Orthodontic Centers of America, 2001 Annual Report

This discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Report. This discussion and other sections of this Report contain some forward-looking statements about our financial condition, results of operations, business and prospects. These statements appear in several sections of this Report and generally include any of the words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “should,” “could,” “will,” “plan” or similar expressions.
     These forward-looking statements include, without limitation, statements regarding our future growth and demand for services, projected or anticipated benefits from the OrthAlliance merger, development and affiliation of new orthodontic and pediatric dental centers, affiliation with existing orthodontic and pediatric dental practices, international expansion, use of technology to improve efficiency and reduce costs, legal proceedings, deferred tax assets, advancement of funds to affiliated practitioners, continued leasing of affiliated center facilities, liquidity and capital resources, funding of our expansion, operations and capital expenditures, payment or nonpayment of dividends, general dentist assistants, anticipated benefits from consolidating our headquarters, management, critical accounting policies and market risk.
     Forward-looking statements are not guarantees of future performance. They involve risks, uncertainties and assumptions, many of which are unpredictable and not within our control. Our future results and shareholder values may differ materially from those expressed in these forward-looking statements because of a variety of risks and uncertainties, including general economic and business conditions, our expectations and estimates concerning future financial performance, financing plans and the impact of competition, anticipated trends in our business, existing and future regulations affecting our business, and other risk factors described in our Annual Report on Form 10–K for the year ended December 31, 2001 and our other filings with the Securities and Exchange Commission and in our public announcements.
     We do not intend to update these forward-looking statements after the date of this Report, even if new information, future events or other circumstances have made them incorrect or misleading as of any future date. For all of these statements, we claim the protection of the safe harbor for forward-looking statements provided in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

General
Our business was established in 1985. At December 31, 2001, we provided business services to 364 orthodontic and pediatric dental practices operating in 879 orthodontic and pediatric dental centers in which 608 orthodontists, pediatric dentists and general dentists were practicing as of December 31, 2001. The following table provides information about these affiliated centers. These amounts do not include the Excluded OrthAlliance Affiliated Practices, which are 38 orthodontic and pediatric dental practices operating in 125 centers with 46 orthodontists and pediatric dentists as of December 31, 2001, which are engaged in litigation with OrthAlliance, Inc. and have ceased paying service fees to OrthAlliance.

	Year Ended December 31,
	1997		1998		1999	2000		2001

Number of centers at
beginning of period	247		360		469	537		592
Number of centers
developed during period	58		54		36	18		28
Number of centers
acquired during period	78		66		32	45		268
Number of centers
consolidated during period	(23	)	(11	)	—	(8	)	(9	)

Number of centers
at end of period	360		469		537	592		879

     Of these 879 affiliated centers at December 31, 2001, 329 were developed by us and 634 were existing centers whose assets we acquired, of which 84 were consolidated into another orthodontic center. Of the 634 acquired centers, 264 were acquired in connection with OrthAlliance becoming our wholly-owned subsidiary on November 9, 2001. We expect that future growth in the number of our affiliated centers will come from both developing centers with existing and newly recruited orthodontists and pediatric dentists and acquiring the assets of, and affiliating with, existing orthodontic and pediatric dental practices.
     Generally, when we develop a new center, all patients treated at the center are new patients and, in the first several months after commencing operations, the center is open only for a limited number of days each month as new patients are added. Our affiliated centers have generally become increasingly more productive and profitable as more new patients are added and existing patients return for monthly follow-up visits. After approximately 26 months of operations, a center’s growth in patient base has typically begun to stabilize as the initial patients complete treatment. At that point, a center can increase the number of patients treated by improving the efficiency of its clinical staff, increasing patient treatment intervals and adding operating days or practitioners. Our affiliated centers may also increase revenue by implementing periodic price increases. Established practices with which we have affiliated have typically increased their revenue by applying our operating strategies and systems, including increased advertising and efficient patient scheduling.

Critical Accounting Policies and Estimates
We provide integrated business services to orthodontic and pediatric dental practices, and our consolidated financial statements include service fees earned under our service and consulting agreements and the expenses of providing these services. We do not consolidate the patient revenue and other operations and accounts of our affiliated practices. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
     We believe that the following critical accounting policies are important to the portrayal of our financial condition and results of operations, and require management’s most difficult subjective or complex judgments due to the sensitivity of the methods, assumptions and estimates used in preparing our consolidated financial statements.

In acquiring the non-professional assets of an orthodontic or pediatric dental practice, and entering into a service or consulting agreement with the practice, we allocate a portion of the consideration paid to the practice in connection with that transaction to an intangible asset, which represents the costs of obtaining the service or consulting agreement. The intangible assets are being amortized on a straight-line basis over the lives of the Service Agreement (up to 25 years). On a regular basis, we evaluate whether events and circumstances have occurred that indicate all or a portion of the carrying amount of these intangible assets may no longer be recoverable. The evaluation of the carrying amount of the intangible assets in relation to estimates of future undiscounted cash flows are based on management’s judgments and assumptions. Future events may affect management’s judgments and assumptions related to these undiscounted cash flows. Any impairment charge recorded will be based on the discounted cash flows method.
We provide allowances for uncollectible amounts based on an estimate of the unrealizable portion of service fees receivables. We base that estimate on an aging of service fees receivable. If circumstances change resulting in an affiliated practice’s inability to make required payments, additional allowances may be required.
At December 31, 2001, we had approximately $61.1 million in deferred tax assets and have provided no valuation allowance related to these deferred tax amounts. We believe that the deferred tax assets are realizable through carry-backs and future reversals of existing taxable temporary differences. In the event that we determine that the deferred tax assets would likely not be realized, a valuation allowance would be required and charged to income when such determination is made.
In connection with our acquisition of OrthAlliance on November 9, 2001, we allocated a portion of the purchase price paid in connection with the merger among OrthAlliance’s assets, including its service, management service and consulting agreements. This purchase price allocation required that we make certain estimates and assumptions in assigning values to OrthAlliance’s assets and liabilities. We did not allocate any of the purchase price to service, management service and consulting agreements with the Excluded OrthAlliance Affiliated Practices. The allocation reflected in the consolidated financial statements included elsewhere in this Report is preliminary and the estimated values may change as more facts become known.
We recorded at December 31, 2001, an amount of $71.8 million of goodwill related to the OrthAlliance merger. Goodwill is carried at cost and is not amortized, but instead will be tested for impairment by applying a fair value concept in accordance with Statement of Financial Accounting Standards No. 142. The evaluation of the impairment loss requires management to make estimates and assumptions. Adverse changes to our operations in connection with OrthAlliance could result in impairment losses in the future.
Under our revenue recognition policy, which is described below, we must make certain estimates, including amounts to be retained by our affiliated practices.

     For further discussion on our accounting policies, see Note 2 to our Consolidated Financial Statements included elsewhere in this Report, primarily related to revenue recognition and stock compensation arrangements.

