a change of control. We have also adopted a change of control protection program for our employees who do not have a significant number of stock options, which provides for cash bonuses to the employees in the event of a change of control. Based on the shares of our common stock outstanding and the market price of our stock on December 31, 2002, these cash bonuses would total approximately $53 million. These compensation programs may affect the price an acquirer would be willing to pay.

 

These provisions could also discourage bids for our common stock at a premium and cause the market price of our common stock to decline.

 

37


Item 7A.    Quantitative and Qualitative Disclosures About Market Risk.

 

Interest rate sensitivity

 

The table below provides information about our financial instruments that are sensitive to changes in interest rates. For our debt obligations, the table presents principal repayments and current weighted average interest rates on these obligations as of December 31, 2002. For our debt obligations with variable interest rates, the rates presented reflect the current rates in effect at the end of 2002. These rates are based on LIBOR plus a margin of 3.0%.

 

    

Expected maturity date


  

Total


  

Fair
value


  

Average
interest
rate


 
    

2003


  

2004


  

2005


  

2006


  

2007


  

Thereafter


        
    

(dollars in millions)

 

Long-term debt:

                                                              

Fixed rate

                       

$

125

         

$

345

  

$

470

  

$

478

  

6.63

%

Variable rate

  

$

8

  

$

9

  

$

9

  

$

9

  

$

307

  

$

507

  

$

849

  

$

849

  

5.10

%

 

Our senior credit facility is based on a floating LIBOR interest rate plus a margin, which is reset periodically and can be locked in for a maximum of six months. As a result, our interest expense is subject to fluctuations as LIBOR interest rates change.

 

One means of assessing exposure to interest rate changes is duration-based analysis that measures the potential loss in net income resulting from a hypothetical increase in interest rates of 100 basis points across all variable rate maturities (sometimes referred to as a “parallel shift in the yield curve”). Under this model, with all else constant, it is estimated that such an increase would have reduced net income by approximately $3.5 million, $1.6 million and $4.7 million, net of tax, for the years ended December 31, 2002, 2001 and 2000, respectively.

 

The Company does not currently use any derivative financial instruments to hedge against interest rate exposure.

 

Exchange rate sensitivity

 

We are currently not exposed to any foreign currency exchange rate risk.

 

Item 8.    Financial Statements and Supplementary Data.

 

See the Index included at “Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.”

 

Item 9.    Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.

 

None.

 

38


PART III

 

Item 10.    Directors and Executive Officers of the Registrant.

 

The information required by this item will appear in, and is incorporated by reference from, the section entitled “Proposal No. 1. Election of Directors” under the subheading “Information concerning nominees to our board of directors” and the section entitled “Executive Officers, Compensation and Other Information” under the subheadings “Information concerning our executive officers” and “Section 16(a) beneficial ownership reporting compliance” included in our definitive proxy statement relating to our 2003 annual stockholder meeting.

 

Item 11.    Executive Compensation.

 

The information required by this item will appear in, and is incorporated by reference from, the section entitled “Proposal No. 1. Election of Directors” under the subheading “Compensation of directors” and the section entitled “Executive Officers, Compensation and Other Information” under the subheadings “Executive compensation,” “Employment agreements” and “Compensation committee interlocks and insider participation” included in our definitive proxy statement relating to our 2003 annual stockholder meeting. The compensation committee report and performance graph required by Items 402(k) and (l) of Regulation S-K are not incorporated herein.

 

Item 12.    Equity Compensation Plan Information.

 

The following table provides information about our common stock that may be issued upon the exercise of options, warrants and rights under all of our existing equity compensation plans and arrangements as of December 31, 2002, including the 1994 Equity Compensation Plan, the 1995 Equity Compensation Plan, the 1997 Equity Compensation Plan, the 1999 Equity Compensation Plan, the 1999 Non-Executive Officer and Non-Director Equity Compensation Plan, the Special Purpose Option Plan (RTC Plan), the 2002 Equity Compensation Plan, the Employee Stock Purchase Plan and the deferred stock unit arrangements. The material terms of each of these plans and arrangements are described in the notes to the December 31, 2002 consolidated financial statements. The 1999 Non-Executive Officer and Non-Director Equity Compensation Plan and the deferred stock unit arrangements were not required to be approved by our shareholders.

 

Plan category


    

Number of shares to be
issued upon exercise of
outstanding options,
warrants and rights


    

Weighted average
exercise price of
outstanding options,
warrants and rights


    

Number of shares remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))


 

Total of shares reflected in columns (a) and (c)


      

(a)

    

(b)

    

(c)

 

(d)

Equity compensation plans approved by shareholders

    

6,891,009

    

$

13.67

    

12,184,516

 

19,075,525

Equity compensation plans not requiring shareholder approval

    

3,221,353

    

$

12.56

    

995,951

 

4,217,304

      
    

    
 

Total

    

10,112,362

    

$

13.32

    

13,180,467

 

23,292,829

      
    

    
 

 

Other information required to be disclosed by item 12 will appear in, and is incorporated by reference from, the section entitled “Security Ownership of Principal Stockholders, Directors and Officers” included in our definitive proxy statement relating to our 2003 annual stockholder meeting.

 

39


 

Item 13.    Certain Relationships and Related Transactions.

 

The information required by this item will appear in, and is incorporated by reference from, the section entitled “Certain Relationships and Related Transactions” included in our definitive proxy statement relating to our 2003 annual stockholder meeting.

 

Item 14.    Controls and Procedures.

 

Management maintains disclosure controls and procedures designed to ensure that information required to be disclosed in the reports filed by the Company pursuant to the Securities Exchange Act of 1934, as amended, or Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and regulations, and that such information is accumulated and communicated to the Company’s management including its Chief Executive Officer and Chief Financial Officer as appropriate to allow for timely decisions regarding required disclosures. Management recognizes that these controls and procedures can provide only reasonable assurance of desired outcomes, and that estimates and judgements are still inherent in the process of maintaining effective controls and procedures.

 

Within 90 days of the date of this report, we carried out an evaluation, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures in accordance with the Exchange Act requirements. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective for timely identification and review of material information required to be included in the Company’s Exchange Act reports, including this report on Form 10-K.

 

We have established and maintain a system of internal controls designed to provide reasonable assurance that transactions are executed with proper authorization and are properly recorded in the Company’s records, and that errors or irregularities that could be material to the financial statements are prevented or would be detected within a timely period. Internal controls are periodically reviewed and revised if necessary, and are augmented by appropriate oversight and audit functions.

