Hanger Orthopedic pays coupon, sees covenant problems over by Labor Day

By Paul Deckelman

New York, Aug. 17 - Hanger Orthopedic Group Inc. is scheduled to meet with its lenders Wednesday, and expects to resolve the issues arising from its noncompliance with credit facility covenants by the Labor Day weekend at the latest, although it will seek restored access to its blocked revolving credit line even before that.

The company also said that it made the scheduled interest payment on its 10 3/8% senior notes due 2009 and has "sufficient " liquidity to continue operations until it can get more financial relief from its lenders.

The company's treasurer, Jason P. Owen, told analysts and investors on an unusually long morning conference call following the release of second-quarter results that the Bethesda, Md.-based operator of orthopedic medicine and prosthetic treatment centers is in violation of its total leverage covenant tests in its credit revolver and term loan B facilities, which say leverage cannot be more than 4.75 times the company's earnings.

He said that Hanger had a preliminary conference call with its bank group last Friday "to discuss certain timing events" and has a more comprehensive conference call with the lenders slated for Wednesday afternoon. During that call, he said that the executives would go through the company's financial performance and make a detailed pitch for amendments to the facilities that would get the company back in compliance.

"We would expect resolution of this matter before the Labor Day weekend," Owen said, noting that would restore the company's access to its credit revolver, currently in limbo because of the covenant violation. The company's chief financial officer, George McHenry, said that as a matter of fiduciary responsibility Hanger would ask the banks for a forbearance agreement, which would restore access to its credit line, before it gets the credit facility amendments it needs.

"We want to give everybody time to be comfortable with the numbers and projections they are given before they are asked to make any changes to the agreement," McHenry said. "We would expect to get that sooner than the date of the amendment."

In answer to an analyst's query about what Hanger would be looking for from the banks in the way of resolution, Owen said that "the Number One thing we have to fix" is curing the covenant default, "whether that means a waiver or an amendment, we'll walk through that in the coming weeks." He declined to be any more specific, saying such discussions in a public forum like a conference call would be premature. He told another analyst that until the company and the banks actually came to an agreement on how to fix the covenant problem he could not say what the credit availability under the restored revolver would likely be.

The banks' analysis

He did say, in answer to another question, that the banks' analysis of the company "is very similar" to the way analysts study a company's results to see which way it is headed. Discussion would most likely center, he said, on "what is [Hanger's] current baseline run rate? What are the opportunities for improvement, both in sales and in profitability? We'll walk them through that" Wednesday.

"We will put out a business plan and discuss the needs of the company. We will operate in that band," he told another questioner seeking some insight as to what would go on at Wednesday's bank meeting.

There was one particularly sharp exchange, as an analyst on the call said it "boggled" his mind that the Hanger executives had let the situation go as far as it did, to the point where the company slid into non-compliance with a financing covenant and had its access to its credit revolver blocked. Even with all of the things going on, including federal investigations into allegations of purported billing irregularities, "why was it so close and why weren't you working with the banks on this on an earlier basis?" he demanded to know.

Owen responded that as of the end of the first quarter in March, the leverage ratio stood at 4.39 times earnings, still comfortably under the 4.75x violation threshold, and debt was actually reduced during the second quarter to $420 million from $439 million the quarter before.

"The earnings [reduction in the second quarter] drove the covenant violation," he said.

Lack of specific figures

At the same time, Hanger was having trouble coming up with definitive figures to bring to its lenders, given the impact of the widely publicized allegations about billing problems at one of its locations, in West Hempstead, N.Y., which sparked the federal investigations, and other factors.

"We did not have a number to take to the banks, as it related to West Hempstead, as it related to payor adjustment, as it related to our bottom-line profitability, until we went to the agent bank a few weeks ago and discussed our prognosis," he explained.

Owen said that the company also "got on the phone with the banks last week and discussed our liquidity position and our timeline and our expected timeline going forward, and now we're going to meet with them [Wednesday] and go through the items that we need to address."

The treasurer said that the revised credit agreement expected to emerge from the negotiations with the lender group would be filed with the third-quarter 10-Q report to the Securities and Exchange Commission.

"Sufficient" liquidity

Owen said that Hanger expects to have "sufficient" liquidity to carry on normal operations, at least until it reaches agreement with the bank group.

McHenry said "we have adequate cash flow" to carry the company through until the credit line is restored, noting that the company is not scheduled to make a large bonus payment to its physician practitioners until the end of the quarter.

The company balance sheet showed $18 million of cash as of this past Friday, which allowed Hanger to make the scheduled $10.375 million semi-annual coupon interest payment on its $200 million of 10 3/8% notes when it came due on Monday. The cash balance as of Tuesday morning, he said, was about $8 million, following the Monday bond payment.

McHenry said that the company's cash balance at the end of June was $1.2 million, after the company paid down $13.5 million of outstanding revolver debt during the quarter, bringing the revolver balance to $40.5 million at the end of the quarter.

He noted that cash flow from operations increased by almost $20 million in the quarter from year-earlier levels.

"You had strong cash flow and that ties in to the reason why we had $13.5 million to pay down the revolver during the quarter," he said.

Besides discussion of its credit covenant situation and other debt and liquidity questions, the company reported that net sales for the quarter rose $6.2 million to $145 million versus $138.9 million a year earlier. However, gross profit fell to $73.2 million, or 50.4% of sales in the latest quarter, from $73.5 million (52.9% of sales) in the year-ago period. Net earnings declined to $2.2 million (10 cents a share) from $7.8 million (34 cents a share) a year ago.

Downplay effects of billing problem

The Hanger executives also downplayed the likely impact of the billing irregularities problem, which came to light in mid-June, when a New York television station reported on allegations of irregularities made by an employee in suburban West Hempstead, one of the company's 614 centers. The U.S. Attorney's office for the Eastern District of New York opened an investigation, subpoenaing records regarding billing activities at various locations, the SEC began a probe and the company retained an outside law firm to conduct its own independent investigation.

Hanger's president and chief operating officer, Tom Kirk, said that "based on the preliminary results of the [company's own] investigation, management believes that any billing discrepancies are likely to be primarily at West Hempstead. Based on the preliminary results of this investigation, management does not believe that the resolution of the matters raised by the allegations will have a material adverse effect on our financial statements."

Kirk noted that sales at that the particular center totaled $1.6 million in calendar year 2002, $1.9 million in calendar 2003 and about $900,000 for the first half of 2004, or about four-tenths of 1% of the company's overall net sales.

Multiple issues prompted earnings delay

McHenry explained that the company had delayed the release of the second-quarter numbers, originally scheduled for last Monday, Aug. 9, because it had to deal with the allegations surrounding the West Hempstead center and the federal scrutiny of billing activities at other centers, as well as a separate accounting issue arising from the recent consolidation of what had been 15 different billing and cash-collection systems into one new system, the OPS.

He said that OPS gave the company a clearer view of its collection and receivables process, and Hanger came to the realization that some receivables previously considered collectable were in fact uncollectable. Because earning statements for past periods would be affected, since receivables had been overstated and bad-debt expense underestimated - and the same was true as well for the earnings data for the second quarter, the company chose to delay filing its results while it tried to sort the whole problem out.

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