Revenue Recognition
Effective January 1, 2000, we changed our fee revenue recognition pursuant to Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (“SAB 101”). SAB 101 summarizes certain of the Securities and Exchange Commission staff’s views in applying generally accepted accounting principles to revenue recognition in financial statements.
     We recognize fee revenue based on a straight-line allocation of patient contract revenue over the terms of the patient contracts (which, for orthodontic patients, average about 26 months), minus the portion of that straight-line allocation retained or to be retained by our affiliated practices. Amounts retained or to be retained by an affiliated practice equal the practice’s proportionate share of the portion of that straight-line allocation of patient contract revenue that is collected during the relevant period, and the patient receivables that represent the uncollected portion of that straight-line allocation of patient contract revenue. Amounts retained or to be retained are reduced by any operating losses, depreciation, interest on outstanding loans, bad debt or other expenses that we have incurred but for which we have not been reimbursed by the practice; however, these unreimbursed expenses reduce amounts retained by an affiliated practice only up to the amounts that would otherwise be retained by the practice. Any remaining unreimbursed expenses would reduce amounts retained or to be retained by the practice in subsequent periods. For OCA’s general form of service and consulting agreements (under which service fees are generally determined, at least in part, based upon a percentage of practice operating profit), the amounts retained or to be retained by an affiliated practice are estimated using the percentage of practice operating profits that may be retained by the practice under the service or consulting agreement. For OrthAlliance’s service, management service and consulting agreements (under which service fees are generally determined, at least in part, based upon a percentage of practice revenue and reimbursement of practice related expenses), amounts retained or to be retained by an affiliated practice are estimated using the percentage of practice revenue that may be retained by the practice under the terms of the service, management or consulting agreement, minus the estimated amount of practice related expenses for which OrthAlliance may be reimbursed under that agreement.
     Many of OrthAlliance’s affiliated practices require that their patients pay a down payment of approximately 25% of the total treatment fee at the commencement of treatment. This results in us receiving cash in advance of incurring certain practice related expenses and recognizing certain service fees as fee revenue, which are deferred and recorded as service fee prepayments. Service fee prepayments represent cash received in excess of service fees that have been recognized as fee revenue, less an estimate of the portion of that cash that the applicable affiliated practice is to retain and practice related expenses that have not yet been incurred.
     The cumulative effect of this change in accounting principle was $50.6 million, net of income tax, which is reflected in our results of operations for 2000. The cumulative effect of the change was also reflected in a reduction in service fees receivable, net of allowance for uncollectible amounts, to $35.4 million as of December 31, 2000 from $87.6 million as of December 31, 1999. The pro forma net income amounts presented in “Selected Financial and Operating Data” and in our consolidated statement of operations were calculated assuming that the change in accounting principle pursuant to SAB 101 was effective throughout all periods presented.
     For periods prior to January 1, 2000, we recognized fee revenue consistent with the proportion of services that we provide our affiliated practices during the term of a patient’s course of treatment and the terms of OCA’s general form of service agreements with affiliated practices. We estimate that, on average, at least 24% of the services we and our employees, including orthodontic assistants and other center staff, provide our affiliated practices, such as staffing, supplies and inventory, computer and management information systems, scheduling, billing and accounting services, relate to the first month of the term of our affiliated practices’ patient contracts. OCA’s general form of service agreements generally provides for monthly service fees based upon the result of approximately 24% of each new patient contract balance during the first month of the term of the patient contract, plus the balance of the patient contract balance allocated equally over the remaining term of the patient contract, minus amounts retained by the affiliated practice. The amounts retained by an affiliated practice are based on a percentage of the operating profit of the practice on a cash basis, generally cash collections minus expenses during the period (in some cases, after reduction for any hourly-based service fees or hourly-based amounts retained by the affiliated practice), plus, in some cases, certain hourly-based amounts. Amounts retained by an affiliated practice that operates a newly developed orthodontic center are typically reduced by operating losses on a cash basis because of start-up expenses. For periods prior to January 1, 2000, we recognized fee revenue attributable to an affiliated practice’s share of these operating losses in the period during which the operating losses were incurred, with such fee revenue totaling about $4.0 million during 1999.

Expenses
Operating expenses of our affiliated centers are our expenses and are recognized as incurred. Employee costs consist of wages, salaries and benefits paid to all of our employees, including orthodontic assistants, business staff and management personnel. General and administrative expenses consist of, among other things, provision for losses on service fees receivable, professional fees, maintenance and utility costs, office supply expense, telephone expense, taxes, license fees, printing expense and shipping expense.

Business Combination with OrthAlliance
On November 9, 2001, OrthAlliance became our wholly-owned subsidiary in a stock-for-stock merger whereby our newly formed subsidiary merged into OrthAlliance. OrthAlliance was formed in October 1996 and provides management and consulting services to orthodontists and pediatric dentists located throughout the United States. As of December 31, 2001, OrthAlliance was affiliated with 118 orthodontic and pediatric dental practices operating in 264 centers with 156 orthodontists and pediatric dentists (not including the Excluded OrthAlliance Affiliated Practices).
     The OrthAlliance merger was accounted for using the purchase method of accounting and the results of operations of OrthAlliance subsequent to November 9, 2001 have been included in our consolidated financial statements for 2001. However, our consolidated financial statements for 2001 do not include any results of operations associated with the Excluded OrthAlliance Affiliated Practices, which are 38 orthodontic and pediatric dental practices operating in 125 centers with 46 orthodontists and pediatric dentists as of December 31, 2001, that are engaged in litigation with OrthAlliance and have ceased paying service fees to OrthAlliance.
     In the OrthAlliance merger, each share of OrthAlliance common stock was converted into 0.10135 shares of our common stock. We issued approximately 1.2 million shares of our common stock with a total value of $32.3 million, based on the closing market price of our common stock reported on the New York Stock Exchange on the day immediately preceding the merger. We also incurred approximately $4.2 million in merger-related expenses and assumed approximately $119.8 million of liabilities in the merger. In addition, we initiated several incentive programs under which OrthAlliance’s affiliated practices could be granted shares of our common stock if, among other things, they entered into a new service agreement with us or entered into amendments to their employment agreement and their service, management service or consulting agreement with OrthAlliance.
     We believe that the OrthAlliance merger is a strategically important transaction, which we believe will provide opportunities for growth in our fee revenue and increases in our operating margin. Our objective is to build sound, long-term business relationships with OrthAlliance’s affiliated practices, and to increase the number of these practices that use our suite of integrated business systems and services. Since entering into a merger agreement with OrthAlliance in May 2001, we have devoted substantial resources to attempting to integrate their practices into our network of other affiliated practices. Some of OrthAlliance’s affiliated practices began using part of our computer and business systems prior to the merger, under a license that we granted to OrthAlliance in October 2001. In addition, approximately 66 of OrthAlliance’s affiliated practices (not including six of the Excluded OrthAlliance Affiliated Practices) agreed, in amendments to their service, management service or consulting agreements with OrthAlliance, to use our proprietary computer software and business systems in their practices. During 2002, we hope to fully implement our business systems for these practices. We also intend to continue to inform other OrthAlliance affiliated practices about the quality and benefits of our systems and services, which we hope will persuade additional practices to use a wide range of these systems and services.
     Before we entered into the merger agreement with OrthAlliance, we anticipated that some portion of OrthAlliance’s affiliated practices would oppose such a merger because of, among other things, disappointment with the market price of OrthAlliance’s common stock (which many practices received in connection with their affiliation with OrthAlliance), unwillingness to affiliate with a competitor of OrthAlliance or perceived differences in the companies’ cultures and operating strategies. Accordingly, we factored the likelihood of a number of dissident practices into our analysis of the economic merits of the merger, and into the structure of the merger agreement and merger consideration (which was based on the number of practices that entered into amendments to their employment agreements and service, management service and consulting agreements with OrthAlliance prior to the merger). Following the announcement of the merger agreement with OrthAlliance in May 2001, a number of OrthAlliance’s affiliated practices did, in fact, file lawsuits against OrthAlliance and/or notify OrthAlliance that it was in default under their service, management service and consulting agreements, in response to which OrthAlliance engaged outside counsel to represent its interests. We believe that, despite these lawsuits, the OrthAlliance merger has financial merit and was a positive development for our company.
     OrthAlliance intends to defend each of these lawsuits vigorously, and to continue to demand that these practices honor their commitments under their agreements with OrthAlliance. We believe that the plaintiffs’ claims in these actions lack merit, and that OrthAlliance has meritorious claims against each of these plaintiffs. Based on our prior experience and discussions with some of these practices or their representatives, we currently believe that some of these practices will settle their lawsuits by paying us an amount of cash in exchange for termination or modification of their service, management service and consulting agreements with OrthAlliance, depending upon the parties’ ability to reach an agreement as to the amount to be paid. We cannot assure you that such an agreement or settlement will be reached in any of these lawsuits. We also cannot, at this time, predict the outcome of these lawsuits or assure you that we will prevail in any of them, nor can we estimate at this time the amount of damages that we might incur or receive in these actions. Due to the uncertainty of this litigation, we have currently assigned no value to service, management service and consulting agreements with the Excluded OrthAlliance Affiliated Practices (which represent 46 of the practitioners engaged in litigation with OrthAlliance and which had ceased to pay service fees to OrthAlliance as of December 31, 2001) for purposes of allocating the purchase price that we paid in the OrthAlliance merger.