 

Subsequent to the date that these controls were last evaluated by the Chief Executive Officer and Chief Financial Officer, we have not made any significant changes in the design and operation of our internal controls, nor have there been changes in other factors that could significantly affect the overall effectiveness of the control environment to process, record and disclose transactions.

 

40


PART IV

 

Item 15.    Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

 

(a) Documents filed as part of this Report:

 

(1)  Index to Financial Statements:

 

    

Page


Report of Management

  

F-1

Independent Auditors’ Report

  

F-2

Consolidated Balance Sheets as of December 31, 2002 and December 31, 2001

  

F-3

Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2002, 2001 and 2000

  

F-4

Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001 and 2000

  

F-5

Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2002, 2001 and
2000

  

F-6

Notes to Consolidated Financial Statements

  

F-7

(2)  Index to Financial Statement Schedules:

    

Independent Auditors’ Report on Financial Statement Schedule

  

S-3

Schedule II—Valuation and Qualifying Accounts

  

S-4

 

(3)  Exhibits:

 

3.1

  

Amended and Restated Certificate of Incorporation of Total Renal Care Holdings, Inc., or TRCH, dated December 4, 1995.(1)

    

3.2

  

Certificate of Amendment of Certificate of Incorporation of TRCH, dated February 26, 1998.(2)

    

3.3

  

Certificate of Amendment of Certificate of Incorporation of DaVita Inc. (formerly Total Renal Care Holdings, Inc.), dated October 5, 2000.(10)

    

3.4

  

Bylaws of TRCH, dated October 6, 1995.(3)

    

4.1

  

Indenture, dated June 12, 1996 by Renal Treatment Centers, Inc., or RTC, to PNC Bank including form of RTC Note.(4)

    

4.2

  

First Supplemental Indenture, dated as of February 27, 1998, among RTC, TRCH and PNC Bank under the 1996 Indenture.(2)

    

4.3

  

Second Supplemental Indenture, dated as of March 31, 1998, among RTC, TRCH and PNC Bank under the 1996 Indenture.(2)

    

4.4

  

Indenture, dated as of November 18, 1998, between TRCH and United States Trust Company of New York, as trustee, and form of Note.(5)

    

4.5

  

Rights Agreement, dated as of November 14, 2002, between DaVita Inc. and the Bank of New York, as Rights Agent. (6)

    

10.1

  

Employment Agreement, dated as of October 18, 1999, by and between TRCH and Kent J. Thiry.(7)*

    

10.2

  

Amendment to Mr. Thiry’s Employment Agreement, dated May 20, 2000.(8)*

    

 

41


10.3  

  

Second Amendment to Mr. Thiry’s Employment Agreement, dated November 28, 2000.(9)*

    

10.4  

  

Employment Agreement, dated as of November 29, 1999, by and between TRCH and Gary W. Beil.(9)*

    

10.5  

  

Employment Agreement, dated as of July 19, 2000, by and between TRCH and Charles J. McAllister.(9)*

    

10.6  

  

Employment Agreement, effective as of April 19, 2000, by and between TRCH and Steven J. Udicious.(10)*

    

10.7  

  

Employment Agreement, dated as of June 15, 2000, by and between DaVita Inc. and Joseph Mello.(11)*

    

10.8  

  

Employment Agreement, dated as of April 1, 2001, by and between DaVita Inc. and Richard K. Whitney.(12)*

    

10.9  

  

Employment Agreement, dated as of October 15, 2002, by and between DaVita Inc. and Lori S. Richardson-Pellicioni.ü*

    

10.10

  

Second Amended and Restated 1994 Equity Compensation Plan.(13) *

    

10.11

  

First Amended and Restated 1995 Equity Compensation Plan.(13)*

    

10.12

  

First Amended and Restated 1997 Equity Compensation Plan.(13)*

    

10.13

  

First Amended and Restated Special Purpose Option Plan.(13)*

    

10.14

  

1999 Equity Compensation Plan.(14)*

    

10.15

  

Amended and Restated 1999 Equity Compensation Plan.(15)*

    

10.16

  

First Amended and Restated Total Renal Care Holdings, Inc. 1999 Non-Executive Officer and Non-Director Equity Compensation Plan.ü

    

10.17

  

2002 Equity Compensation Plan.(16)*

    

10.18

  

Credit Agreement, dated as of May 3, 2001, by and among DaVita Inc., the lenders party thereto, Bank of America, N.A., as the Administrative Agent, Banc of America Securities LLC, as Joint Book Manager and Credit Suisse First Boston Corporation, as Joint Book Manager and Syndication Agent (the “Credit Agreement”).(17)

    

10.19

  

Amendment No. 1, dated as of December 4, 2001, to the Credit Agreement by and among DaVita Inc., the lenders party thereto, Bank of America, N.A., as the Administrative Agent, Banc of America Securities LLC, as Joint Book Manager and Credit Suisse First Boston Corporation, as Joint Book Manager and Syndication Agent.(10)

    

10.20

  

Security Agreement, dated as of May 3, 2001, made by DaVita Inc. and the subsidiaries of DaVita Inc. named therein to Bank of America, N.A., as the Collateral Agent for the lenders party to the Credit Agreement.(17)

    

10.21

  

Subsidiary Guaranty, dated as of May 3, 2001, made by the subsidiaries of DaVita Inc. named therein in favor of the lenders party to the Credit Agreement.(17)

    

10.22

  

Guaranty, entered into as of March 31, 1998, by TRCH in favor of and for the benefit of PNC Bank.(2)

    

10.23

  

Credit Agreement, dated as of April 26, 2002, by and among DaVita Inc., the lenders party thereto, Credit Suisse First Boston Corporation as Administrative Agent and Joint Book Manager, Banc of America Securities LLC as Joint Book Manager and Bank of America, N.A., as Syndication Agent (“the Credit Agreement”).(12)**

    

10.24

  

Amendment No. 1, dated as of May 9, 2002, to the Credit Agreement by and among DaVita Inc., the lenders party thereto, Credit Suisse First Boston Corporation as Administrative Agent and Joint Book Manager, Banc of America Securities LLC as Joint Book Manager and Bank of America, N.A., as Syndication Agent.(12)

    

 

42


10.25

  

Security Agreement, dated as of April 26, 2002, made by and among DaVita Inc. and the subsidiaries of DaVita Inc. named therein to Credit Suisse First Boston, Cayman Islands Branch, as the Collateral Agent for the lenders party to the Credit Agreement.(12)

    

10.26

  

Subsidiary Guarantee, dated as of April 26, 2002, made by the subsidiaries of DaVita Inc. named therein in favor of the lenders party to the Credit Agreement.(12)

    

10.27

  