Overview of Service and Consulting Agreements
We provide a wide range of services to our affiliated practices, including marketing and advertising, management information systems, staffing, supplies and inventory, scheduling, billing, financial reporting, accounting and other administrative and business services. These services are provided under long-term agreements with affiliated orthodontists and pediatric dentists and/or their wholly-owned professional corporation or other entity, with terms that generally range from 20 to 40 years.
     The specific form of agreement is based upon the dental regulatory provisions of the particular state in which an affiliated practice is located. In most states, we use a form of service agreement, with some minor variations from state to state. In a small number of states with particularly stringent laws relating to the practice of dentistry, we use a consulting agreement, which also varies somewhat from state to state. OrthAlliance and its affiliated practices are parties to service, management service and consulting agreements that differ in some respects from the service and consulting agreements that OCA has historically used.
     During 2001, about 95.2% of our fee revenue was attributable to service agreements, including, for periods after November 9, 2001, OrthAlliance’s service and management service agreements, and about 4.8% of our fee revenue was attributable to consulting agreements, including, for periods after November 9, 2001, OrthAlliance’s consulting agreements.

OCA Service Agreements
Under OCA’s general form of service agreement, we provide affiliated practices with a wide range of business services in exchange for monthly service fees based upon the result of about 24% of new patient contract balances in the first month of treatment plus the balance of the patient contract balances allocated equally over the remaining terms of the patient contracts (which average about 26 months), minus amounts retained by the affiliated practice. The amounts retained by an affiliated practice are based on a percentage of the operating profits of the practice on a cash basis, generally cash collections minus expenses during the period (in some cases, after reduction for any hourly-based service fees or hourly-based amounts retained by the affiliated practice), plus, in some cases, certain hourly-based amounts. These service fees generally represent reimbursement for direct and indirect expenses that we incur in providing services to an affiliated practice (including employee costs, marketing and advertising costs, office rent, utilities expense, supply costs and general and administrative expenses), a portion of the operating profits of the affiliated practice on a cash basis, a percentage of the affiliated practice’s revenue, a fee amount dependent on the affiliated practice’s revenue and expenses, and in some cases, hourly-based service fees. Excluding reimbursement of direct and indirect expenses and any hourly-based service fees, service fees based on the operating profits of the affiliated practice generally range from 40% to 50% of a mature practice’s cash operating profits (in some cases, after reduction for any hourly-based service fees or hourly-based amounts retained by an affiliated practice).

OCA Consulting Agreements
Under OCA’s general form of consulting agreement, the types of services we provide to affiliated practices are generally similar to the services we provide under our general form of service agreement. Fees paid to us under the consulting agreements generally are a combination of, depending on the service being performed, cost-based types of fees, flat monthly fees and hourly fees.

OrthAlliance Service and Consulting Agreements
Under OrthAlliance’s general form of service agreements, OrthAlliance generally must provide or arrange for certain services for its affiliated practices, and advise and assist the practices with respect to certain other services. These services are generally similar to those provided under OCA’s service agreements. OrthAlliance is generally responsible for paying certain practice expenses, for which it is to be reimbursed by the affiliated practice. If the practice’s collections are insufficient to fund the practice’s current practice expenses, then OrthAlliance is generally obligated to advance funds for those expenses. Under these service agreements, OrthAlliance generally receives service fees based on either (i) a percentage of adjusted practice revenue (generally about 17%), which is to be earned by OrthAlliance on an accrual basis of accounting and received on a cash basis, subject, in some cases, to a minimum dollar amount of annual service fees during the first five years of the agreement, (ii) a percentage of adjusted practice revenue (generally about 17%), which is to be earned by OrthAlliance on an accrual basis of accounting, and received on a cash basis, subject to annual adjustments based upon improvements in the affiliated practice’s operating margin, and, in some cases, subject to a minimum dollar amount of annual service fees during the first five years of the agreement; or (iii) a flat monthly fee with annual fixed-dollar increases.
     Under OrthAlliance’s general form of consulting agreements, OrthAlliance must provide certain specified services to its affiliated practices, provide other services at the request of the practices and consult with or advise the affiliated practices with respect to other services. These services are generally similar to those provided under OCA’s service agreements. Under these agreements, OrthAlliance receives a consulting fee based on one of the three fee structures described above with respect to OrthAlliance’s service agreements.
     Under OrthAlliance’s general form of management service agreements, which are used for practices that were affiliated with New Image prior to OrthAlliance’s acquisition of those agreements in March 2000, OrthAlliance is to provide and remit payment for a wide range of services for its affiliated practices, including providing facilities, equipment, support personnel, utilities, supplies, bookkeeping, marketing and billing and collections services. These management service agreements generally provide for a service fee that varies from month to month depending on the particular practice’s practice revenue and operating expenses. Service fees are calculated based on two grids set forth in the management service agreement that determine the portion of practice revenue, on a cash basis, that is to be retained by the affiliated practice. One grid determines a percentage of practice revenue, on a cash basis, to be retained by the affiliated practice based on the amount of such practice revenue during the prior calendar quarter. Pursuant to this grid, OrthAlliance’s service fees generally increase if the affiliated practice’s practice revenue increases and the service fees generally decrease if the affiliated practice’s practice revenue decreases. The other grid determines an offsetting or additional percentage of such practice revenue to be retained by the affiliated practice, based on the practice’s operating expenses during the prior calendar quarter. Pursuant to this grid, OrthAlliance’s service fees generally decrease if the affiliated practice’s operating expenses increase and the service fees generally increase if the affiliated practice’s operating expenses decrease. The management service agreements generally provide for maximum service fees of 19.5% of the practice’s practice revenue on a cash basis. A few of OrthAlliance’s management service agreements provide for a fixed percentage service fee.

Fee Revenue Attributable to Service and Consulting Agreements
During 2001, fee revenue that was attributable to service agreements totaled $334.1 million, or 95.2% of fee revenue, including, for periods after November 9, 2001, OrthAlliance’s service and management service agreements, and fee revenue that was attributable to consulting agreements totaled $16.9 million, or 4.8% of fee revenue, including, for periods after November 9, 2001, OrthAlliance’s consulting agreements. During 2000, fee revenue that was attributable to service agreements totaled $256.7 million, or 95.5% of fee revenue, and fee revenue that was attributable to consulting agreements totaled $12.1 million, or 4.5% of fee revenue. During 1999, fee revenue that was attributable to service agreements totaled 95.7% of fee revenue, and fee revenue that was attributable to consulting agreements totaled 4.3% of fee revenue.
     During 2001, our operating margin, or operating profit as a percentage of fee revenue, for fee revenue attributable to service agreements was 29.8%, including, for periods after November 9, 2001, OrthAlliance’s service and management service agreements, and our operating margin for fee revenue attributable to consulting agreements was 25.7%, including, for periods after November 9, 2001, OrthAlliance’s consulting agreements. The decrease in operating margin from consulting agreements during 2001 was primarily due to increased marketing and advertising expense during 2001. During 2000, our operating margin for fee revenue attributable to service agreements was comparable to that for fee revenue attributable to consulting agreements, with an operating margin for fee revenue attributable to service agreements of 29.8% and an operating margin for fee revenue attributable to consulting agreements of 29.3%. During 1999, our operating margin for fee revenue attributable to service agreements was 34.3% and our operating margin for fee revenue attributable to consulting agreements was 26.6%, due to the addition of new orthodontic centers affiliated under consulting agreements that were not operating at full capacity. The change in operating margin from 1999 to 2000 was primarily due to the effect on fee revenue for 2000 from our change in fee revenue recognition policy effective January 1, 2000. See “Results of Operations” below.

Seasonality
Our affiliated practices have experienced their highest volume of new cases in the summer and other periods when schools are not typically in session. During these periods, children have a greater opportunity to visit an orthodontist or pediatric dentist to commence treatment. Consequently, our affiliated practices have experienced higher revenue during the first and third quarters of the year as a result of increased patient starts. During the Thanksgiving and Christmas seasons, our affiliated practices have experienced reduced volume and fourth quarter revenue for our affiliated practices has been generally lower as compared to other periods. Seasonality in recent periods has been mitigated by the impact of additional practices.

Emerging Issues Task Force Issue No. 97-2
We do not have a controlling financial interest in our affiliated practices. In accordance with guidance in Emerging Issues Task Force Issue No. 97-2, we do not consolidate the patient revenue and other operations and accounts of our affiliated practices within our financial statements.

Results of Operations
The following table provides information about the percentage of fee revenue represented by some of the items in our consolidated statements of income. Information for 2000 and 2001 includes the effect of the change in revenue recognition we adopted effective January 1, 2000.

	Year Ended December 31,
	2001		2000		1999

Fee revenue	100.0	%	100.0	%	100.0	%
Direct expenses:
Employee costs	28.8		29.0		27.1
Orthodontic supplies	8.4		7.9		7.6
Rent	8.8		8.9		8.2
Marketing and advertising	7.5		8.2		7.5

Total direct expenses	53.5		54.0		50.4
General and administrative	11.2		10.6		10.3
Depreciation and amortization	5.7		5.6		5.4

Operating profit	29.6		29.8		33.9
Interest (income) expense	1.6		1.4		1.0

Income before income taxes	28.0		28.4		32.9
Provision for income taxes	10.6		10.6		12.5

Income before cumulative effect
of changes in accounting principles	17.4		17.8		20.4

Cumulative effect of changes in accounting
principles, net of income tax benefit	—		(18.8	)	(0.2	)