Amendment #4, dated November 16, 2001, to Agreement No. 19990110 between Amgen Inc. and Total Renal Care, Inc. (10)**

    

10.28

  

Agreement No. 20010259, dated November 16, 2001 between Amgen USA Inc. and Total Renal Care, Inc.(10)**

    

10.29

  

Amendment #1, dated December 31, 2002, to Agreement No. 20010259 between Amgen USA Inc. and Total Renal Care, Inc.ü**

    

12.1

  

Statement re: Computation of Ratios of Earnings to Fixed Charges. ü

    

21.1

  

List of our subsidiaries. ü

    

23.1

  

Consent of KPMG LLP.ü

    

24.1

  

Powers of Attorney with respect to DaVita.ü(Included on Page II-1)

    

99.1

  

Certification of the Chief Executive Officer, dated February 27, 2003, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü

    

99.2

  

Certification of the Chief Financial Officer, dated February 27, 2003, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü

    

ü Included in this filing.
* Management contract or executive compensation plan or arrangement.
** Portions of this exhibit are subject to a request for confidential treatment and have been redacted and filed separately with the SEC.
(1) Filed on March 18, 1996 as an exhibit to our Transitional Report on Form 10-K for the transition period from June 1, 1995 to December 31, 1995.
(2) Filed on March 31, 1998 as an exhibit to our Form 10-K for the year ended December 31, 1997.
(3) Filed on October 24, 1995 as an exhibit to Amendment No. 2 to our Registration Statement on Form S-1 (Registration Statement No. 33-97618).
(4) Filed on August 5, 1996 as an exhibit to RTC’s Form 10-Q for the quarter ended June 30, 1996.
(5) Filed on December 18, 1998 as an exhibit to our Registration Statement on Form S-3 (Registration Statement No. 333-69227).
(6) Filed on November 19, 2002 as an exhibit to our Form 8-K reporting the adoption of the Rights Agreement.
(7) Filed on November 15, 1999 as an exhibit to our Form 10-Q for the quarter ended September 30, 1999.
(8) Filed on August 14, 2000 as an exhibit to our Form 10-Q for the quarter ended June 30, 2000.
(9) Filed on March 20, 2001 as an exhibit to our Form 10-K for the year ended December 31, 2000.
(10) Filed on March 1, 2002 as an exhibit to our Form 10-K for the year ended December 31, 2001.
(11) Filed on August 15, 2001 as an exhibit to our Form 10-Q for the quarter ended June 30, 2001.
(12) Filed on May 14, 2002 as an exhibit to our Form 10-Q for the quarter ended March 31, 2002.
(13) Filed on March 29, 2000 as an exhibit to our Form 10-K for the year ended December 31, 1999.
(14) Filed on February 18, 2000 as an exhibit to our Registration Statement on Form S-8 (Registration Statement No. 333-30736).
(15) Filed on April 27, 2001 as an exhibit to the Definitive Proxy Statement for our 2001 Annual Meeting of Stockholders.
(16) Filed on March 14, 2002 as an exhibit to the Definitive Proxy Statement for our 2002 Annual Meeting of Stockholders.
(17) Filed on June 8, 2001 as an exhibit to our Registration Statement on Form S-4 (Registration Statement No. 333-62552).

 

43


 

(b) Reports on Form 8-K:

 

Current report on Form 8-K dated November 18, 2002, which was filed on November 19, 2002, reporting under Item 5, Other Events, that upon approval by the Board of Directors of the Registrant on November 14, 2002, the Registrant adopted a Rights Agreement. A copy of the Rights Agreement was attached to the Form 8-K as Exhibit 4.1.

 

44


 

DAVITA INC.

 

REPORT OF MANAGEMENT

 

Management is responsible for the preparation, integrity and fair presentation of the accompanying consolidated financial statements of DaVita Inc. and its subsidiaries. The financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and include amounts that are based on management’s best estimates and judgements. Financial information included elsewhere in this Annual Report on Form 10-K for the year ended December 31, 2002 is consistent with that in the financial statements.

 

Management has established and maintains a system of internal controls designed to provide reasonable assurance as to the integrity, reliability and accuracy of the financial statements. Management also maintains disclosure controls and procedures designed to accumulate, process and report materially accurate information within the time periods specified in the Securities and Exchange Commission’s rules and regulations.

 

Internal controls and disclosure controls are periodically reviewed and revised if necessary, and are augmented by appropriate oversight and audit functions, as well as an active Code of Conduct requiring adherence to the highest levels of personal and professional integrity. Management however, recognizes that these controls and procedures can provide only reasonable assurance of desired outcomes.

 

The consolidated financial statements have been audited and reported on by our independent auditors, KPMG LLP, who report directly to the Audit Committee of the Board of Directors. The Audit Committee, which is comprised solely of independent directors, monitors the integrity of the Company’s financial reporting process and systems of internal controls and disclosure controls, monitors the independence and performance of the Company’s independent auditors, ensures the effectiveness of an anonymous compliance hotline available to all employees, and holds regular meetings without the presence of management.

 

The Company has carried out an evaluation of the effectiveness of the design and operations of the Company’s internal controls and disclosure controls and procedures in accordance with the Exchange Act requirements. Based upon that evaluation, management has concluded that the Company’s internal controls are adequate to provide reasonable assurance that transactions are fairly presented in the consolidated financial statements, and that disclosure controls and procedures are effective for timely identification and review of material information required to be included in the Company’s Exchange Act reports, including this Annual Report.

 

Kent J. Thiry

 

Richard K. Whitney

 

Gary W. Beil

Chief Executive Officer

 

Chief Financial Officer

 

Vice President and Controller

 

 

F-1


 

INDEPENDENT AUDITORS’ REPORT

 

The Board of Directors and Shareholders

DaVita Inc.

 

We have audited the accompanying consolidated balance sheets of DaVita Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income and comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the consolidated financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of DaVita Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Note 1 to the consolidated financial statements, effective July 1, 2001, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations,” and certain provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” as required for goodwill and intangible assets resulting from business combinations consummated after June 30, 2001. In 2002, the Company changed its method of accounting for goodwill and other intangible assets for all other business combinations.

 

/s/    KPMG LLP

 

Seattle, Washington

February 21, 2003

 

F-2


 

DAVITA INC.

 

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except per share data)

 

    

December 31,


 
    

2002


    

2001


 

ASSETS


                 

Cash and cash equivalents

  

$

96,475

 

  

$

36,711

 

Accounts receivable, less allowance of $48,927 and $52,475

  

 

344,292

 

  

 

333,546

 

Inventories

  

 

34,929

 

  

 

34,901

 

Other current assets

  

 

28,667

 

  

 

9,364

 

Deferred income taxes

  

 

40,163

 

  

 

60,142

 

    


  


Total current assets

  

 

544,526

 

  

 

474,664

 

Property and equipment, net

  

 

298,475

 

  

 

252,778

 

Amortizable intangibles, net

  

 

63,159

 

  

 

73,108

 

Investments in third-party dialysis businesses

  

 

3,227

 

  

 

4,346

 

Other long-term assets

  

 

1,520

 

  

 

2,027

 

Goodwill

  

 

864,786

 

  

 

855,760

 

    


  


    

$

1,775,693

 

  

$

1,662,683

 

    


  


LIABILITIES AND SHAREHOLDERS’ EQUITY


                 

Accounts payable

  

$

77,890

 

  

$

74,630

 

Other liabilities

  

 

101,389

 

  

 

111,164

 

Accrued compensation and benefits

  

 

95,435

 

  

 

88,826

 

Current portion of long-term debt

  

 

7,978

 

  

 

9,034

 

Income taxes payable

  

 

9,909

 

  

 

15,027

 

    


  


Total current liabilities

  

 

292,601

 

  

 

298,681

 

Long-term debt

  

 

1,311,252

 

  

 

811,190

 

Other long-term liabilities

  

 

9,417

 

  

 

5,012

 

Deferred income taxes

  

 

65,930

 

  

 

23,441

 

Minority interests

  

 

26,229

 

  

 

20,722

 

Commitments and contingencies

                 

Shareholders’ equity:

                 

Preferred stock ($0.001 par value, 5,000,000 shares authorized; none issued)

                 

Common stock ($0.001 par value, 195,000,000 shares authorized; 88,874,896 and 85,409,037 shares issued)

  

 

89

 

  

 

85

 

Additional paid-in capital

  

 

519,369

 

  

 

467,904

 

Retained earnings

  

 

213,337

 

  

 

56,008

 

Treasury stock, at cost (28,216,177 and 888,700 shares)

  

 

(662,531

)

  

 

(20,360

)

    


  


Total shareholders’ equity

  

 

70,264

 

  

 

503,637

 

    


  


    

$

1,775,693

 

  

$

1,662,683

 

    


  


 

See notes to consolidated financial statements.

 

F-3


 

DAVITA INC.

 

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(dollars in thousands, except per share data)

 

    

Year ended December 31,


 
    

2002


    

2001


    

2000


 

Net operating revenues

  

$

1,854,632

 

  

$

1,650,753

 

  

$

1,486,302

 

Operating expenses:

                          

Dialysis centers and labs

  

 

1,217,685

 

  

 

1,100,652

 

  

 

1,032,153

 

General and administrative

  

 

154,453

 

  

 

129,194

 

  

 

123,624

 

Depreciation and amortization

  

 

64,665

 

  

 

105,209

 

  

 

111,605

 

Provision for uncollectible accounts

  

 

26,877

 

  

 

(2,294

)

  

 

39,649

 

Impairments and valuation adjustments

  

 

(380

)

           

 

4,556

 

    


  


  


Total operating expenses

  

 

1,463,300

 

  

 

1,332,761

 

  

 

1,311,587

 

    


  


  


Operating income

  

 

391,332

 

  

 

317,992

 

  

 

174,715

 

Other income (loss), net

  

 

5,790

 

  

 

4,644

 

  

 

(7,201

)

Debt expense

  

 

71,636

 

  

 

72,438

 

  

 

116,637

 

Minority interests in income of consolidated subsidiaries

  

 

(9,299

)

  

 

(9,260

)

  

 

(5,942

)

    


  


  


Income before income taxes and extraordinary items

  

 

316,187

 

  

 

240,938

 

  

 

44,935

 

Income tax expense

  

 

129,500

 

  

 

104,600

 

  

 

27,960

 

    


  


  


Income before extraordinary items

  

 

186,687

 

  

 

136,338

 

  

 

16,975

 

Extraordinary (loss) gain related to early extinguishment of debt, net of tax of $19,572 in 2002, $(652) in 2001 and $2,222
in 2000

  

 

(29,358

)

  

 

977

 

  

 

(3,490

)

    


  


  


Net income

  

$

157,329

 

  

$

137,315

 

  

$

13,485

 

    


  


  


                            

Basic earnings per common share:

                          

Income before extraordinary items

  

$

2.60

 

  

$

1.63

 

  

$

0.21

 

Extraordinary (loss) gain, net of tax

  

 

(0.41

)

  

 

0.01

 

  

 

(0.04

)

    


  


  


Net income

  

$

2.19

 

  

$

1.64

 

  

$

0.17

 

    


  


  


                            

Diluted earnings per common share:

                          

Income before extraordinary items

  

$

2.28

 

  

$

1.51

 

  

$

0.20

 

Extraordinary (loss) gain, net of tax

  

 

(0.32

)

  

 

0.01

 

  

 

(0.04

)

    


  


  


Net income

  

$

1.96

 

  

$

1.52

 

  

$

0.16

 

    


  


  


Weighted average shares for earnings per share:

                          

Basic

  

 

71,831,000

 

  

 

83,768,000

 

  

 

81,581,000

 

    


  


  


Diluted

  

 

90,480,000

 

  

 

103,454,000

 

  

 

83,157,000

 

    


  


  


                            

STATEMENTS OF COMPREHENSIVE INCOME

                          

Net income

  

$

157,329

 

  

$

137,315

 

  

$

13,485

 

Other comprehensive income:

                          

Foreign currency translation

                    

 

4,718

 

    


  


  


Comprehensive income

  

$

157,329

 

  

$

137,315

 

  

$

18,203

 

    


  


  


 

See notes to consolidated financial statements.