Net income (loss)	17.4	%	(1.0	)%	20.2	%

2001 Compared to 2000
Overview. Our net income was $61.1 million in 2001, compared to a net loss of $2.9 million for 2000, primarily due to significant increase in fee revenue during 2001 and the cumulative effect of a change in accounting principle in 2000 of $50.6 million, net of an income tax benefit, with respect to our change in revenue recognition effective January 1, 2000 pursuant to SAB 101. During 2001, our operating margin (or operating profits as a percentage of fee revenue) slightly decreased to 29.6% from 29.8% for 2000. Our fee revenue increased 30.5% to $351.0 million during 2001, from $268.8 million for 2000. Our direct expenses increased 29.2% to $187.8 million during 2001, from $145.3 million for 2000. As a percentage of fee revenue, our direct expenses slightly decreased to 53.5% during 2001 from 54.0% for 2000.
     Fee Revenue. Fee revenue increased $82.1 million, or 30.5%, to $351.0 million for 2001 from $268.8 million for 2000. We attribute $54.2 million of this increase to the growth in fee revenue of centers open throughout both periods and to the contribution to fee revenue after November 9, 2001 from practices affiliated with OrthAlliance, and $27.9 million of this increase to centers opened since January 1, 2000. We recognized revenue of $23.9 million during 2001 and $57.3 million during 2000 that was included in the cumulative effect of changes in accounting principles during 2000. The increase in fee revenue during 2001, as compared to 2000, was also due to an increase in the number of patients being treated by our affiliated practices and an increase in the average amount of fees that patients were charged for treatment. During 2001, our affiliated practices initiated treatment of about 200,000 patients, an increase of 24.2% from about 161,000 patients during 2000, representing initial new patient contract balances of $640.4 million for 2001, an increase of 29.6% from $494.1 million for 2000. At December 31, 2001, our affiliated practices had a total of about 484,000 patient contracts, compared to about 343,000 patient contracts at December 31, 2000. These amounts exclude the Excluded OrthAlliance Affiliated Practices.
     Employee Costs. Employee costs increased $23.0 million, or 29.4%, to $101.1 million for 2001 from $78.1 million for 2000. As a percentage of fee revenue, employee costs decreased to 28.8% for 2001 from 29.0% for 2000. As a result of developments in orthodontic technology, a patient may be seen every six to eight weeks, rather than the traditional four weeks, without compromising quality of care. Consistent with industry trends, our affiliated orthodontists have begun increasing the intervals between patient treatments. During 2001, patients in our affiliated orthodontic centers averaged 45.9 days between office visits, compared to an average of 43.6 days during 2000. This increase in patient treatment interval reduces the number of office visits during the term of a patient’s treatment, which continues to average about 26 months, and results in lower employee costs per patient. The increased interval does not, however, reduce the amount of treatment fees per patient. Therefore, the increased interval reduces the employee costs incurred with respect to an individual patient relative to the patient’s treatment fee.
     Orthodontic Supplies. Orthodontic supplies expense increased $8.2 million, or 38.7%, to $29.4 million for 2001 from $21.2 million for 2000. As a percentage of fee revenue, orthodontic supplies expense increased to 8.4% for 2001 from 7.9% for 2000. This increase was primarily due to increases, for the first time in about three years, in prices charged for orthodontic supplies by certain of our vendors.
     Rent. Rent expense increased $6.9 million, or 28.8%, to $30.9 million for 2001 from $24.0 million for 2000. This increase was primarily due to centers acquired, affiliated, opened or relocated after 2000. As a percentage of fee revenue, rent expense slightly decreased to 8.8% for 2001 from 8.9% for 2000. This decrease was due, in part, to the fact that we maintained a corporate office in leased office space located in Ponte Vedra Beach, Florida for only a portion of 2001, as compared to all of 2000.
     Marketing and Advertising. Marketing and advertising expense increased $4.5 million, or 20.5%, to $26.5 million for 2001 from $22.0 million for 2000. The increase in this expense primarily resulted from increases in marketing and advertising related to growth in fee revenue for existing centers as well as marketing and advertising for centers added after 2000. As a percentage of fee revenue, marketing and advertising expense decreased to 7.5% for 2001 from 8.2% for 2000. This decrease was primarily due to advertising in more effective media in 2001 and, to a lesser extent, to the fact that OrthAlliance affiliated practices generally advertised less than other OCA affiliated practices.
     General and Administrative. General and administrative expense increased $11.0 million, or 38.7%, to $39.4 million for 2001 from $28.4 million for 2000. As a percentage of fee revenue, general and administrative expense increased to 11.2% for 2001 from 10.6% for 2000. The increase in general and administrative expense primarily resulted from increases in fees paid to financial institutions, costs to install DSL lines for our affiliated centers and office supplies expense. Fees paid to financial institutions primarily related to costs incurred to amend our $100.0 million revolving line of credit and to obtain a $50.0 million bridge credit facility in connection with the OrthAlliance merger. The DSL connection allows for certain software applications to be provided through a World Wide Web interface, which enables affiliated practices to access and update patient records, accounting records and other data from any location. The increase in office supplies expense was primarily attributable to price increases by certain vendors, some of which increased prices for the first time in about three years, and an increase in office supplies use due to an increased number of patients and affiliated practices during 2001.
     Depreciation and Amortization. Depreciation and amortization expense increased $4.6 million, or 30.3%, to $19.8 million for 2001 from $15.2 million for 2000. The increase in this expense is a result of the fixed assets acquired and service agreements entered into for centers developed, acquired or relocated after 2000. As a percentage of fee revenue, depreciation and amortization expense was 5.7% for 2001, compared to 5.6% for 2000. There was no amortization of the goodwill amount recorded as a result of the OrthAlliance acquisition.
     Operating Profit. Operating profit increased $24.0 million, or 30.0%, to $104.0 million for 2001 from $80.0 million for 2000. As a percentage of fee revenue, operating profit decreased to 29.6% for 2001 from 29.8% for 2000.
     Interest. Net interest expense increased $2.0 million, or 54.0%, to $5.7 million for 2001 from $3.7 million for 2000. As a percentage of fee revenue, net interest expense increased to 1.6% for 2001 from 1.4% for 2000. The increase in this expense resulted from an increase since 2000 in the average balance of borrowings under our $100.0 million revolving line of credit and $50.0 million bridge credit facility associated with expansion in new and existing markets and the OrthAlliance merger, and an increase in the average interest rate charged for those borrowings.
     Provision for Income Taxes. Provision for income taxes increased $8.5 million, or 30.7%, to $37.1 million for 2001 from $28.6 million for 2000. Our effective income tax rate was 37.8% for 2001 and 2000. Our change in accounting principle pursuant to SAB 101 effective January 1, 2000 resulted in deferred tax assets of $41.4 million. We have provided no valuation allowance for these deferred tax assets. We believe that the deferred tax assets at December 31, 2001 are realizable through carrybacks and future reversals of existing taxable temporary differences.
     Cumulative Effect of a Change in Accounting Principle. During 2000, we recorded a cumulative effect of a change in accounting principle of $50.6 million, net of an income tax benefit of $30.6 million, with respect to our change in revenue recognition effective as of January 1, 2000 pursuant to SAB 101.
     Net Income (Loss). During 2001, our net income increased to $61.1 million, compared to a net loss of $2.8 million for 2000, primarily due to a significant increase in fee revenue during 2001 and the cumulative effect of a change in accounting principle in 2000 of $50.6 million, net of an income tax benefit, with respect to our change in revenue recognition effective January 1, 2000 pursuant to SAB 101. As a percentage of fee revenue, net income for 2001 was 17.4%, as compared to (1.0)% for our net loss for 2000, as a result of the factors discussed above.