 

F-4


DAVITA INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

 

    

Year ended December 31,


 
    

2002


    

2001


    

2000


 

Cash flows from operating activities:

                          

Net income

  

$

157,329

 

  

$

137,315

 

  

$

13,485

 

Adjustments to reconcile net income to cash provided by operating activities:

                          

Depreciation and amortization

  

 

64,665

 

  

 

105,209

 

  

 

111,605

 

Impairments and valuation adjustments

  

 

(380

)

           

 

4,556

 

(Gain) loss on divestitures

  

 

(771

)

  

 

1,031

 

  

 

(2,875

)

Deferred income taxes

  

 

62,468

 

  

 

10,093

 

  

 

8,906

 

Non-cash debt expense

  

 

3,217

 

  

 

2,396

 

  

 

3,008

 

Stock option expense and tax benefits

  

 

22,212

 

  

 

17,754

 

  

 

2,908

 

Equity investment losses (income)

  

 

(1,791

)

  

 

(3,228

)

  

 

931

 

Foreign currency translation loss

                    

 

4,718

 

Minority interests in income of consolidated subsidiaries

  

 

9,299

 

  

 

9,260

 

  

 

5,942

 

Distributions to minority interests

  

 

(6,165

)

  

 

(7,942

)

  

 

(6,564

)

Extraordinary loss (gain)

  

 

29,358

 

  

 

(977

)

  

 

3,490

 

Changes in operating assets and liabilities, net of effect of acquisitions and divestitures:

                          

Accounts receivable

  

 

(17,699

)

  

 

(37,167

)

  

 

59,564

 

Inventories

  

 

(342

)

  

 

(13,575

)

  

 

9,402

 

Other current assets

  

 

(19,089

)

  

 

3,321

 

  

 

15,150

 

Other long-term assets

  

 

527

 

  

 

227

 

  

 

2,683

 

Accounts payable

  

 

10,822

 

  

 

(3,906

)

  

 

(28,716

)

Accrued compensation and benefits

  

 

6,837

 

  

 

17,990

 

  

 

26,365

 

Other current liabilities

  

 

2,585

 

  

 

9,728

 

  

 

19,445

 

Income taxes

  

 

14,455

 

  

 

17,105

 

  

 

45,473

 

Other long-term liabilities

  

 

4,458

 

  

 

157

 

  

 

1,608

 

    


  


  


Net cash provided by operating activities

  

 

341,995

 

  

 

264,791

 

  

 

301,084

 

Cash flows from investing activities:

                          

Additions of property and equipment, net

  

 

(102,712

)

  

 

(51,233

)

  

 

(41,088

)

Acquisitions and divestitures, net

  

 

(18,511

)

  

 

(66,939

)

  

 

1,120

 

Divestitures of non-continental U.S. operations

                    

 

133,177

 

Investments in and advances to affiliates, net

  

 

5,064

 

  

 

25,217

 

  

 

488

 

Intangible assets

  

 

(342

)

  

 

(11

)

  

 

(342

)

    


  


  


Net cash (used in) provided by investing activities

  

 

(116,501

)

  

 

(92,966

)

  

 

93,355

 

    


  


  


Cash flows from financing activities:

                          

Borrowings

  

 

2,354,105

 

  

 

1,709,996

 

  

 

1,913,893

 

Payments on long-term debt

  

 

(1,855,199

)

  

 

(1,866,232

)

  

 

(2,390,929

)

Debt redemption premium

  

 

(40,910

)

                 

Deferred financing costs

  

 

(10,812

)

  

 

(9,285

)

  

 

(3,092

)

Interest rate swap liquidation proceeds

                    

 

6,257

 

Net proceeds from issuance of common stock

  

 

29,257

 

  

 

19,560

 

  

 

2,658

 

Purchase of treasury shares

  

 

(642,171

)

  

 

(20,360

)

        
    


  


  


Net cash used in financing activities

  

 

(165,730

)

  

 

(166,321

)

  

 

(471,213

)

    


  


  


Net increase (decrease) in cash and cash equivalents

  

 

59,764

 

  

 

5,504

 

  

 

(76,774

)

Cash and cash equivalents at beginning of year

  

 

36,711

 

  

 

31,207

 

  

 

107,981

 

    


  


  


Cash and cash equivalents at end of year

  

$

96,475

 

  

$

36,711

 

  

$

31,207

 

    


  


  


 

See notes to consolidated financial statements.

 

F-5


DAVITA INC.

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(in thousands)

 

    

Common Stock


 

Additional paid-in capital


    

Notes receivable from shareholders


   

Retained earnings (deficit)


   

Treasury Stock


    

Accumulated other comprehensive income (loss)


   

Total


 
    

Shares


  

Amount


        

Shares


   

Amount


      

Balance at December 31, 1999

  

81,193

  

$

81

 

$

426,025

 

  

$

(192

)

 

$

(94,792

)

                

$

(4,718

)

 

$

326,404

 

Shares issued to employees and others

  

126

        

 

720

 

                                         

 

720

 

Options exercised

  

817

  

 

1

 

 

2,080

 

                                         

 

2,081

 

Repayment of notes receivable, net of interest accrued

                      

 

109

 

                                

 

109

 

Income tax benefit on stock options exercised

             

 

1,977

 

                                         

 

1,977

 

Stock option expense (benefit)

             

 

(126

)

                                         

 

(126

)

Foreign currency translation

                                                     

 

4,718

 

 

 

4,718

 

Net income

                              

 

13,485

 

                        

 

13,485

 

    
  

 


  


 


 

 


  


 


Balance at December 31, 2000

  

82,136

  

 

82

 

 

430,676

 

  

 

(83

)

 

 

(81,307

)

                

 

—  

 

 

 

349,368

 

Shares issued to employees and others

  

132

        

 

602

 

                                         

 

602

 

Options exercised

  

3,141

  

 

3

 

 

18,872

 

                                         

 

18,875

 

Repayment of notes receivable, net of interest accrued

                      

 

83

 

                                

 

83

 

Income tax benefit on stock options exercised

             

 

17,087

 

                                         

 

17,087

 

Stock option expense

             

 

667

 

                                         

 

667

 

Net income

                              

 

137,315

 

                        

 

137,315

 

Treasury stock purchases

                                      

(889

)

 

$

(20,360

)

          

 

(20,360

)

    
  

 


  


 


 

 


  


 


Balance at December 31, 2001

  

85,409

  

 

85

 

 

467,904

 

  

 

—  

 

 

 

56,008

 

 

(889

)

 

 

(20,360

)

  

 

—  

 

 

 

503,637

 

Shares issued to employees and others

  

45

        

 

798

 

                                         

 

798

 

Options exercised

  

3,421

  

 

4

 

 

28,455

 

                                         

 

28,459

 

Income tax benefit on stock options exercised

             

 

22,150

 

                                         

 

22,150

 

Stock option expense

             

 

62

 

                                         

 

62

 

Net income

                              

 

157,329

 

                        

 

157,329

 

Treasury stock purchases

                                      

(27,327

)

 

 

(642,171

)

          

 

(642,171

)

    
  

 


  


 


 

 


  


 


Balance at December 31, 2002

  

88,875

  

$

89

 

$

519,369

 

  

$

—  

 

 

$

213,337

 

 

(28,216

)

 

$

(662,531

)

  

$

—  

 

 

$

70,264

 

    
  

 


  


 


 

 


  


 


 

See notes to consolidated financial statements.

 

F-6


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

 

 

1.    Organization and summary of significant accounting policies

 

Organization

 

DaVita Inc. operates kidney dialysis centers and provides related medical services primarily in dialysis centers and in contracted hospitals across the United States. These operations represent a single business segment. See Note 18 regarding the Company’s divestiture of its operations outside the continental United States during 2000.

 

Basis of presentation

 

These consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States. The financial statements include the Company’s subsidiaries and partnerships that are wholly-owned, majority-owned, or in which the Company maintains a controlling financial interest. All significant intercompany transactions and balances have been eliminated. Non-consolidated equity investments are recorded under the equity or cost method of accounting as appropriate. Prior year balances and amounts have been classified to conform to the current year presentation.

 

Use of estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the use of estimates and assumptions that affect the reported amounts of revenues, expenses, assets, liabilities and contingencies. Although actual results in subsequent periods will generally differ from these estimates, such estimates are developed based on the best information available to management and management’s best judgements at the time made. All significant assumptions and estimates underlying the reported amounts in the financial statements and accompanying notes are regularly reviewed and updated. Changes in estimates are reflected in the financial statements based upon on-going actual experience trends, or subsequent settlements and realizations depending on the nature and predictability of the estimates and contingencies. Interim changes in estimates are generally applied prospectively within annual periods.

 

The most significant assumptions and estimates underlying these financial statements and accompanying notes generally involve revenue recognition and provisions for uncollectible accounts, impairments and valuation adjustments, accounting for income taxes and variable compensation accruals. Specific estimating risks and contingencies are further addressed in these notes to the consolidated financial statements.

 

Net operating revenues

 

Revenues are recognized as services are provided to patients. Operating revenues consist primarily of reimbursement for dialysis and ancillary services to patients. A usual and customary fee schedule is maintained for dialysis treatments and other patient services; however, actual collectible revenue is normally at a discount to the fee schedule. Medicare and Medicaid programs are billed at pre-determined net realizable rates per treatment that are established by statute or regulation. Most non-governmental payors, including contracted managed care payors, are billed at our usual and customary rates, but a contractual allowance is recorded to adjust to the expected net realizable revenue for services provided. Contractual allowances along with provisions for uncollectible accounts are estimated based upon credit risks of third-party payors, contractual terms, inefficiencies in our billing and collection processes, regulatory compliance issues and historical collection experience. Revenue recognition uncertainties inherent in the Company’s operations are addressed in AICPA Statement of Position (SOP) No. 00-1 Auditing Health Care Third-Party Revenues and Related Receivables. As addressed in SOP No. 00-1, net revenue recognition and allowances for uncollectible billings require the use of

 

F-7


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

estimates of the amounts that will actually be realized considering, among other items, retroactive adjustments that may be associated with regulatory reviews, audits, billing reviews and other matters.

 

Management services are provided to dialysis centers not owned by the Company. The management fees are typically determined as a percentage of the centers’ patient revenues and are included in net operating revenues as earned. Any costs incurred in performing these management services are recognized in dialysis operating and general and administrative expenses.

 

Other income

 

Other income includes interest income on cash investments, earnings and losses from non-consolidated equity investments and other non-operating gains and losses.

 

Cash and cash equivalents

 

Cash equivalents are highly liquid investments with maturities of three months or less at date of purchase.

 

Inventories

 

Inventories are stated at the lower of cost (first-in, first-out) or market and consist principally of drugs and dialysis related supplies.

 

Property and equipment

 

Property and equipment are stated at cost reduced by any impairments. Maintenance and repairs are charged to expense as incurred. Depreciation and amortization expenses are computed using the straight-line method over the useful lives of the assets estimated as follows: buildings, 20 to 40 years; leasehold improvements, the shorter of their estimated useful life or the lease term; and equipment and software, principally 3 to 8 years. Disposition gains and losses are included in current earnings.

 

Amortizable intangibles

 

Amortizable intangible assets include noncompetition agreements and deferred debt issuance costs, each of which have determinate useful lives. Noncompetition agreements are amortized over the terms of the agreements, typically three to twelve years, using the straight-line method. Deferred debt issuance costs are amortized to debt expense over the term of the related debt using the effective interest method.

 

Goodwill

 

Goodwill represents the difference between the purchase cost of acquired businesses and the fair value of the net assets acquired, and includes intangible assets that are neither contractual nor separable, such as patient lists.

 

Under Statement of Financial Accounting Standards (SFAS) No. 142 Goodwill and Other Intangible Assets, which became effective January 1, 2002, goodwill is not amortized after December 31, 2001, but is assessed for valuation impairment as circumstances warrant and at least annually. An impairment charge would be recorded to the extent the book value of goodwill exceeds its fair value. The Company operates as one reporting unit for

 

F-8


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

goodwill impairment assessments. If this standard had been effective as of January 1, 2000, net income and diluted net income per share would have been $162,350 or $1.76 per share and $40,516 or $0.49 per share for 2001 and 2000, respectively.

 

Impairment of long-lived assets

 

Long-lived assets including property and equipment, investments, and amortizable intangible assets are reviewed for possible impairment whenever significant events or changes in circumstances, including changes in our business strategy and plans, indicate that an impairment may have occurred. An impairment is indicated when the sum of the expected future undiscounted net cash flows identifiable to that asset or asset group is less than its carrying value. Impairment losses are determined from actual or estimated fair values, which are based on market values, net realizable values or projections of discounted net cash flows, as appropriate. Interest is not accrued on impaired loans unless the estimated recovery amounts justify such accruals.

 

SFAS No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets, which became effective January 1, 2002, supercedes SFAS No. 121 Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. SFAS No. 144 allows different approaches in cash flow estimation and extends discontinued operations treatment, previously applied only to operating segments, to more discrete business components. The impairment model under SFAS No. 144 is otherwise largely unchanged from SFAS No. 121, and adoption of this standard did not have a material effect on the Company’s financial statements.

 

Income taxes

 

Federal, state and foreign income taxes are computed at current enacted tax rates, less tax credits. Taxes are adjusted both for items that do not have tax consequences and for the cumulative effect of any changes in tax rates from those previously used to determine deferred tax assets or liabilities. Tax provisions include amounts that are currently payable, as well as changes in deferred tax assets and liabilities that arise because of temporary differences between the timing of when items of income and expense are recognized for financial reporting and income tax purposes, and any changes in the valuation allowance caused by a change in judgement about the realizability of the related deferred tax assets.