2000 Compared to 1999
Overview. We experienced a net loss of $2.8 million in 2000, compared to net income of $45.8 million for 1999, primarily due to the cumulative effect of a change in accounting principle of $50.6 million, net of an income tax benefit of $30.6 million, with respect to our change in revenue recognition effective January 1, 2000 pursuant to SAB 101. Net income before the cumulative effect of the change in accounting principle was $47.7 million for 2000, compared to $46.5 million for 1999. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, net income, excluding the cumulative effects of changes in accounting principles, increased 44.5% to $47.7 million for 2000 from $33.0 million for 1999.
     During 2000, our operating margin (or operating profits as a percentage of fee revenue) decreased to 29.8% from 33.9% for 1999. This decrease was primarily due to the effect on our fee revenue for 2000 from our change in fee revenue recognition policy effective January 1, 2000. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, our operating margin would have increased to 29.8% for 2000 from 27.0% for 1999.
     Our fee revenue increased 18.8% to $268.8 million during 2000, from $226.3 million for 1999. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, fee revenue increased 30.7% to $268.8 million for 2000, from $205.6 million for 1999.
     Our direct expenses increased 27.6% to $145.3 million during 2000, from $113.9 million for 1999. As a percentage of fee revenue, our direct expenses increased to 54.0% during 2000 from 50.4% for 1999, primarily due to the effect on our fee revenue for 2000 from our change in fee revenue recognition policy effective January 1, 2000. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, our direct expenses decreased as a percentage of fee revenue to 54.0% for 2000 from 55.4% for 1999.
     Fee Revenue. Fee revenue increased $42.5 million, or 18.8%, to $268.8 million for 2000 from $226.3 million for 1999. We attribute $28.8 million of this increase to the growth in fee revenue of centers open throughout both periods and $13.7 million of this increase to centers opened since January 1, 1999. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, fee revenue increased $63.2 million, or 30.7%, to $268.8 million for 2000 from $205.6 million for 1999. The increase in fee revenue during 2000 was also due to an increase in the number of patients being treated by our affiliated practices and an increase in the average amount of fees that patients were charged for treatment. During 2000, our affiliated practices initiated treatment of about 160,639 patients, an increase of 27.2% from 126,307 patients during 1999, representing initial new patient contract balances of $494.1 million for 2000, an increase of 33.9% from $369.1 million for 1999. At December 31, 2000, our affiliated practices had a total of about 343,370 patient contracts, compared to about 267,965 patient contracts at December 31, 1999. In 2000, approximately 30% of our affiliated practices implemented a fee increase from $109 per month to $119 per month, with an increase in the final payment from $436 to $476.
     Employee Costs. Employee costs increased $16.9 million, or 27.6%, to $78.1 million for 2000 from $61.2 million for 1999. As a percentage of fee revenue, employee costs increased to 29.0% for 2000 from 27.1% for 1999, due to the effect on fee revenue for 2000 from our change in fee revenue recognition policy effective January 1, 2000 pursuant to SAB 101, which offset capacity efficiencies achieved through general changes to patient treatment schedules by our affiliated orthodontists which resulted in fewer treatments per patient contract and lower employee costs per patient. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, employee costs decreased as a percentage of fee revenue to 29.0% for 2000 from 29.8% for 1999, due to capacity efficiencies achieved through general changes to patient treatment schedules by our affiliated orthodontists which resulted in fewer treatments per patient contract and lower employee costs per patient. As a result of developments in orthodontic technology, a patient may be seen every six to eight weeks, rather than the traditional four weeks, without compromising quality of care. Consistent with industry trends, our affiliated orthodontists have begun increasing the intervals between patient treatments. During 2000, patients in our affiliated orthodontic centers averaged 43.6 days between office visits, compared to an average of 39.3 days during 1999. This increase in patient treatment interval reduces the number of office visits during the term of a patient’s treatment, which continues to average about 26 months, and results in lower employee costs per patient. The increased interval does not, however, reduce the amount of treatment fees per patient. Therefore, the increased interval reduces the employee costs incurred with respect to an individual patient relative to the patient’s treatment fee.
     Orthodontic Supplies. Orthodontic supplies expense increased $4.1 million, or 24.0%, to $21.2 million for 2000 from $17.1 million for 1999. As a percentage of fee revenue, orthodontic supplies expense increased to 7.9% for 2000 from 7.6% for 1999, due to the effect on fee revenue for 2000 from our change in revenue recognition effective January 1, 2000 pursuant to SAB 101, which offset cost improvements attained through bulk purchasing and our proprietary inventory control and ordering system. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, orthodontic supplies expense, as a percentage of fee revenue, decreased to 7.9% for 2000 from 8.3% for 1999.
     Rent. Rent expense increased $5.4 million, or 29.0%, to $24.0 million for 2000 from $18.6 million for 1999. We attribute the increase in this expense to centers affiliated, opened or relocated after 1999. As a percentage of fee revenue, rent expense increased to 8.9% for 2000 from 8.2% for 1999. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, rent expense decreased slightly as a percentage of fee revenue to 8.9% for 2000 from 9.1% for 1999.
     Marketing and Advertising. Marketing and advertising expense increased $5.1 million, or 30.2%, to $22.0 million for 2000 from $16.9 million for 1999. The increase in this expense primarily resulted from increases in marketing and advertising related to growth in fee revenue for existing orthodontic centers as well as marketing and advertising for orthodontic centers added after 1999. As a percentage of fee revenue, marketing and advertising expense increased to 8.2% for 2000 from 7.5% for 1999, due to the effect on fee revenue for 2000 from our change in fee revenue recognition effective January 1, 2000 pursuant to SAB 101. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, marketing and advertising expense, as a percentage of fee revenue, remained constant at 8.2% for 2000 and 1999.
     General and Administrative. General and administrative expense increased $5.1 million, or 21.8%, to $28.4 million for 2000 from $23.3 million for 1999. The increase in general and administrative expense primarily resulted from the addition of orthodontic centers and increases in our affiliated orthodontists’ patient base after 1999. As a percentage of fee revenue, general and administrative expense increased to 10.6% for 2000 from 10.3% for 1999 due to the effect on fee revenue for 2000 from our change in revenue recognition policy effective January 1, 2000 pursuant to SAB 101. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, general and administrative expense decreased as a percentage of fee revenue to 10.6% for 2000 from 11.7% for 1999.
     Depreciation and Amortization. Depreciation and amortization expense increased $2.9 million, or 23.9%, to $15.2 million for 2000 from $12.2 million for 1999. The increase in this expense is a result of the fixed assets acquired and service agreements entered into for orthodontic centers developed, acquired or relocated after 1999. As a percentage of fee revenue, depreciation and amortization expense increased to 5.6% for 2000 from 5.4% for 1999. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, depreciation and amortization expense decreased as a percentage of fee revenue to 5.6% for 2000 from 6.0% for 1999.
     Operating Profit. Operating profit increased $3.1 million, or 4.0%, to $80.0 million for 2000 from $76.9 million for 1999. As a percentage of fee revenue, operating profit decreased to 29.8% for 2000 from 33.9% for 1999 as a result of the factors discussed above. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, operating profit increased $25.6 million, or 47.0%, to $80.0 million for 2000 from $55.4 million for 1999, and increased as a percentage of fee revenue to 29.8% for 2000 from 27.0% for 1999, as a result of the factors discussed above.
     Interest. Net interest expense increased $1.5 million, or 69.3%, to $3.7 million for 2000 from $2.2 million for 1999. As a percentage of fee revenue, net interest expense increased to 1.4% for 2000 from 1.0% for 1999. The increase in this expense resulted from an increase since 1999 in the average balance of borrowings under our $100.0 million revolving line of credit associated with expansion in new and existing markets and an increase in the average interest rate charged for those borrowings. The increase in net interest expense as a percentage of fee revenue was also due to the effect on fee revenue for 2000 from our change in fee revenue recognition effective January 1, 2000 pursuant to SAB 101. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, net interest expense increased as a percentage of fee revenue to 1.4% for 2000 from 1.2% for 1999, due to an increase since 1999 in the average balance of borrowings under our $100.0 million revolving line of credit associated with expansion in new and existing markets and an increase in the average interest rate charged for those borrowings.
     Provision for Income Taxes. Provision for income taxes increased $343,000, or 1.2%, to $28.6 million for 2000 from $28.2 million for 1999. Our effective income tax rate was 37.8% for 2000 and 1999. Our change in accounting principle pursuant to SAB 101 effective January 1, 2000 resulted in deferred tax assets of $41.4 million. We have provided no valuation allowance for these deferred tax assets. We believe that the deferred tax assets at December 31, 2000 are realizable through carrybacks and future reversals of existing taxable temporary differences. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, provision for income taxes increased $8.6 million, or 43.0%, to $28.6 million for 2000 from $20.0 million for 1999.
     Cumulative Effect of a Change in Accounting Principle. During 2000, we recorded a cumulative effect of a change in accounting principle of $50.6 million, net of an income tax benefit of $30.6 million, with respect to our change in revenue recognition effective as of January 1, 2000 pursuant to SAB 101. During 1999, we recorded a cumulative effect of a change in accounting principle of $678,000, net of an income tax benefit of $410,000, with respect to our adoption in 1999 of Statement of Position 98-5, “Reporting on the Costs of Start-Up Activities.”
     Net Income (Loss). Net income (loss) decreased $48.6 million, or 106.2%, to a net loss of $2.8 million for 2000 from net income of $45.8 million for 1999, primarily due to the cumulative effect of our change in accounting principle during 2000 pursuant to SAB 101. As a percentage of fee revenue, the net loss for 2000 was (1.0)%, as compared to 20.1% for net income for 1999, as a result of the factors discussed above. On a pro forma basis, calculated as if our change in accounting principle pursuant to SAB 101 effective January 1, 2000 had been in effect throughout 1999 and 2000, net income, excluding the cumulative effects of changes in accounting principles, increased $14.7 million, or 44.5%, to $47.7 million for 2000 from $33.0 million for 1999, and increased as a percentage of fee revenue to 17.9% for 2000 from 16.1% for 1999, as a result of the factors discussed above.