 

Minority interests

 

Consolidated income is reduced by the proportionate amount of income accruing to minority interests. Minority interests represent the equity interests of third-party owners in consolidated entities which are not wholly-owned. As of December 31, 2002, there were 20 consolidated entities with third-party minority ownership interests.

 

Stock-based compensation

 

Stock-based compensation for employees is determined in accordance with Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees, as allowed under SFAS No. 123 Accounting for Stock-Based Compensation. Stock option grants to employees do not result in an expense if the exercise price is at least equal to the market price at the date of grant. Stock option expense is also measured and recorded for certain modifications to stock options as required under FASB Interpretation No. 44 Accounting for Certain Transactions Involving Stock Compensation. Stock options issued to non-employees and deferred stock units are valued using the Black-Scholes model and amortized over the respective vesting periods.

 

 

F-9


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Pro forma net income and earnings per share.    If the Company had adopted the fair value-based compensation expense provisions of SFAS No. 123 upon the issuance of that standard, net income (loss) and net income (loss) per share would have been adjusted to the pro forma amounts indicated below:

 

    

Year ended December 31,


 
    

2002


    

2001


    

2000


 
    

(in thousands, except per share)

 

Net income (loss):

                          

As reported

  

$

157,329

 

  

$

137,315

 

  

$

13,485

 

Unrecognized fair value stock option expense, net of tax

  

 

(9,429

)

  

 

(17,231

)

  

 

(20,467

)

    


  


  


Pro forma net income (loss)

  

$

147,900

 

  

$

120,084

 

  

$

(6,982

)

    


  


  


Pro forma basic earnings per share:

                          

Pro forma net income (loss)

  

$

147,900

 

  

$

120,084

 

  

$

(6,982

)

    


  


  


Weighted average shares outstanding during the year

  

 

71,787

 

  

 

83,768

 

  

 

81,593

 

Vested deferred stock units

  

 

44

 

                 

Reduction in shares in connection with notes receivable from employees

                    

 

(12

)

    


  


  


Weighted average shares for basic earnings per share calculation

  

 

71,831

 

  

 

83,768

 

  

 

81,581

 

    


  


  


Basic net income (loss) per share—Pro forma

  

$

2.06

 

  

$

1.43

 

  

$

(0.09

)

    


  


  


Basic net income per share—As reported

  

$

2.19

 

  

$

1.64

 

  

$

0.17

 

    


  


  


Pro forma diluted earnings per share:

                          

Pro forma net income (loss)

  

$

147,900

 

  

$

120,084

 

  

$

(6,982

)

Debt expense savings, net of tax, from assumed conversion of convertible debt

  

 

19,661

 

  

 

4,222

 

        
    


  


  


Net income (loss) for diluted earnings per share calculations

  

$

167,561

 

  

$

124,306

 

  

$

(6,982

)

    


  


  


Weighted average shares outstanding during the year

  

 

71,787

 

  

 

83,768

 

  

 

81,593

 

Vested deferred stock units

  

 

44

 

                 

Reduction in shares in connection with notes receivable from employees

                    

 

(12

)

Assumed incremental shares from stock plans

  

 

4,184

 

  

 

2,708

 

        

Assumed incremental shares from convertible debt

  

 

15,394

 

  

 

4,879

 

        
    


  


  


Weighted average shares for diluted earnings per share calculations

  

 

91,409

 

  

 

91,355

 

  

 

81,581

 

    


  


  


Diluted net income (loss) per share—Pro forma

  

$

1.83

 

  

$

1.36

 

  

$

(0.09

)

    


  


  


Diluted net income per share—As reported

  

$

1.96

 

  

$

1.52

 

  

$

0.16

 

    


  


  


 

The fair values of historical option grants were estimated as of the date of grant using the Black-Scholes option-pricing model with the following assumptions for grants in 2002, 2001 and 2000, respectively: dividend yield of 0% for all periods; weighted average expected volatility of 40%, 40% and 72%; risk-free interest rates of 3.99%, 4.44% and 6.13% and weighted average expected lives of 3.5, 3.8 and 3.5 years. The expected volatility is the most significant assumption affecting the fair value estimates. A 10% difference in the expected volatility for 2002 would have approximately a $700 pretax impact on the pro forma stock option expense for 2002.

 

F-10


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

 

Interest rate swap agreements

 

The Company has from time to time entered into interest rate swap agreements as a means of managing interest rate exposure. These agreements were not for trading or speculative purposes, and had the effect of converting a portion of our variable rate debt to a fixed rate. Net amounts paid or received have been reflected as adjustments to interest expense. The Company had no interest rate swap agreements as of December 31, 2002 and 2001.

 

Foreign currency translation

 

Prior to June 2000, the Company had operations in Argentina and Europe. The operations in Argentina were relatively self-contained and integrated within Argentina. The currency in Argentina, which was considered the functional currency, was tied to the U.S. dollar at all times during which the Company had operations in Argentina. Operations in Europe were translated into U.S. dollars at period-end exchange rates and any unrealized gains and losses were accounted for as a component of other comprehensive income. Unrealized gains and losses on debt denominated in a foreign currency that was considered a hedge of the net investment in foreign operations were accounted for as a component of other comprehensive income until June 2000 when we divested our non-continental operations and paid the foreign-denominated debt in full.

 

Other new accounting standards

 

SFAS No. 145 Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections was issued in April 2002. Under SFAS No. 145, which is effective January 1, 2003, gains or losses from extinguishment of debt will no longer be classified as extraordinary items, but will be included as a component of income from continuing operations. Extraordinary items prior to 2003 will be reclassified for consistent presentation. Although the $29,358 extraordinary loss, net of tax, for 2002 will be reclassified in future comparative financial statements as $48,930 of ordinary expense before taxes, this classification change will have no impact on net income or net income per share.

 

FASB Interpretation No. 45 Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others was issued in November 2002. This Interpretation clarifies the requirements for a guarantor’s disclosures in its interim and annual financial statements about its obligations under certain guarantees that it has issued and which remain outstanding. The Interpretation also clarifies the requirements related to the recognition of a liability for the fair value of the obligation undertaken by the guarantor at the inception of the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The disclosure requirements are currently effective with the recognition and initial measurement provisions applying to prospective guarantees issued or modified after December 31, 2002. These provisions are not expected to have a material impact on the Company’s financial statements.

 

2.    Earnings per share

 

Basic net income per share is calculated by dividing net income by the weighted average number of common shares outstanding. Diluted net income per share includes the dilutive effect of convertible debt (under the if-converted method), stock options (under the treasury stock method) and unvested deferred stock units.

 

F-11


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

 

The reconciliation of the numerators and denominators used to calculate basic and diluted net income per share is as follows:

 

    

Year ended December 31,


 
    

2002


  

2001


  

2000


 
    

(in thousands, except per share)

 

Basic:

                      

Net income

  

$

157,329

  

$

137,315

  

$

13,485

 

    

  

  


Weighted average shares outstanding during the year

  

 

71,787

  

 

83,768

  

 

81,593

 

Vested deferred stock units

  

 

44

               

Reduction in shares in connection with notes receivable from employees

                

 

(12

)

    

  

  


Weighted average shares for basic earnings per share calculations

  

 

71,831

  

 

83,768

  

 

81,581

 

    

  

  


Basic net income per share

  

$

2.19

  

$

1.64

  

$

0.17

 

    

  

  


Diluted:

                      

Net income

  

$

157,329

  

$

137,315

  

$

13,485

 

Debt expense savings, net of tax, from assumed conversion of convertible
debt

  

 

19,661

  

 

19,449

        
    

  

  


Net income for diluted earnings per share calculations

  

$

176,990

  

$

156,764

  

$

13,485

 

    

  

  


Weighted average shares outstanding during the year

  

 

71,787

  

 

83,768

  

 

81,593

 

Vested deferred stock units

  

 

44

               

Reduction in shares in connection with notes receivable from employees

                

 

(12

)

Assumed incremental shares from stock plans

  

 

3,255

  

 

4,292

  

 

1,576

 

Assumed incremental shares from convertible debt

  

 

15,394

  

 

15,394

        
    

  

  


Weighted average shares for diluted earnings per share calculations

  

 

90,480

  

 

103,454

  

 

83,157

 

    

  

  


Diluted net income per share

  

$

1.96

  

$

1.52

  

$

0.16

 

    

  

  


 

Options to purchase 881,350 shares at $23.63 to $33.00 per share, 630,668 shares at $19.04 to $33.00 per share, and 7,887,079 shares at $6.70 to $33.50 per share were excluded from the diluted earnings per share calculations for 2002, 2001 and 2000, respectively, because they were anti-dilutive. For 2002 and 2001, the calculation of diluted earnings per share assumes conversion of both the 5 5/8% convertible subordinated notes and the 7% convertible subordinated notes. For 2000, conversion was not assumed for either the 5 5/8% notes or the 7% notes because conversion would have been anti-dilutive.

 

3.    Accounts receivable

 

The provisions for uncollectible accounts receivable, prior to offsetting recoveries in 2002, 2001 and 2000, were $32,069, $32,926 and $39,649, respectively. The provisions before cash recoveries in 2002, 2001 and 2000 were approximately 1.8%, 2.0% and 2.7% of current operating revenues, respectively. During 2000 and 2001, substantial improvements were made in the Company’s billing and collection processes, and cash recoveries of $5,192 and $35,220 were realized during 2002 and 2001 on accounts receivable reserved in 1999.

 

Revenues associated with patients whose primary coverage is under Medicare and Medicaid programs accounted for approximately 56%, 57% and 58% of total dialysis revenues in the continental U.S. for 2002, 2001 and 2000, respectively. Accounts receivable from Medicare and Medicaid were approximately $110,000 as of December 31, 2002. No other single payor accounted for more than 5% of total accounts receivable.

 

F-12


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

 

4.    Other current assets

 

Other current assets were comprised of the following:

 

    

December 31,


    

2002


  

2001


Supplier rebates and other non-trade receivables

  

$

16,567

  

$

4,090

Operating advances to managed centers

  

 

3,284

  

 

2,337

Prepaid expenses and deposits

  

 

8,816

  

 

2,937

    

  

    

$

28,667

  

$

9,364

    

  

 

Operating advances to managed centers are generally unsecured and interest bearing.

 

5.    Property and equipment

 

Property and equipment were comprised of the following:

 

    

December 31,


 
    

2002


    

2001


 

Land

  

$

932

 

  

$

1,039

 

Buildings

  

 

5,084

 

  

 

6,959

 

Leasehold improvements

  

 

204,778

 

  

 

184,764

 

Equipment

  

 

301,285

 

  

 

260,142

 

Additions in progress

  

 

49,466

 

  

 

16,627

 

    


  


    

 

561,545

 

  

 

469,531

 

Less accumulated depreciation and amortization

  

 

(263,070

)

  

 

(216,753

)

    


  


    

$

298,475

 

  

$

252,778

 

    


  


 

Depreciation and amortization expense on property and equipment was $54,701, $53,182 and $56,330 for 2002, 2001 and 2000, respectively.

 

Applicable interest charges incurred during significant facility expansion and construction are capitalized as one of the elements of cost and are amortized over the assets’ estimated useful lives. Interest capitalized was $1,888, $751 and $1,125 for 2002, 2001 and 2000, respectively.

 

6.    Amortizable intangibles

 

Amortizable intangible assets were comprised of the following:

 

    

December 31,


 
    

2002


    

2001


 

Noncompetition agreements

  

$

104,479

 

  

$

105,130

 

Deferred debt issuance costs

  

 

24,666

 

  

 

23,195

 

    


  


    

 

129,145

 

  

 

128,325

 

Less accumulated amortization

  

 

(65,986

)

  

 

(55,217

)

    


  


    

$

63,159

 

  

$

73,108

 

    


  


 

F-13


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

 

Amortization expense from noncompetition agreements was $9,964, $10,162 and $10,223 for 2002, 2001 and 2000, respectively. Deferred debt issuance costs are amortized to debt expense as described in Note 11.

 

Scheduled amortization charges from amortizable intangible assets as of December 31, 2002 were as follows:

 

      

Noncompetition agreements


    

Deferred debt issuance costs


2003

    

$

9,589

    

$

3,321

2004

    

 

9,229

    

 

3,201

2005

    

 

8,457

    

 

3,080

2006

    

 

7,186

    

 

2,942

2007

    

 

5,280

    

 

2,682

 

7.    Investments in third-party dialysis businesses

 

Investments in third-party dialysis businesses and related advances were as follows:

 

    

December 31,


    

2002


  

2001


Investments in non-consolidated businesses

  

$

3,227

  

$

3,403

Loans generally convertible to equity investments, less allowance of $926

         

 

943

    

  

    

$

3,227

  

$

4,346

    

  

 

During 2002, 2001 and 2000, the Company recognized income (loss) of $1,791, $2,126, and $(931), respectively, relating to investments in non-consolidated businesses under the equity method. These amounts are included in other income (loss).

 

8.    Goodwill

 

Changes in the book value of goodwill were as follows:

 

    

Year ended December 31,


 
    

2002


    

2001