Liquidity and Capital Resources
The following table summarizes information about our cash flow for the years ended December 31, 2001, 2000 and 1999:

(in thousands)		2001			2000			1999

Net cash provided
by operating activities	$	43,796		$	43,473		$	21,654
Net cash used in
investing activities		(45,473	)		(52,362	)		(43,075	)
Net cash provided
by financing activities		14,150			7,884			25,642

Operating Activities
Net cash provided by operating activities was $43.8 million for 2001, a slight increase from $43.5 million for 2000. Net cash provided by operating activities during 2001 was positively impacted by an increase in net income before the cumulative effect of a change in accounting principles during 2001 of $13.4 million, or 28.1%, an increase in depreciation and amortization during 2001 of $4.7 million, or 30.6%, and a decrease during 2001 in deferred income taxes of $6.8 million, or 87.7%, as compared to 2000. Offsetting these positive impacts on net cash provided by operating activities during 2001 were an increase in service fees receivable during 2001 of $24.0 million, and a decrease in accounts payable and other current liabilities during 2001 of $10.9 million, as compared to 2000. The decrease in accounts payable and other current liabilities during 2001 was primarily due to payment of liabilities assumed in connection with the OrthAlliance merger in November 2001. The increase in service fees receivable during 2001 was primarily attributable to an increase in the number of patients being treated by our affiliated practices. Our working capital at December 31, 2001 was $51.9 million, including cash and cash equivalents of $14.2 million, compared to working capital at December 31, 2000 of $39.6 million, including cash and cash equivalents of $4.7 million. During 2001, current assets increased $50.6 million, due to increases in cash, service fees receivable and advances to affiliated practices, while current liabilities increased $38.2 million, due to increases in accounts payable, accrued salaries and other accrued liabilities, service fees prepayments and amounts payable to affiliated practices, as compared to 2000.
     Net cash provided by operating activities was $43.5 million for 2000, an increase of $21.8 million, or 100.8%, from $21.7 million for 1999. This increase was primarily due to a change of income tax payment methods, whereby cash paid for income taxes during 1999 exceeded the 1999 provision by $7.0 million. Our working capital at December 31, 2000 was $39.6 million, including cash and cash equivalents of $4.7 million, compared to working capital of $102.3 million at December 31, 1999, including cash and cash equivalents of $5.8 million. The overall decrease in working capital during 2000 was primarily due to a decrease in service fees receivables, net of uncollectible amounts, to $35.4 million at December 31, 2000 from $87.6 million at December 31, 1999, as a result of the cumulative effect of our change in accounting principle effective January 1, 2000 pursuant to SAB 101.

Investing Activities
Net cash used in investing activities was $45.5 million for 2001, a decrease of $6.9 million, or 13.2%, from $52.4 million for 2000. This decrease was primarily due to a decrease of $11.8 million in cash used to acquire service or consulting agreements during 2001, as compared to 2000. During 2001, we acquired service and consulting agreements primarily by issuing 1.2 million shares of our common stock in connection with the merger with OrthAlliance. Partially offsetting that decrease was an increase of $4.1 million in cash used for advances to affiliated practices in 2001, as compared to 2000.
     Net cash used in investing activities was $52.4 million for 2000, an increase of $9.3 million, or 21.6%, from $43.1 million for 1999. This increase was primarily due to an increase of $11.1 million in cash used for acquiring service and consulting agreements during 2000. During 2000, we entered into agreements to acquire the assets of, and affiliate with, 71 practices operating in 55 existing orthodontic centers. We made payments to practices with which we affiliated in earlier periods for a total acquisition cost of about $34.2 million, consisting of an aggregate principal amount of $1.3 million of promissory notes issued by us, an aggregate of 227,000 shares of our common stock and about $28.2 million of cash.

Financing Activities
Net cash provided by financing activities was $14.1 million for 2001, an increase of $6.2 million, or 79.5%, from $7.9 million in 2000. This increase was primarily due to an increase of $18.7 million in borrowings under our revolving line of credit and bridge credit facility during 2001, as well as an increase of $10.5 million in the issuance of our common stock related to the exercise of stock options during 2001, as compared to 2000. Partially offsetting these increases was an increase of $21.4 million during 2001 in repayments of notes payable to affiliated practices and long-term debt, as compared with 2000. We used the proceeds from the exercise of the stock options during 2001 to repay a portion of the indebtedness outstanding under our revolving line of credit. We borrowed an additional $11.5 million under the revolving line of credit and $50.0 million under our bridge credit facility in 2001, primarily to repay $59.5 million of indebtedness outstanding under OrthAlliance’s revolving line of credit upon the merger with OrthAlliance.
     Net cash provided by financing activities was $7.9 million for 2000, a decrease of $17.8 million, or 69.3%, from $25.6 million for 1999. This decrease was primarily due to decreased borrowings in 2000 under our revolving line of credit, as compared to 1999. We borrowed $23.1 million less in 2000 than in 1999. The overall decrease in 2000 was partially offset by increased proceeds from the issuance of common stock in 2000 as a result of increased stock options exercised by our employees and affiliated orthodontists and amounts received under our stock purchase program for affiliated orthodontists. In 2000, we also received $2.6 million as the repayment of loans outstanding under our Key Employee Stock Purchase Program.

Capital Resources and Uses of Capital
Our development and acquisition costs, capital expenditures and working capital needs have been, and we expect will continue to be, financed through a combination of cash flow from operations, bank borrowings and the issuance of notes and shares of our common stock. We intend to continue to lease, rather than purchase, facilities for our affiliated centers in order to maximize our available capital.
     Our capital expenditures consist primarily of the costs associated with the development of additional affiliated centers. The average cost of developing a new orthodontic center in the United States is about $325,000, including the cost of equipment, leasehold improvements, working capital and start-up losses associated with the initial operations of the orthodontic center. These costs are shared by us and the particular affiliated practice. We generally bear an affiliated practice’s share of these costs until we are reimbursed by the practice. In some cases, we assist our practices in obtaining financing for their share of these costs by providing a guaranty of loans from our primary lender. At December 31, 2001, the outstanding balance of these amounts that we guaranteed was about $1.9 million, compared with about $2.5 million at December 31, 2000. We also intend to continue to make advances of about $40,000 to newly-affiliated practices during the first year of an affiliated center’s operations, which advances bear no interest and typically are repaid during the second year of the affiliated center’s operations. We intend to fund these advances and any continued financing through a combination of bank borrowings and cash from operations.
     At December 31, 2001, outstanding indebtedness under promissory notes that we issued to affiliated practices to acquire the assets of existing orthodontic practices was about $8.7 million, including promissory notes previously issued by OrthAlliance and assumed in the OrthAlliance merger, compared to about $3.5 million at December 31, 2000, with maturities ranging from one to three years and interest rates ranging from 6.0% to 10.0% per year.
     We maintain a $100.0 million revolving line of credit, of which $69.0 million was outstanding at December 31, 2001, with a lending group that consists of Wachovia Bank, N.A., Bank of America FSB, Bank One, N.A., and Hibernia National Bank. The revolving line of credit, which expires in October 2003, provides funding for our general working capital and expansion of the number of affiliated centers, and bears interest at varying rates above the lender’s prime rate or LIBOR. Amounts borrowed under the line of credit are secured by a security interest in our ownership interests in our operating subsidiaries. On November 9, 2001, the line was amended to allow for the merger with OrthAlliance, and we concurrently borrowed from the line to repay a portion of OrthAlliance’s revolving line of credit as part of the merger. Upon repaying the outstanding balance, OrthAlliance’s revolving line of credit was terminated.
     On November 9, 2001, we obtained a $50.0 million bridge credit facility from Bank of America FSB, under which we immediately borrowed the full $50.0 million, all of which was outstanding at December 31, 2001. Borrowings under this bridge credit facility bear interest at varying rates above the lender’s prime rate or LIBOR. We used proceeds from borrowings under the bridge credit facility, along with additional borrowings under our revolving line of credit, to repay $59.5 million of indebtedness outstanding under OrthAlliance’s revolving line of credit upon the merger with OrthAlliance. Under the bridge credit facility, we have the right, upon written notice at least 30 days prior to November 9, 2002, to extend the bridge credit facility to October 7, 2003. We anticipate that we will either repay a portion of the bridge credit facility through cash flow from operations, enter into a new long-term financing arrangement to replace the bridge credit facility, or extend the term of the bridge credit facility to October 2003. If we exercise our right to extend the facility until October 7, 2003, the interest rates that would apply to all borrowings under the bridge credit facility would increase to the following:

Time Period		Interest Rate

October 2002—January 21, 2003		10.00%
February 1, 2003—April 30, 2003		10.50%
May 1, 2003—July 31, 2003		11.00%
August 1, 2003—October 7, 2003		11.50%

     We are currently reviewing our projections for cash needs and the possibility of obtaining a new long-term financing arrangement providing more favorable interest rates and terms.
     Our revolving line of credit and our bridge credit facility require that we maintain certain financial and nonfinancial covenants under the terms of the credit agreements, including a maximum leverage ratio, minimum fixed charge coverage ratio and minimum consolidated net worth ratio. These credit agreements also impose restrictions on our acquisitions, investments, dividends and other aspects of our business. If we do not comply with these covenants and restrictions, the lenders could demand immediate payment of all amounts borrowed under both the revolving line of credit and the bridge credit facility, and terminate our ability to borrow funds under those credit facilities. At December 31, 2001, we were in compliance with these covenants and restrictions.
     Also contributing to the increase in long-term debt at December 31, 2001, compared to December 31, 2000, was approximately $14.4 million of notes payable by OrthAlliance to certain of its affiliated practices and to affiliates of Goldman Sachs, which were assumed as part of the merger with OrthAlliance.
     During the next 12 months, we believe that our cash needs will primarily relate to development of additional centers and affiliation with additional practices in the United States and other countries, capital expenditures for our affiliated centers and computer systems, repayment of amounts owing under our bridge credit facility and other indebtedness, payment of income taxes, potential acquisitions of other companies or assets and general corporate purposes. Our cash needs could vary significantly depending upon our growth, results of operations and ability to affiliate with additional centers and practices, as well as the outcome of pending litigation and other contingencies. We expect to fund these cash needs through a combination of cash flow from our operations and funds available under our revolving line of credit, as well as a replacement or extension of our bridge credit facility. We currently believe that we will be able to meet our anticipated funding requirements for at least the next 12 months; however, our ability to meet these funding needs could be adversely affected if we were to suffer adverse results from our operations or lose a material portion of our affiliated practices, if our affiliated practices were to suffer adverse results of operations or a material loss of patients, if we suffer adverse outcomes from pending litigation and other contingencies, if we are unable to replace our bridge credit facility on favorable terms or if we violate the covenants and restrictions to which we are subject under our revolving line of credit and bridge credit facility.

New Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board (FASB) issued Statements of Financial Accounting Standards No. 141, “Business Combinations,” and No. 142, “Goodwill and Other Intangible Assets,” effective for fiscal years beginning after December 31, 2001. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, and prohibits the use of the pooling-of-interests method for such transactions. SFAS 142 requires that goodwill and intangible assets with indefinite lives, including such assets recorded in past business combinations, no longer be amortized to earnings, but instead be tested for impairment by measuring the reporting unit at fair value with the initial impairment test performed within six months from the beginning of the year in which the standard is adopted. SFAS 142 also requires that the impairment test be performed at least annually thereafter, with interim testing required if circumstances warrant. Intangible assets with finite lives will continue to be amortized over their useful lives and reviewed for impairment. We applied provisions of SFAS No. 141 and No. 142 in accounting for the November 9, 2001 business combination with OrthAlliance, and did not amortize goodwill arising from the combination in accordance with SFAS No. 142. On January 1, 2002, we adopted SFAS No. 141 and No. 142. We have not completed our initial evaluation of impairment of this goodwill required under SFAS No. 142. Based on our preliminary evaluation, we do not believe that our existing goodwill balance is currently impaired under the new standard; however, no assurances can be given regarding future impairment. We anticipate completing the initial evaluation by June 30, 2002, which is within the six month transition period allowed under SFAS No. 142.
     In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which addresses the financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of” and provisions of APB Opinion No. 30, “Reporting the Results of Operations – Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” for the disposal of a segment of a business. We adopted SFAS No. 144 on January 1, 2002, which did not impact our financial position or results of operations.
     We adopted SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, on January 1, 2001. As we have no derivatives, there was no financial statement impact.

Quantitative and Qualitative Disclosures about Market Risk
The market risk inherent in our market risk sensitive instruments is the potential loss arising from adverse changes in interest rates and foreign currency exchange rates. All financial instruments that we hold described below we hold for purposes other than trading.
     We adopted Financial Accounting Standards Board Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, on January 1, 2001. We do not currently hold any derivative instruments and, accordingly, do not believe that this adoption will have a material impact on our financial reporting.

Interest Rate Risk
Our lines of credit and amounts due from affiliated practices expose our earnings to changes in short-term interest rates since the interest rates on the financial instruments are variable. For lines of credit, if (i) the variable rates on our financial instruments were to increase by 1% from the rate at December 31, 2001, and (ii) we borrowed the maximum amount available under our lines of credit ($153 million) for all of 2002, solely as result of the increase in interest rates, our interest expense would increase, resulting in a $960,709 decrease in net income, assuming an effective tax rate of approximately 37.8%.
     This analysis does not consider the effects of the reduced level of overall economic activity that could exist in such an environment, or the effect of such a change in interest rates as of another or future date. Further, in the event of a change of such magnitude, we would likely take actions to further mitigate our expose to the change.

Foreign Exchange Risk
We typically do not hedge our foreign currency exposure. Our foreign operations generated an immaterial loss during 2001. Funds generated from our foreign operations in 2001 were retained in those countries to fund operations. We believe that our exposure to foreign currency rate fluctuations is not currently material to our financial condition or results in operations.

Market for Our Common Equity and Related Stockholder Matters
Our common stock is listed on the New York Stock Exchange under the symbol “OCA.” The following table sets forth, for the periods indicated, the range of high and low sale prices per share for our common stock, as reported on the New York Stock Exchange.

		High		Low

2001:
First quarter	$	31.31	$	18.50
Second quarter		32.98		16.80
Third quarter		32.25		21.65
Fourth quarter		32.00		22.50

2000:
First quarter	$	20.25	$	11.06
Second quarter		27.44		15.63
Third quarter		35.31		21.94
Fourth quarter		34.94		23.44

At March 28, 2002, the last reported sale price of our common stock was $27.61 per share, and the number of holders of record of our common stock was approximately 235.
We have never declared or paid cash dividends on our common stock. We expect that any future earnings will be retained for the growth and development of our business. Accordingly, we do not anticipate that we will declare or pay any cash dividends on our common stock for the foreseeable future. The declaration, payment and amount of future dividends, if any, will depend upon our future earnings, results of operations, financial position and capital requirements, among other factors. In addition, our revolving line of credit does not permit us to pay cash dividends.

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